A financial statement is a statement consisting of financial records of an organization. These are made by the company in order to make the investors of the company aware of the financial health and position of the company.
Financial statements are of three types mainly;
- Income Statement/ Profit or Loss Account
- Balance Sheet
- Cash flow Statement
There is another type of statement called Statement of Retained Earning also made by the company but it depends on the policies of the company otherwise this statement is adjusted in the Income Statement.
Financial Statements are the only main and concrete way in which the directors of the company make themselves accountable to the shareholders of the company.
Purpose and Importance
- The main purpose of financial statements is to disclose the financial health and position of the company.
- This is used by the investors, shareholders in order to be aware of the activities that are going on in the company.
- It is very important as by this the directors of the company are made accountable.
- It is also a mean of communication between directors and shareholders.
- The financial statements should be written in easy and understandable words and abbreviations and jargons should be avoided.
- This is compulsory so that readers with reasonable financial awareness can also understand it easily.
- These financial statements should reliable and believable.
Ways of Misleading Financial Statements
Financial statements are shown and revealed to gain the trust of the shareholders but sometimes the companies lose the trust of the investors by misleading them about the company through financial statements.
There are three ways of misleading financial statements;
- Fraudulent misrepresentation of the affairs of the company. The management of the company usually does it deliberately and in this way they lose the trust and confidence of the investors in their own company.
- Another technique is to use aggressive accounting techniques and creative accounting techniques. Aggressive accounting is actually the deliberate display of higher revenues than real. While creative accounting is the technique of following the rules but not in the real means.
- The third method is the use complex and complicated words which are not known to the shareholders. The use of jargons and abbreviations are also a part of this. Hence, the terms used in the financial statements should be known to the shareholders and easily understandable by them.
Directors report is another form of report, which is presented by the Board of Directors to the shareholders of the company. This is presented in Annual Report of the company. The main purpose of this report is to reveal the information that is meant to be disclosed. Moreover, it is in a portrayal form.
Aggressive accounting is a legal accounting technique in which the revenues are shown higher than they really are. This is done in some limits prescribed by the regulatory bodies of the companies.
If the revenue is shown higher than a prescribed limit, it is then considered to be a fraud. This should be done just within accepted accounting practices. The aggressive accounting is also accepted by the external auditors although their job is not to detect the fraud done in the financial statements.
These aggressive accounting practices have some effects on the company’s performance like they make it seen well. Hiding the real information in short time period. Hiding losses of the subsidiaries ad not capitalizing expenses i.e. showing the expenses as assets of the company. Leasing and borrowing through special purpose vehicles. A special purpose vehicle is actually a daughter company which is protected from the financial risk of the parent company. This is made for special purpose of acquisition of other companies or transactions within the company or with other companies. It is sometimes also called as special purpose entity.
Financial Reporting and Investors Confidence
It is responsibility of the internal auditors to provide sufficient assurances to investment community about reliability of financial statements. If the financial statements are not true and are not reliable and believable then the investor’s confidence is shattered and they will be reluctant to invest in that company again. Moreover, the share price of the company would be effected and the value of the company will ultimately fall down and the intangible property i.e. reputation of the company will be ruined.
This can be explained by the case of Enron, as it betrayed the shareholders by window-dressing. Window-dressing is actually used to make the appearance of the financial health and position of the company better before displaying it to the shareholders.
In case of bond markets, the credibility of the company matters. The bonds have their own credit rating agencies like Standards and poor, Moody’s etc. AAA till BBB are the bond in which the investors like to invest. While, the bonds having ratings CCC and further are said to be having high risk, however, where there is high risk there is high return but people are usually reluctant to invest in these bonds as their credibility is low.
March 19, 2019