Financial statements Essay Example

Financial statements

Executive Summary

Financial statements are used by different stakeholders to obtain information about the financial health of the organization. The three main financial statements include the balance sheet, cash flow statements and income statement. All the financial statements have strengths as well as weaknesses. The main strength of the financial statements is the ability to provide information about the financial performance of the organization. The revenue being collected by an organization can be provided by the income statement. The financial prospects as well as the financial ratios can be obtained through the use of a balance sheet. The cash that the organization is receiving or paying out can be determined through the use of a cash flow statement. The main weakness of all the financial statements is the risk of manipulation of the information or false representation. The financial statements can be used by organizations to falsely indicate that the company is performing well. It is also evident that the financial statement cannot be used to predict or forecast the future financial performance of an organization. Lack of ethics as in the case of Enron Corporation may lead to the misuse of the financial statements. None of the single financial statements can be used effectively on its own as it cannot provide all the information required by the stakeholders. All the three financial statements should be used in order to obtain adequate financial information of an organization.

Introduction

Financial statements play an important role in provides useful information to different stakeholders. Financial information of the organization can be obtained in the financial statements. There are several types of financial statements that can be used to provide the stakeholders with the financial information. The three main financial statements include the balance sheet, income statement and cash flow statement (Joo, et al, 2014). The balance sheet is used to report the financial position of a business at a specific time point in time. The income statement reports the results of earning activities for a specific period of time. The cash flow statement reports the cash inflows and outflows from operating and other activities over a reporting period. The financial information therefore plays an important role in enabling the stakeholders to make decisions. However, the financial statements have both strengths and weaknesses. This has the potential of affecting the decisions made by the stakeholders. The case of Enron Corporation highlighted one of the major weaknesses of financial statements (Brown, 2012. Other factors such as ethics also need to be considered when sealing with the financial statements. The paper critically discusses the strengths and weaknesses of financial statements in relation to its use by different stakeholders.

Discussion

Strengths

According to Penman (2013), a balance sheet is formatted in a way that allows the investors to obtain crucial information about the financial situation of the company. An informed opinion about the return prospects as well as the possible risk at the company can be determined through the use of a balance sheet. This information may therefore influence the decision of the investor on whether or not to invest at the company. Financial ratios can be calculated based on the information that has been provided in the balance sheet. The financial ratios provide useful information that can be used to determine the financial health of the organization. The information about the financial health of the company enables the investors to know whether the profits or losses are being made.

Warren and Young, (2011) point out that most of the investors are usually interested in investing in an organization that is making profits. The cash position of the company can be determined through the use of the balance sheet. The information such as liquidity, leverage, working capital and cash position can be obtained from the balance sheet. This information is important to the investors in determining whether the company is likely to default on its credit obligations. The risk of bankruptcy can also be determined by the investors using the information obtained from the balance sheet (Young, et al, 2011). The asset turnover rate of the company can be accessed through the use of the balance sheet. This is an important measure of how effectively the assets at the company are used. Return on equity which is an important profitability measure can also be established through the use of a balance sheet (Warren & Young, 2011).

Income statement has strengths in terms of providing revenue information. The income statement is thorough and it provides detailed information about the revenue of the organization (Botzem, 2012). It also accounts for the normal costs that are associated with managing operations as well as the additional costs which may involve taxes. The revenue gained from interest accrued by business investment is also reflected in the income statement. This is therefore an ideal source of revenue information for the shareholders and investors. According to Botzem (2012), income statement provides useful information that can be used by the investors who are interested in buying stock. The information about earnings per share is provided in the income statement (Smith, 2014). Investors are interested with higher earnings per share as it indicates that the business is more valuable. The investors can therefore make decisions based on the information available in the income statement. The investors can use the information to determine the level of competitiveness of the company in terms of its stock. The information about the past financial performance of the organization can be obtained through an income statement. This information may be used by the investors for predicting the future performance of the organization. Rahman, (2013), argues that the information about the income and expenses of the organization can be obtained through the use of the income statement. The information can be used by the shareholders to determine the effectiveness of resource utilization within the organization. Income statement is thus useful for the investors in determining the revenue being generated by the organization.

Cash flow statement provides useful information about the ability of an organization to generate cash. The cash flow statement provides direct information to the stakeholders about the issues related to cash (Weiping, 2013). The creditors can obtain information about repayments of debts as well as the overdue accounts from the cash flow statement. The management can also use the information from the cash flow statement to make decisions elated to future cash flow. The employees can also be in a position to know whether the organization will be able to pay their wages and salaries (Reeve, et al, 2012). The cash flow statement can also provide information about the future projections or forecasts. This is important to the investors in terms of determining where the organization is likely to perform well in future. The investors in most cases are concerned about the future of the company. The cash flow information is difficult to manipulate as compared to the other financial statements. This is because it represents the cash in and the cash out without the effects of accounting policies. The sources of the cash are clearly indicated in the cash flow statement which may make it difficult for the organization to be engaged in fraud or illegality (Wild, Shaw & Chiappetta, 2012). The quality of the revenue of the entity can be provided in details through the use of the cash flow statement. This may include information such as the payment of bills by the customers. Non accountant such as employees and any other stakeholders can easily understand the information provided in the cash flow statement (Wild, Shaw & Chiappetta, 2012).

