Investing

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Jun 19, 2005

Are financial accounting statements useful to investors?

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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