Financial Reporting: Definition, Objectives, and Importance!

The main objective of financial reporting is to provide financial information to the current capital provides to make decisions. This information might also be useful to users who are not capital providers. The general purpose financial reporting develops superior reporting standards to help in the efficient functioning of economies and the efficient allocation of resources in capital markets.

General-purpose financial reporting focuses on an extensive range of user’s needs that cannot obtain financial information needed from the entity. It should be broad enough to comprehend information for various users. Therefore, the financial report is where they depend on to acquire information. Diverse users may require different information which might go beyond the scope of general purpose financial reporting.

The financial reports are prepared from the entity’s perspective (deemed to have substance on its own, spate from that of its owners), instead of the entity’s capital providers. An entity attains economic resources (its assets) from capital providers in exchange for claims to those resources (its liabilities and equity). Capital providers include;

Equity investors:

Equity investors normally invest economic resources in an entity expecting to receive a return on, as well as a return of, the resources invested in. Hence, equity investors concern with the amount, timing, uncertainty of an entity’s future cash flows and the entity’s competence in generating those cash flows which affects the prices of their equity interests. Furthermore, they concern with the performance of directors and management of the entity in discharging their responsibility to make efficient and profitable use of the assets invested.

Lenders:

Lenders usually expect to receive a return in the form of interest, repayments of borrowings, and increases in the prices of debt securities. The Lenders have similar interests as equity investors.

Other creditors:

Other creditors provide resources because of their relationship with the entity, instead of a capital provider; no primary relationship.

1. Employee – salary or compensation
2. Suppliers – extended credit
3. Customer – prepay for goods and services
4. Managers – responsible for preparing financial reports

Capital providers make decisions through useful information provided in financial reporting by the particular entity. Financial reporting usefulness in assessing cash flow prospects depends on the entity’s current cash resources and the ability to generate sufficient cash to reimburse its capital providers. Besides, financial reporting usefulness in assessing stewardship includes the management’s responsibilities to protect the entity’s economic resources (assets) from unfavorable effects.

Management is also liable for safeguarding the assets of the entity which conforms to the laws, regulations and contractual provisions; thus, the importance of management’s performance in the decision usefulness. The general purpose of financial reporting limits to the information that does not reflect pertinent information from other sources that should consider by the users.

Financial reporting information base on estimates, judgments, and models of the financial effects on an entity of transactions and other events in which, is only ideal for preparers and standard setters to strive. Achieving the framework’s vision of ideal financial reporting to the fullest will be difficult in the short term because of technical infeasibility and cost constraints.

Financial reporting should include information about: the economic resources of an entity (assets), the claims of the entity are (liabilities and equity), the effects of transaction and any events or circumstances that can affect the entity’s resources and claims and provide useful information about the ability of entity to generate its cash flow and how well the entity meets its management responsibilities.

The usefulness of financial reporting to the users:

1. Provide useful information about the amount, timing, and uncertainty of future cash flow
2. Identify the entity’s financial strengths and weaknesses (especially for capital providers)
3. Indicate the potential of the entity’s cash flow for its economic resources and claims
4. Identify the effectiveness of the entity’s management responsibilities
5. Assess the availabilities of the entity’s nature and quantity of the resources for the use in its operation
6. Estimate the values of the entity.

The quantitative measures and other information regarding the changes in entity’s economic resources and claims in the financial report can help the users to assess the amount, timing, and uncertainty of its cash flow; and indicate the effectiveness of management responsibilities.

Furthermore,

The entity must provide a positive return on its economic resources to generate net cash inflows, and return the earning to its investors. Other information like the variability of returns, past financial performance, and management’s ability can use to assess the entity’s future financial performance.

The information regarding the accrual accounting in financial reporting can better provide the users to assess the entity’s past financial performance and prospects in generating net cash inflows without obtaining additional capital from its investors.

The entity’s cash flow performance in financial reporting assists the investors to understand the entity’s business model and operation by assessing how the entity obtains and spends cash. Information about its borrowing, repayment of borrowing, cash dividends and other distribution to investors, as well as the factors of entity’s liquidity and solvency, can also assist the investors to determine the entity’s cash flow accounting.

