Why Financial Statements Are So Important

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Millions of persons depend on financial statements for vital information about the profit (or loss) performance, financial condition, and cash flows of businesses. This sweeping congregation of financial report users includes bankers deciding whether to make loans to businesses; investors deciding whether to buy, hold, or sell stocks and bonds of public corporations; buyers and sellers of businesses deciding the value of companies; owners of closely held businesses evaluating how their ventures are doing; suppliers deciding whether to sell to businesses on credit; and pension fund managers carrying out their fiduciary responsibility, which requires due diligence in managing other people's money.

For that matter, what about business managers? Managers are the first and most immediate users of financial statements. Managers depend on their income statements to know how much profit was made (or how much loss was incurred). Managers also need balance sheet and cash flow information to keep on top of the financial condition of the business, to spot any solvency problems that may be developing, and to plan for the capital requirements of the business.

In short, both insiders and outsiders need dependable financial statements that are designed for and meet the needs and interests of the users of these sources of financial information.

Financial statements are the primary and only direct source of information for the profit performance of a business, and for its financial condition and cash flow information. Other sources of financial information about a company are secondary sources, which pass along information reported in the company's financial statements. Public businesses put out press releases announcing their latest earnings performance, but these are preliminary and subject to later confirmation in their financial reports.

It goes without saying that financial statements should be reliable and meet the information demands of users. Financial statement users generally are interested in three main things about a business:

1. Its profit (or loss) performance.

2. Its financial condition and in particular the solvency prospects of the company, which refers to the ability of the business to pay its liabilities on time and to avoid getting into financial trouble.

3. Its capitalization (ownership) structure, which refers to the one or more classes of capital stock shares issued by the company, whether any debt of the company can be converted into capital stock, the number of capital stock purchase options given to managers and employees including the terms of the options, and any other direct or indirect claims that participate in the profit of the business.

Investors and other users may seek additional information in the financial statements of a business—such as whether it has enough cash in the bank plus future cash flow to provide for growth. But, the three items listed above constitute the hard core of information users look for in financial statements.

This chapter looks at the accounting rules that govern profit measurement and financial statement disclosure. Financial statements are no better than the standards that are used to prepare the statements. As mentioned earlier, these rules are called generally accepted accounting principles (GAAP), and include both accounting methods and disclosure requirements. How good are the rules? Why are GAAP changed from time to time?

I think an outside observer surveying the scene would conclude that the financial reporting system works well, and therefore the rules (generally accepted accounting principles) are adequate to the purpose and functions of financial statements. On the other hand, a rumble of criticism persists that has not subsided over the years. Perhaps expectations of financial statement users have risen. Perhaps financial accounting can't keep up with the growing complexity and sophistication of the business and economic environment.

This chapter takes a critical look at GAAP, the governing rules of financial reporting. The following discussion is meant in a friendly sense; the critical remarks that follow assume that the present state of affairs is sound and works reasonably well. However, the present system is not perfect and some improvements could be made.

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