WHAT ARE FINANCIAL STATEMENTS USED FOR AND HOW?

The question of what financial statements are used for is an important one as it raises awareness as to the importance accounting as a whole. Many debates went on in the past and are in fact still going on now amongst academics and professional accountants on the relevance of accounting numbers. This whole argument was triggered by the classical work of Ball and Brown of 1968. The bone of contention was if the release of accounting information has any impact on share prices and shareholders wealth. Well, this article will not join in such debate but will rather collate the various uses that the financial statements can be put into. Before that is however done, it will be wise to briefly discuss how financial statements are used. Hence,

HOW TO USE FINANCIAL STATEMENTS

Financial statements can be used both as a qualitative tool as well as a quantitative tool. The most appropriate way to use a financial statement is to leverage on both the qualitative as well as the quantitative element of it.

Accounting information as contained in the financial statements is not supposed to be used in their raw state without firstly doing some analysis and adjustments. This is a bitter fact that every user of accounting information will have to bear with. An average user of accounting information is battling with at least two bottlenecks. Those bottlenecks are (1) inflexibility caused by legislation, and (2) financial statement noise caused by interior motives of managers- fraud.

The first thing to do whenever you pick up any financial statement is to look at the notes to the accounts and other documents accompanying it. This exercise will give you an indication of what the overall financial outlook of the company might be. This no doubt is an art that requires experience and dedication to learn.

Ask yourself this all important question; are things adding up? A company whose ratios have been showing signs of decline in activities and profitability cannot produce a super profitable accounting result that can be relied upon. This is not minding what the auditors might have said about the account in the auditor’s report. The crux of the matter is that subjective judgements are in most cases required for a credible financial analysis to be made. The sooner you learn to do this, the better you will become at performing quality fundamental analysis of a company or project. Now that your understanding of how financial statements are used is refreshed, let us now proceed the subject matter of this post.

7 (SEVEN) USES OF FINANCIAL STATEMENT

Financial statements can be used in several ways. Some of the most common uses of a company’s annual report are identified and briefly discussed below:

AS AN INPUT IN VALUATION

Financial statements when used properly acts as the main source of information for business valuation. Like discussed earlier, both qualitative (non financial) and quantitative information can be derived from facts and figures contained in an annual report. The whole process of business analysis starts reverse engineering of a company’s books of accounts.

INVESTMENT DECISION MAKING

Based on the outcome of the valuation process using different methods of valuation carried out above by a financial analyst or an investment accountant, high quality and reliable economic decisions can be made as far as investing decision is concerned. Different methods of valuation are used to determine a reasonable value for our target asset. This value is then compared with set standard. This process of taking good investment decision is known as investment appraisal or capital budgeting.

STATISTICAL PURPOSE

Government and other not for profit organizations uses accounting information to make out data for statistical purposes. This is however not the only source of data, but it is a significant source of data.

PLANNING AND CONTROL

Managements of businesses rely on information provided through management accounting information for planning and control purposes. Some company prepare a different statement for managerial accounting purposes. But this has over the time proved to be costly, so statutory financial statements are taken one step further to make it suitable for decision making and budgeting.

NEGOTIATION

Most business negotiations are made based on the information contained in the financial statement. This is one of the reasons why business plans most often contain a form of financial statement or the other. The logic behind this is that people trust you more when you have facts and figures to back whatever you tell them. Potential clients will award a contract to the person whose financial position can be verified.

REWARD AND REMUNERATION

Reward and remuneration system is one area of management accounting where both scholars and practitioners never agree on. Some are of the opinion that managers get motivated if they know that their rewards are remuneration is based on reported profit, while others argue that basing rewards system on financial terms can lead to suboptimal decisions being made. The fact of the matter is that neither end of the spectrum is ideal. The ideal point is somewhere at the centre. The major problem is how to identify that ideal point. To this end, financial statements are used as partial tool for motivation.

AS A COMMUNICATION TOOL

One of the main uses of financial reporting is to communicate financial information to interested parties. This is why accountants are called business communicators. The whole business process will crumble if stakeholders are left in the dark. In fact, sending reports to business owners assumed a new dimension since the advent of the ‘legal entity’ concept. This is a situation where the business is seen as a different entity from the owners. The owners must be abreast with the running of their investments hence, the need for financial statements.

CONCLUSION

We have discussed at length just to answer the question of what financial statements are used for and how they are used. Care has been taken to touch all relevant issues that might come up in discussion of this magnitude. However, knowledge acquisition is not something that you start and finish just in one process.

I encourage you to keep the desire for learning burning. Motivation to learn is all that you need in your quest to developing your life enhancing skills.