Nature, Function, Objectives, Benefits, Limitations of financial Reporting

Financial Reporting may be defined as communication of published financial statements and related information from a business enterprise to third parties (external users) including shareholders, creditors, customers, governmental authorities and the public. It is the reporting of accounting information of an entity (individual, firm, company, government enterprise) to a user or group of users.

Company financial reporting is a total communication system involving the company as issuer (preparer); the investors and creditors as primary users, other external users; the accounting profession as measurers and auditors; and the company law regulatory or administrative authorities.

Nature

• Accounting Conventions:

\Accounting Standards prescribe certain conventions applicable in the process of accounting. We have to apply these conventions while preparing these statements. For example, the valuation of inventory at cost price or market price, depending on whichever is lower.

• Recorded facts:

We need to first record facts in monetary form to create the statements. For this, we need to account for figures of accounts like fixed assets, cash, trade receivables, etc.

• Postulates:

Apart from conventions, even postulates play a big role in the preparation of these statements. Postulates are basically presumptions that we must make in accounting. For example, the going concern postulate presumes a business will exist for a long time. Hence, we have to treat assets on a historical cost basis.

• Personal judgments:

Even personal opinions and judgments play a big role in the preparation of these statements. Thus, we have to rely on our own estimates while calculating things like depreciation.

Function

• Investment Decisions

Investors use the information to decide whether to invest, and the price per share at which they want to invest. An acquirer uses the information to develop a price at which to offer to buy a business.

• Credit Decisions

Lenders use the entire set of information in the financials to determine whether they should extend credit to a business, or restrict the amount of credit already extended. Financial statements may sometimes be used as the basis for terminating an outstanding loan.

• Taxation Decisions

Taxation decisions. Government entities may tax a business based on its assets or income, and can derive this information from the financials.

• Subsidiary Evaluations

Financial statements can be presented for individual subsidiaries or business segments, to determine their results at a more refined level of detail.

• Union Bargaining Decisions

A union can base its bargaining positions on the perceived ability of a business to pay; this information can be gleaned from the financial statements. Thus, a union may not push too hard if an employer has suffered losses for several years in a row.

Objectives

An evaluation of company financial reporting requires some agreement on its objectives. Financial reporting is not an end in itself but is a means to certain objectives.

The objectives of financial reporting and financial statements have been discussed for a long time. While there is no final statement on objectives, to which all parties (of financial reporting) have agreed, some consensus has been developing on the objectives of financial reporting.

At present, the following may be described as the primary objectives of financial reporting:

(а) Investment Decision-making.

(b) Management Accountability.

(a) Investment Decision-Making:

The basic objective of financial reporting is to provide information useful to investors, creditors and other users in making sound investment decisions. These decisions concern the efficient allocation of investment funds and the selection among investment opportunities.

The True-blood Committee stated that “…the basic objective of financial statements is to provide information useful for making economic decisions.” Recently, the FASB (USA) in its Concept No. 1 also concluded that financial reporting should provide information that is useful to present and potential investors and creditors and other users in making rational investment, credit and similar decisions.

It is essential to have an understanding of the investment decision process applied by external users in order to provide useful information to them. The investors seek such investment which will provide the greatest total return with an acceptable range of risk. Investment return is comprised of future interest or dividends and capital appreciation (or loss).

The investors while making investment decisions aim to determine the amount and certainty of a company’s future earning power in order to estimate their future cash return in dividends and capital appreciation. Earning power is the ability of a business firm to produce continuous earnings from the operating assets of the business over a period of years, which may differ from accounting net income.

The financial statements and other business data are analysed in relation to the enterprise’s environment to project this future earning power. Investors compare returns on alternative investments relative to risk, which (risk) is the degree of uncertainty of future returns. The risk premium is a measure of uncertainty which is defined as the possible variation of the actual from the expected return.

The investment decision process may be pictured as a three-legged stool. One leg is the analysis of the company and its securities and of the industry in which it operates. The second is the assessment of the economic environment, including the business outlook, financial markets and interest rates, international trade and finance, and political and regulatory developments.

