Financial Statements: A Map or a Maze?
By Eddy Sumar – March 1, 2011
Every entrepreneur and business owner should become acquainted with a special financial instrument called the financial statement. Financial statements are vital because they tell the world about the financial health of the business enterprise.
Financial statements, on the one hand, can be beneficial and serve as a ‘map’ leading its users to make appropriate financial decisions to reach their financial destination safely. On the other hand, they can be manipulated and dressed up to lead its users into a ‘maze’ of deceit and financial shenanigans.
Lyn Fraser, in her book Understanding Financial Statements, uses the metaphors “map” and “maze” as she discusses financial statements. She states that a “map helps its user to reach a desired destination through clarity of representation” (1984, p. 1). On the other hand, a “maze…attempts to confuse its user by purposely introducing conflicting elements and complexities that prevent reaching the desired goal” (p. 1).
Thus, in order to protect users against pitfalls and financial shenanigans, the Financial Accounting Standard Board (FASB) issues Statements of Financial Accounting Standards (SFASs) which establish Generally Accepted Accounting Principles known as GAAP. This should help users of financial statements to identity the other kind of GAP--Games Accountants Play. In addition, FASB issues Statements of Financial Accounting Concepts (SFACs) which provide a theoretical foundation upon which to base GAAP. Furthermore, to protect innocent users from possible deceit and manipulation, the Security and Exchange Commission (SEC) has the authority to determine GAAP and to regulate the accounting profession.
To help users navigate safely to their destination, FASB has issued SFACs which include among them SFAC No. 1, “Objectives of Financial Reporting by Business Enterprises,” SFAC No. 2, “Qualitative Characteristics of Accounting Information,” and SFAC No. 6, “Elements of Financial Statements” (a replacements of No. 3).
According to SFAC No. 1, financial reporting is intended to provide information that is useful in making business and economic decisions. In addition, the information should be comprehensible, understandable, and helpful to the users in assessing the economic resources and claims against those resources which could affect the enterprise’s future cash flows. SFAC No. 2 expresses the qualities that make accounting information useful: Relevance and Reliability. So when users examine the financial statements of a given enterprise, they should be confident that the information is relevant, that is predictive and timely. Moreover, they should also count on the information being reliable, that is to say verifiable, and fairly and faithfully represents the financial position of the enterprise. In addition to relevance and reliability, the information should be comparable and consistent. SFAC No. 6 defines the ten interrelated elements of financial statements that directly relate to measuring performance and financial status of an enterprise. The ten elements are:
1. Assets
2. Liabilities
3. Equity
4. Investments by owners
5. Distribution to owners
6. Comprehensive income
7. Revenues
8. Expenses
9. Gains
10. Losses
To continue to navigate safely, users should be assured that the financial map—the financial statements—were based on standards, assumptions and principles that reflect the wisdom of the accounting model that includes: Business Entity, Going Concern, Historical Cost, Conservatism, Realization, Matching, Consistency, and Full Disclosure.
There are several users of financial statements. Some are internal; others are external. Among the internal users we find owners and managers who require financial statements to make important business decisions that affect the company’s continued operations. They are interested in the profitability of the business. Employees and labor unions need these reports to negotiate with management in labor related issues. Among the external users, we find governments who want the financial statements prepared for tax purposes. Investors make use of financial statements to assess the viability of investing in a business. Financial institutions (banks and other lending companies) use them to make lending decisions. According to one survey of bank lending officers, half of them answered that they would refuse a loan to a company that did not submit financial statements. Creditors, vendors and suppliers ask for financial statements to assess the creditworthiness of the business enterprise. Both lenders and creditors are usually interested in cash flow and short-term liquidity. Furthermore, the media and the general public are also interested in financial statements for a variety of reasons.
Thus, business owners, entrepreneurs, investors, creditors, lenders, and a host of other users of financial statements need to become acquainted with this important tool. Financial statements can help them to decipher and make sense of what is happening in the company to determine its true financial picture and position.
Indeed, financial statements can become a “maze” of confusion and complexities when financial statements are inconsistent, inadequate, doctored or window dressed, and do not fairly present the financial position of the company. Certainly then, the user can be intentionally misled to reach the wrong conclusions. But by becoming acquainted with the key elements and the techniques to decipher and understand this important tool, the user will be protected from entering a ‘maze’ and will transform the financial statements into a veritable ‘map’ that is useful to guide and direct.
