Introducing Financial Statements

Defining the Financial Statement

A financial statement is a formal report of the financial activities of a business, person, or other entity. Financial statements are a key component of accounting, the process of communicating information about a financial entity. Financial statements are presented and structured with conventions accepted by accounting and regulatory personnel. An entity's financial statement typically includes four basic components: a balance sheet, income statement, cash flow statement, and statement of changes in equity:

Keeping Money Organized Financial Statements help keep money organized.

1. The company's balance sheet reports on its assets, liabilities, and ownership equity. It is often described as a "snapshot of a company's financial condition" at a single point in time. Balance sheets usually present assets in one section and liabilities and net worth in the other.
   
   
2. An income statement reports a company's expenses and profits to show whether the company made or lost money. It also displays the revenues of a specific period and the costs and expenses charged against these revenues. In contrast with the balance sheet, which represents a single moment in time, the income statement represents a period of time.
   
   
3. A cash flow statement shows how changes in income affect cash and cash equivalents, breaking the analysis down to operating, investing, and financing. Essentially, the cash flow statement concerns the flow of cash in and out of the business. As an analytical tool, it helps determine a company's short-term viability.
   
   
4. A statement of changes in equity explains the company's equity throughout the reporting period. The statement breaks down changes in the owners' interest in the organization and the application of retained profit or surplus from one accounting period to the next. Line items typically include profits or losses, dividends paid, redemption of stock, and any other items credited to retained earnings.

For complex entities, financial statements often include an extensive set of notes explaining financial policies. The notes typically describe each item in detail. For example, they may explain financial figures or the accounting methods used to prepare the statement.

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Uses of the Financial Statement

Financial Statements are used for a Multitude of Different Purposes

Readers of a financial statement seek to understand key facts about the performance and disposition of a business. They make decisions about the business based on their reading of the statements. Because financial statements are widely relied upon, they must be straightforward to read and understand.

For large corporations, these statements are often complex and may include an extensive set of notes to the financial statements, an explanation of financial policies, and management discussion and analysis. The notes typically describe each item on the balance sheet, income statement, and cash flow statement in further detail. Notes to financial statements are considered an integral part of the financial statements.

Owners and managers frequently use financial statements to make important business decisions, for example:

• Whether or not to continue or discontinue part of the business.
  
  
• Whether to make or to purchase certain materials.
  
  
• Whether to acquire or to rent/lease certain equipment in the production of goods.

The documents are also helpful in making long-term decisions and as a source of historical records.

Budget One of the uses of financial statements is as a budgeting tool, as in this example.

Other individuals and entities use financial statements, too.

For example:

• Prospective investors use financial statements to perform financial analysis, which is a key component in making investment decisions.
  
  
• A lending institution will examine the financial health of a person or organization and use the financial statement to decide whether or not to lend funds.
  
  
• Philanthropies may use the financial statements of a non-profit as a component in determining where to donate funds.
  
  
• Government entities (tax authorities) need financial statements to ascertain the propriety and accuracy of taxes and other duties declared and paid by a company.
  
  
• Vendors who extend credit may use financial statements to assess the business's creditworthiness.
  
  
• Employees also may use reports in making collective bargaining agreements

Limitations of Financial Statements

Limitations of Financial Statements

Financial statements can be limited by intentional manipulation, differences in accounting methods, and a sole focus on economic measures. Some argue that financial statements are limited by inaccuracies due to intentional manipulation of figures, cross-time or cross-company comparison difficulties if statements are prepared with different accounting methods, and an incomplete record of a firm's economic prospects due to a sole focus on financial measures.

PHWC Statement of Financial Position, 2021 by Irvin Sto. Tomas

One limitation of financial statements is that they are open to human interpretation and error, sometimes even intentional manipulation of figures. In the United States, especially in the post-Enron era, there has been substantial concern about the accuracy of financial statements. High-profile cases in which management manipulated figures in financial statements to indicate inflated economic performance highlighted the need to review the effectiveness of accounting standards, auditing regulations, and corporate governance principles.

As a result, there has been a renewed focus on the objectivity and independence of auditing firms. An audit of the financial statements of a public company is usually required for investment, financing, and tax purposes, and these are usually performed by independent accountants or auditing firms and included in the annual report. Additionally, regarding corporate governance, managing officials like the CEO and CFO are personally liable for attesting that financial statements are not untrue or misleading, and making or certifying misleading financial statements exposes the people involved to substantial civil and criminal liability.

Another set of limitations of financial statements arises from different ways of accounting for activities across periods and companies. This can make it difficult to compare a company's finances across time or to compare finances across companies. Different countries have developed their accounting principles, making international comparisons of companies difficult. However, the Generally Accepted Accounting Principles (GAAP), a set of guidelines and rules, are one means by which uniformity and comparability between financial statements are improved. Recently, there has been a push toward standardizing accounting rules by the International Accounting Standards Board (IASB).

Another limit to financial statements as a window into the creditworthiness or investment attractiveness of an entity is that financial statements focus solely on financial measures of health. Even traditional investment analysis incorporates information outside financial statements to make organizational assessments. However, other methods, such as full cost accounting (FCA) or true cost accounting (TCA), argue that an organization's health cannot just be determined by its economic characteristics. Therefore, one must collect and present information about environmental, social, and economic costs and benefits (collectively known as the "triple bottom line") to evaluate accurately.