Besides,

Information about the changes in the entity’s resources and claims not resulting from financial performance may assist the investors to differentiate the changes that are results of the entity’s financial performance and those that are not.

The information of management explanation should include in financial reporting to assist users for a better understanding of management decisions in any events and circumstances that have affected or may affect the entity’s financial performance. It is because the internal parties know about the entity’s performance than the external users.

Importance of Financial Reporting:

The importance of financial reporting cannot overemphasize. It is required by every stakeholder for multiple reasons & purposes. The following points highlight why financial reporting framework is important:

1. It helps an organization comply with various statues and regulatory requirements. The organizations are required to file financial statements with ROC, Government Agencies. In the case of listed companies, quarterly as well as annual results are required to file to stock exchanges and publish.
2. It facilitates the statutory audit. The Statutory auditors are required to audit the financial statements of an organization to express their opinion.
3. Financial Reports form the backbone for financial planning, analysis, benchmarking and decision making. These uses for the above purposes by various stakeholders.
4. Financial reporting helps organizations to raise capital both domestic as well as overseas.
5. Based on financials, the public in large can analyze the performance of the organization as well as its management.
6. Forbidding, labor contracts, government supplies, etc., organizations require to furnish their financial reports & statements.

The importance of financial statements lies in their utility to satisfy the varied interest of different categories of parties such as management, creditors, public, etc.

In Management:

An increase in the size and complexities of factors affecting the business operations necessitate a scientific and analytical approach in the management of modern business enterprises. The management team requires up to date, accurate and systematic financial information for the purposes.

Financial statements help the management to understand the position, progress, and prospects of business vis-a-vis the industry. By providing the management with the causes of business results, they enable them to formulate appropriate policies and courses of action for the future.

The management communicates only through these financial statements, their performance to various parties and justifies their activities and thereby their existence. A comparative analysis of financial statements reveals the trend in the progress and position of the enterprise; and, enables the management to make suitable changes in the policies to avert unfavorable situations.

In the Shareholders:

Management separate from ownership in the case of companies. Shareholders cannot, directly, take part in the day-to-day activities of the business. However, the results of these activities should be reported to shareholders at the annual general body meeting in the form of financial statements.

These statements enable the shareholders to know about the efficiency and effectiveness of the management; and, also the earning capacity and financial strength of the company.

In Lenders/Creditors:

The financial statements serve as a useful guide for the present and future suppliers and probable lenders of a company. It is through a critical examination of the financial statements; that these groups can come to know about the liquidity, profitability and long-term solvency position of a company. This would help them to decide about their future course of action.

In Labor:

Workers are entitled to bonus depending upon the size of profit as disclosed by the audited profit and loss account. Thus, P & L a/c becomes greatly important to the workers. In wages negotiations also, the size of profits and profitability achieved are greatly relevant.

In the Public:

Business is a social entity. Various groups of society, though directly not connected with the business, are interested in knowing the position, progress, and prospects of a business enterprise. They are financial analysts, lawyers, trade associations, trade unions, the financial press, research scholars, and teachers, etc. It is only through these published financial statements; these people can analyze, judge and comment on the business enterprise.

In the National Economy:

The rise and growth of the corporate sector, to a great extent, influence the economic progress of a country. Unscrupulous and fraudulent corporate management shatter the confidence of the general public in joint-stock companies; which is essential for economic progress and retard the economic growth of the country.

Financial Statements come to the rescue of the general public by providing information by which they can examine; and, assess the real worth of the company and avoid being cheated by unscrupulous persons. The law endeavors to raise the level of business morality by compelling the companies to prepare financial statements in a clear; and, systematic form and disclose material information.

This has increased the confidence of the public in companies. Financial statements are also essential for the various regulatory bodies such as tax authorities, Registrar of companies, etc. They can judge whether the regulations are being strictly followed; and, also whether the regulations are producing the desired effect or not, by evaluating the financial statements. Read and share the given article (Financial Reporting: Definition, Objectives, and Importance) in Hindi.