The third is the portfolio decision in which these two streams of information are integrated into an investment appraisal related to the objectives of the investor individual or fund.

Portfolio decisions sort out expected rates of return relative to risk, as the investor (portfolio manager) seeks that combination of securities which will produce the highest total return available within the risk constraints adopted for the portfolio. In this continual winnowing process, investment funds tend to flow toward the most favourably situated companies and industries and away from the weaker and less promising areas.

Investment decision and investment values, both, are comparative, not absolute. In all investment decisions, comparison is made in order to determine the most attractive (greatest) returns in relation to risk first, comparison between one type of security us. another; second, comparison between one company vs. another within each category; third, comparison within a company over time.

Comparison requires uniform standards of measurement. Where different accounting measurements are used in similar situations, investors and financial analysts make their own accounting adjustments to achieve comparability, provided adequate information is available to do so.

But the attribute of comparability can be achieved at a lower cost (associated with financial reporting system), and with equal benefit for all investors, by eliminating the alternatives.

(b) Management Accountability:

A second basic objective of financial reporting is to provide information on management accountability to judge management’s effectiveness in utilizing the resources and running the enterprise.

Management of an enterprise is periodically accountable to the owners not only for the custody and sale-keeping of enterprise resources, but also for their efficient and profitable use and for protecting them to the extent possible from unfavorable economic impacts of factors in the economy such as technological changes, inflation or deflations.

Management accountability is of very great interest not only to existing shareholders and other users but also to potential shareholders, creditors and users. A company generally offers shares, debentures etc., to the prospective investing public and therefore it should accept accountability responsibilities to prospective investors also. Certainly annual and other financial statements is intended to play a major role in this regard.

The management accountability concept includes information about future activities, budgets, forecast financial statements, capital expenditure proposal etc. Accountability is beyond the narrow limits of companies’ regal responsibilities to shareholders (and sometimes debenture-holder and creditors).

It obviously includes the interests of persons other than existing shareholders. Management is accountable for the values of assets as well as for their costs. In this way, the financial statements not only inform but also protect the various interests of the shareholders and other users.

There is a school of thought which contends that financial accounting and reporting based on ‘decision-making’ may differ from financial accounting and reporting based on ‘accountability objective’.

This is because decision-making objective and accountability objective differ from each other in some respects such as the following:

Firstly, ‘economic decision-making objective’ focus on the contents of financial statements and how the information reported therein are useful to economic decisions. This objective emphasises more the reliability of information than the accounting system used in producing financial statements.

For instance, cash balance appearing on a balance sheet, if it reflects actual cash balance, will contribute to the decision-making objective and it is immaterial whether cash balance has been determined on the basis of cash book or after mere cash count at the end of an accounting period.

On the other hand, ‘management accountability objective’ mainly emphasises accounting system and procedures used in producing financial statements and other related information. It implies that financial statement figures are supported by adequate documents, records and system.

Secondly, the decision-making objective assumes that the accountant should aim at serving the decision-makers’ informational requirements. That is, his task is to design an information system which is most useful to users in helping them to make sound decisions.

Benefits

• Better Transparency of Records:

It helps the organization present better to increase the transparency of records.

• Helps in Ratio Analysis:

It helps in ratio analysis so that the trends can be compared with the industry and measure performance.

• Improved Legal Compliance:

It improves legal compliance as the organization can comply with more legal formalities due to public presentations.

• Better Decisions:

It helps to make better decisions to safeguard investments.

Limitations of Financial Reporting

• Comparable Not Presented:

In the financial reporting presentation, only the current year’s data is presented. Comparison with the previous year is not reflected hence it becomes difficult for investors to compare.

• No Discussions of Non-Financial Data:

Non-financial data is not presented and reported in the financial reporting framework. Hence the important non-financial data remains unaffected.

• Presented for Specific Time Period:

It is presented for the period mentioned instead of from the beginning to the end of the period to make a better clear picture.