Weaknesses

The balance sheet is a considered as a snapshot of the financial position of a company at a given point in time (Edwards, 2013). This has the potential of providing misleading information to the customers. The cash position of a company may appear high at the end of the year however; this does not necessarily mean that the company is likely to perform well in the next years. This is because the company could e intending to distribute a large amount of cash to the shareholders in form of a dividend. Such intentions cannot be established through the use of a balance sheet. Investors may therefore end up investing based on misleading information. The balance sheet alone cannot be used to make satisfactory decisions as it does not provide benchmark data (Kimmel & Kieso, 2013). Benchmark data is required in order to make comparisons with peer companies. Fair market value is not adequately reflected in the balance sheet. The information provided in the balance sheet regarding the fixed assets is based on the historical cost. This involves the amount that the asset was purchased for. The changes that have taken place over time are not reflected and hence making it impossible for the balance sheet to provide a reflection of the fair market value. The lack of fair market value impacts negatively on the accuracy of the information provided in the balance sheet (Pashang, Österlund & Johansson, 2014). The balance sheet may therefore fail to provide adequate information about the actual position of the organization.

The information provided in the income statement has several weaknesses which may affect its use by different stakeholders. The income statement may different depending on the method used to carry out the calculations. The use of FIFO or LIFO accounting methods to measure inventory may produce different results (Becker & Steinhoff, 2014). This has a direct impact on the accuracy of the figures provided to the stakeholders. During the preparation of the income statement, judgments and estimates are usually made depending on the expertise and views of the accountant. This may therefore lead to the provision of misleading information. The accountant may make wrong estimates or judgments intentionally in order to portray a healthy financial image of the company (Needles, Powers & Crosson, 2012). This was the case of Enron Corporation which led to massive losses among the shareholders. The misrepresentation of value is thus a major problem with the income statement and this is dependent on the levels of ethics within the organization. In organizations where the level of ethics is low, the income statement provided may not represent the actual financial position of the organization. The income statement does not provide information that may be used to determine the future success of the company. This increases the risk for the shareholders who are using the income statement. The information about how a company makes its sales is not provided in the income statement (Schmidgall & Yu, 2013). This means that the companies could be involved in illegalities but the shareholders may not know about it.

The cash flow statement can be used by the organization to inconvenience other stakeholders. In most cases some of the companies delay the payment of the suppliers in order to increase the net cash inflows (Kimmel & Kieso, 2013).This is an indication that the information provided may not be accurate and it can be misleading. The investors may end up obtaining the wrong impression of the company if the cash flow is used for decision making. The organizations may also opt to use lease agreements when making purchase in order to avoid paying cash (Penman, 2013).This is to avoid the incidences of the cash being reflected in the cash flow statement. This is an indication that cash flow is still open to fraud in an organization that is not ethical. The cash flow does not entirely reflect the earnings of the entity. This means that it may not provide the investors or shareholders with all the information that they require about the organization. The cash flow statement also ignores the accrual or matching concepts which is important in accounting (Weiping, 2013). The single financial statements cannot be used on their own to provide information about the financial performance of the organization. It is for this reason that most of the stakeholders prefer using all types of financial statements. Assessing the financial performance of an organization requires an in-depth analysis of all the financial statement. The levels of accuracy of the financial information of an organization can be obtained through the proper analysis of all the financial statements.

Conclusion

In conclusion, it is evident that there are different types of financial statements that can be used to provide the financial information of an organization. The financial health of the organization can be determined through the use of financial statements. Each of the financial statements has its strengths as well as weaknesses. The main strength of the balance sheet is its ability to provide information about the prospects of the organization as well as its possible risks. However, it is apparent that the balance sheet may not provide adequate information about the financial health of the company. It can also be noted that the main strength of the income statement is its ability to provide information about the revenue being collected by the organization. The information can be used to determine the profits and losses within an organization. It is evident that the main weakness of the income statement is prone to manipulation. The manipulation of the financials information has the potential of misleading the stakeholders. It is evident that the income statement can only be effective if the levels of ethics within an organization are high. The Cash flow statement also has some strengths as well as weaknesses. It is worth noting that it has the ability to provide the stakeholders with information about the cash in and cash out. Nevertheless, its main weakness is its inability to provide clear information about the future of the organization.

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