Free Essay Are financial accounting statements useful to investors?

majorfinance · Uploaded by **majorfinance** on Jun 19, 2005

Are financial accounting statements useful to investors?

1.1 Introduction

Financial accounting statements are summaries of monetary data about an enterprise and are used in an attempt to help make informed decisions in the present and future.

Financial statements portray the effects of transactions and other events by grouping them into broad classes (or elements) according to their economic characteristics.

The three basic financial statements are the balance sheet, the income statement and the cash flow statement. There are many different entities that utilise financial statements. Financial statements may be drawn up for private individuals, non-profit organisations, manufacturers and service industries. Three major groups that take advantage of the usefulness of financial statements are large corporations, investors and the government.

Financial statements play a decisive role in each of these entities financial decisions. Corporations decide how much credit to extend to customers and how much should be distributed to investors in dividends. Investors use a company's financial statements to decide whether or not it would prove advantageous to invest their money, and if so, how much. The government uses financial statements to determine how much an entity is required to pay in taxes.

Each decision as stated above does not always require the same financial statement, however. A balance sheet would be used in the decision-making process for assessing a competing firm and determining a customer's credit limit. It provides the user with data about available resources as well as the claims to those resources. An income statement would prove useful in determining credit extension to customers, distribution of dividends, taxes and investment opportunities. It provides the user with data about the profitability of the enterprise detailing sources of revenue and the expenses which reduce profit.

A cash flow statement would be a useful tool in each instance because it gives a brief description of how much cash is coming in, going out and to where exactly. It reports cash flows from investing, financing, or operating activities. Although each one is unique in its own respect, each financial statement is a necessary tool in making any financial decision.

1.2 Financial reporting, investors, limitations of accounting

Investors are generally considered one of the primary users of financial statements. They use the financial statements to determine the current profitability of the firm and attempt to predict its future profitability. Their interest is in the future growth of a company's stock price and/or the likelihood of the company paying dividends to the owner.

To be useful to investors financial reporting should provide information about the economic resources of an enterprise, the claims to those resources (obligations of the enterprise to transfer resources to other entities and owners' equity), and the effects of transactions, events and circumstances that change resources and claims to those resources.

It should provide information that is useful to potential investors in making rational investment and similar decisions. The information should be comprehensible and help investors assess the amounts, timing and uncertainty of prospective net cash flows to the related enterprise.

It should provide information about an enterprise's financial performance during a period. Investors often use information about the past to help in assessing the prospects of an enterprise. Thus, although investment decisions reflect investors' expectations about future enterprise performance, those expectations are commonly based at least partly on evaluations of past enterprise performance.

Financial reporting should provide information about how an enterprise obtains and spends cash, about its borrowing and repayment of borrowing, about its capital transactions, including cash dividends and other distributions of enterprise resources to owners and about other factors that may affect an enterprise's liquidity or solvency.

All financial reporting is concerned in varying degrees with decision making. The need for information on which to base investment underlies the objectives of financial reporting. The usefulness of information must be evaluated in relation to the purposes to be served and the objectives of financial reporting are focused on the use of accounting information in decision making.

Financial information is relevant if it is appropriate to its expected use. It is relevant if used to assist with decisions, including ability to provide feedback and to predict. It its important that the financial statements do not become cluttered with trivial disclosures. Otherwise the overall usefulness of the financial statements will decline.

Although financial statements provide information useful to investors, they have some limitations.

A critical assumption in the use of financial statements is often made that the past will predict the future. For trends that have continued for many years this will usually be true, but what is happening with fast moving and growing markets? Investors often try to estimate the future performance of the company based on previous information, but there is no guarantee that the company would perform as expected because nobody can predict the uncertainties of the changing world in general.

Further financial statements should report enough information for outsiders to make well-informed decisions about the company. Even though financial statements are disclosed at least once annually, semi-annually or quarterly, there is a lapse period between one disclosure and the next. Within this short lapse, there could be major changes in a company's finances which are not yet revealed to the public before the next disclosure.

Thus potential investors would not be able to make a continual assessment of the company; their decisions would have to be based on the latest financial statements if the company does not make any non-obligatory updates.

1.3 Conclusion

Concluding we can say that financial statements provide useful information for potential investors but they have to be considered carefully as they have some limitations. Within a decision-making process investors have to consider all financial statements at the same time as no single one statement tells the whole story. The income statement, for example, provides an incomplete picture of performance without reference to the balance sheet or the cash flow statement. As a result, investors and others need information from each of the statements to make their decisions.