Why accurate financial statements are important to business interests

¶ … Financial Statements

Importance of Financial Statements

The Importance of Accurate Financial Statements to Outside Business Interests

The four financial statements are the balance sheet, income statement, statement of cash flow, and statement of owner's equity. All of these statements are interactive even though they each serve a unique purpose. They are intended to assess the health of a business and their accuracy is vitally important to investors, creditors and other outside interests. The income statement, statement of cash flow, and statement of owner equity, close out at the end of each year. The balance sheet amounts are carried over from year to year (Kurtz, 2010).

Discussion

Both internal and external entities use these statements in order to inform the decision making process. These documents provide pertinent information on the financial position (balance sheet), profitability (income statement), and operating, investing, and financing activities (statement of cash flow and statement of owners equity) of a company. No one statement is enough to provide sufficient information to get a complete picture of a company's financial position, however, taken together the analyst has the information needed to understand the company's profitability, operating, investing, and financing activities (Horngren, Harrison, & Oliver, 2012).

Briefly, the balance sheet is comparison of assets to liabilities and equity. This statement is indicative of a company's position at a specific time. The income statement is a record of a company's operations over a given period of time. It shows a company's expenses, losses and revenues and is indicative of the company's net income during that period of time. The statement of cash flows is intended to provide information about a company's cash receipts and cash payments for operations, investments and financing during an accounting period. Finally, the statement of owner's equity is intended to show changes in owner's or shareholder's equity from one fiscal year to the next. Owner contributions and any additional capitol, such as the sale of new shares, are added to the equity, while dividend payments and owner withdrawals are subtracted. Financial statements are generally supplemented by information from management to explain anomalies in revenues that may have occurred during the course of the accounting period (U.S. Security and Exchange Commission, 2007).

Many financial reports, or the accounts and data they represent, are subject to various regulations and standards from organizations such as the Securities Exchange Commission (SEC), the Financial Accounting Standards Board (FASB), and the International Accounting Standards Board (IASB) (Wild, Shaw, & Chiappetta, 2009). Much like any language, financial statements could have their own dialect. For example, knowing about the use of cash-based accounting vs. accrual based accounting could impact some very serious business or investment decisions. The various regulations, standards, and Generally Accepted Accounting Principles (GAAP) help to provide uniformity.

All GAAP standards are based on four basic principles: consistency, relevance, reliability, and comparability. Consistency means that all data should be collected and presented in the same manner across all periods. Any change in the way in which specific data are collected or presented must be noted and explained. Relevance states that all information being reported should be appropriate assist users in evaluating that information. Reliability implies that the accounting data presented in financial statements is reliable and can be verified by an independent party such as an outside auditor. Comparability ensures that one firm's financial statements can be compared with those of a similar business (Kurtz, 2010).

In the United States the Financial Accounting Standards Board (FASB) is primarily responsible for evaluating, setting, or modifying GAAP. The U.S. Securities and Exchange Commission (SEC) is the statutory authority charged with establishing financial accounting and reporting standards for publicly held companies, however, the SEC's policy has been to rely on the accounting industry for this function (Kurtz, 2010).

Specifically, these statements are used by shareholders, executives, employees, investors, potential lenders (such as banks or vendors), and any other persons or institutions that needs to analyze a company's financial well-being. These interested parties may use financial statements for diagnostic purposes, with different interests scrutinizing different ratios. An investor could look at inventory turnover. An excess of inventory may indicate excessive storage and/or spoilage. On the other hand too little inventory could be a sign of potential loss of sales and customers due to stock shortages. Managers may look at the same data in order to regulate the flow of production.

A company's credit manager might focus on the rate of turnover in accounts receivable in order to assess a company's credit policies. Others may evaluate the sales-to-fixed-assets ratio, a high ratio reflects efficient use of money invested in plant and other productive or capitol assets. Corporate leaders, investors, and stockholders tend to look at overall profitability in order to judge performance. Many investors look to for a high payout ratio; however some speculators interested in long-term investments may be more interested in stock values as growth companies tend to have a low payout ratio because they reinvest their earnings.

Government officials generally focus their attention on compliance issues related to valuation regulations and the fair representation of taxable income. Collective bargaining organizations look for revenue sources that may be tapped to increase the wages and benefits of their members. Buyers of bonds look for indicators of long-term solvency, whereas short-term creditors pay special attention to cash flow and short-term liquidity. Both long and short-term investors look for companies that have low leverage ratios such as debt to total assets (Lasher, 2008).

There are two principal methods of keeping track of a firm's income and expenses, the cash method and the accrual method. These methods differ only in the timing of when sales and purchases are credited or debited to business accounts. The cash method requires that income is counted when cash is actually received and expenses are counted when actually paid. The accrual requires that transactions are counted when they happen, regardless of when the money is actually received or paid.