Financial statements, on the one hand, can be beneficial and serve as a ‘map’ leading its users to make appropriate financial decisions to reach their financial destination safely. On the other hand, they can be manipulated and dressed up to lead its users into a ‘maze’ of deceit and financial shenanigans.
Lyn Fraser, in her book Understanding Financial Statements, uses the metaphors “map” and “maze” as she discusses financial statements. She states that a “map helps its user to reach a desired destination through clarity of representation” (1984, p. 1). On the other hand, a “maze…attempts to confuse its user by purposely introducing conflicting elements and complexities that prevent reaching the desired goal” (p. 1).
Thus, in order to protect users against pitfalls and financial shenanigans, the Financial Accounting Standard Board (FASB) issues Statements of Financial Accounting Standards (SFASs) which establish Generally Accepted Accounting Principles known as GAAP. This should help users of financial statements to identity the other kind of GAP--Games Accountants Play. In addition, FASB issues Statements of Financial Accounting Concepts (SFACs) which provide a theoretical foundation upon which to base GAAP. Furthermore, to protect innocent users from possible deceit and manipulation, the Security and Exchange Commission (SEC) has the authority to determine GAAP and to regulate the accounting profession.
To help users navigate safely to their destination, FASB has issued SFACs which include among them SFAC No. 1, “Objectives of Financial Reporting by Business Enterprises,” SFAC No. 2, “Qualitative Characteristics of Accounting Information,” and SFAC No. 6, “Elements of Financial Statements” (a replacements of No. 3).
According to SFAC No. 1, financial reporting is intended to provide information that is useful in making business and economic decisions. In addition, the information should be comprehensible, understandable, and helpful to the users in assessing the economic resources and claims against those resources which could affect the enterprise’s future cash flows. SFAC No. 2 expresses the qualities that make accounting information useful: Relevance and Reliability. So when users examine the financial statements of a given enterprise, they should be confident that the information is relevant, that is predictive and timely. Moreover, they should also count on the information being reliable, that is to say verifiable, and fairly and faithfully represents the financial position of the enterprise. In addition to relevance and reliability, the information should be comparable and consistent. SFAC No. 6 defines the ten interrelated elements of financial statements that directly relate to measuring performance and financial status of an enterprise. The ten elements are:
1. Assets
2. Liabilities
3. Equity
4. Investments by owners
5. Distribution to owners
6. Comprehensive income
7. Revenues
8. Expenses
9. Gains
10. Losses
To continue to navigate safely, users should be assured that the financial map—the financial statements—were based on standards, assumptions and principles that reflect the wisdom of the accounting model that includes: Business Entity, Going Concern, Historical Cost, Conservatism, Realization, Matching, Consistency, and Full Disclosure.
There are several users of financial statements. Some are internal; others are external. Among the internal users we find owners and managers who require financial statements to make important business decisions that affect the company’s continued operations. They are interested in the profitability of the business. Employees and labor unions need these reports to negotiate with management in labor related issues. Among the external users, we find governments who want the financial statements prepared for tax purposes. Investors make use of financial statements to assess the viability of investing in a business. Financial institutions (banks and other lending companies) use them to make lending decisions. According to one survey of bank lending officers, half of them answered that they would refuse a loan to a company that did not submit financial statements. Creditors, vendors and suppliers ask for financial statements to assess the creditworthiness of the business enterprise. Both lenders and creditors are usually interested in cash flow and short-term liquidity. Furthermore, the media and the general public are also interested in financial statements for a variety of reasons.
Thus, business owners, entrepreneurs, investors, creditors, lenders, and a host of other users of financial statements need to become acquainted with this important tool. Financial statements can help them to decipher and make sense of what is happening in the company to determine its true financial picture and position.
Indeed, financial statements can become a “maze” of confusion and complexities when financial statements are inconsistent, inadequate, doctored or window dressed, and do not fairly present the financial position of the company. Certainly then, the user can be intentionally misled to reach the wrong conclusions. But by becoming acquainted with the key elements and the techniques to decipher and understand this important tool, the user will be protected from entering a ‘maze’ and will transform the financial statements into a veritable ‘map’ that is useful to guide and direct.