What’s it: Financial reporting refers to documenting and providing financial information to stakeholders. Companies prepare and present financial reports regularly, usually quarterly and annually. While the annual financial statements are audited, the quarterly financial statements may not be. Public companies whose shares are listed on the stock exchange are required to submit the report to the public. In contrast, a closed company may not have such an obligation.
Financial reporting is essential for stakeholders. This is because they depend on the company’s financial statements to make economic decisions regarding the company. For example, lenders use numbers on financial statements to determine a company’s creditworthiness. Likewise, investors use financial data in valuations before buying company shares.
What are the characteristics of an effective financial reporting framework?
The three criteria for effective financial reporting include transparency, comprehensiveness, and consistency. They are critical to achieving a coherent reporting framework in which all sections must conform based on the underlying logic.
Transparency. Transparent reporting frameworks should reflect the underlying economic activities. Thus, stakeholders get complete information about the company’s financial condition. In addition, full disclosure and fair representation raise transparency.
Comprehensiveness. A comprehensive reporting framework records all transactions with financial consequences based on universal principles.
Consistency. Financial transactions with similar circumstances should be measured and reported similarly, regardless of the industry type, geography, and period. However, there is also a need for flexibility to allow companies more flexibility in reporting results according to the underlying economic activity.
What is the purpose of financial reporting? And why is financial reporting important?
Financial reporting aims to provide company financial information to stakeholders. The outputs, the financial statements, are essential because they rely on the information in them to make economic decisions, such as whether or not to give loans by creditors. In addition, they track and analyze financial statements to assess cash flow and ability to pay obligations.
In addition, financial reporting has also become a routine part of several companies, especially public companies. They are obligated to release financial reports regularly because regulations require them to be transparent to the public.
Investors, creditors, and other interested parties can make decisions about providing company resources through financial reports. They include decisions about buying company stocks and bonds or making loans.
For example, we are stock investors. Financial information is critical in building a stock valuation model before we decide to buy a company’s stock. With this model, we can assess the fair price of the company’s shares and determine whether the current price is undervalued or overvalued. And to make the model, we must examine and analyze financial data while confirming it with operational data. Therefore, we cannot build a model relying solely on operational information.
Likewise, if we are creditors, we rely on financial statements to make decisions, such as whether to give a loan. We use financial statements to assess a company’s creditworthiness by calculating the company’s leverage level, coverage ratio, and other related ratios.
What is meant by standardization in financial reporting?
Standardized financial reporting is critical. As we know, transactions within companies are very complex and diverse. Accountants use several assumptions and methods to present them in financial statements or estimates. Of course, those assumptions and estimates will vary between accountants if they are unstandardized.
Therefore, standardization in reporting provides consistency. It makes us uniformly treat certain practices or operations in the chosen environment when presenting accounting events. Thus, the financial statements are more comparable. By being standardized, we will be more confident in making performance comparisons between two or more companies.
The two global financial reporting standards are:
- International Financial Reporting Standards (IFRS) by the International Accounting Standards Board (IASB)
- Generally Accepted Accounting Principles (GAAP) by the Financial Accounting Standards Board (FASB).
What are the three main sections of financial statements?
Financial statements have several sections. The main three are:
- Balance sheet
- Income statement
- Cash flow statement.
Balance sheet or statement of financial position. This section presents the company’s assets, liabilities, and shareholder’s equity at a given time. The accounting equation describes the relationship between the three: assets equal liabilities plus shareholders’ equity.
Assets represent company resources. Liabilities are claims by creditors against these resources. And equity is a residual claim by shareholders on resources after obligations to creditors are fulfilled.
Income statement. It provides information regarding financial performance during the accounting period. In this section, we can find the company’s revenues and expenses. And total revenue minus total expenses equals net income.
The income statement is linked to the balance sheet through the shareholder equity section, i.e., retained earnings. The mathematical relationship between the two parts is presented in the equation below:
- Final retained earnings = Prior retained earnings + Net income – Dividends
Cash flow statement. This section presents cash outflows and inflows. The reporting is grouped into operating cash flows, investment cash flows, and financing cash flows. All three represent the company’s business activities. Through this section, we can find out how much money the company made in the accounting period.
The cash flow statement is linked to the balance sheet through the cash balance in the current assets section. The current cash balance represents the previous year’s cash balance plus the net change in cash on the cash flow statement.
In addition to the three sections above, there is a statement of changes in equity. This section reports any changes in investment by the business owner. This helps us understand changes in the company’s financial position. Then, we might also find other sections, such as:
- Management reports on internal control over financial statements
- Independent auditor’s report
- Notes to financial statements
Who uses the financial statements?
Users of financial statements can come from within the company’s organization, such as shareholders, management, and employees. Or they are external parties such as creditors and regulators. Each has its own interest in the financial statements.
Shareholders are interested in the money they invest in the company. So they rely on returns from two sources: dividends and capital gains. The latter they receive when they sell their holdings at a higher price than when they buy.
Shareholders want the company to make more money. They are also happy if the company pays dividends regularly and – perhaps in large amounts. Therefore, they look at financial statements to assess the company’s ability to generate profits and cash flow because it affects the dividends they receive and the company’s stock price.
Management relies on financial reports to make business decisions about the company’s operations and finances. Their goal is to enable companies to achieve sustainable growth and competitive advantage.
Creditors provide loans to companies. They must decide whether to make a loan, extend a loan facility, or provide a waiver. Creditors expect their money back on time with the agreed interest. They are interested in financial statements to assess a company’s creditworthiness. They are interested in cash flow and the company’s ability to generate stable and sustainable cash flows.
Customers are interested in a healthy company when they take on long-term cooperation. When the company is healthy, they are more likely to fulfill its obligations in the long term. For example, they tie up the company in long-term contracts to supply the goods they need. And they evaluate the company’s health by examining financial data.
Regulators and government
Some regulators, such as the Securities and Exchange Commission (SEC), examine financial statements to ensure they comply with the rules set by the regulator. Likewise, the government has an interest in financial reports for taxation.
What to read next
- Financial Statement: Importance, Components, Users
- Financial Statement Analysis: Scope, Required Information, Steps, And Methods
- Financial Reporting: Importance, Effective Criteria
- Financial Reporting Framework: Meaning, Criteria