Back to '2.1: Balance Sheets and Income Statements\'
Introducing Financial Statements
This lesson will introduce you to financial statements, their uses, and their limitations. This broad overview will help frame the upcoming lessons on each individual statement.
Financial statements can be limited by intentional manipulation, differences in accounting methods, and a sole focus on economic measures.
LEARNING OBJECTIVE
Summarize the common limitations found in financial statements
KEY POINTS
- One limitation of financial statements is that they are open to human interpretation and error, in some cases even intentional manipulation of figures to inflate economic performance.
- Another set of limitations of financial statements arises from different ways of accounting for activities across time periods and across companies, which can make comparisons difficult.
- Another limit to financial statements as a window into the creditworthiness or investment attractiveness of an entity is that financial statements focus solely on financial measures. Some argue for a "triple bottom line" including social and environmental measures.
TERMS
- corporate governance
involves the roles and relationships between a company's management, its board, its shareholders and other stakeholders, and the goals for which the corporation is governed. Much of the contemporary interest in corporate governance is concerned with mitigation of the conflicts of interests and the nature and extent of accountability of people in the business.
- audit
an audit of financial statements is the verification of the financial statements of a legal entity intended to enhance the degree of confidence of intended users in the financial statements by providing reasonable assurance that the financial statements are presented fairly.
- GAAP
Generally Accepted Accounting Principles refer to the standard framework of guidelines, conventions, and rules accountants are expected to follow in recording, summarizing, and preparing financial statements in any given jurisdiction.
Limitations of Financial Statements
The limitations of financial statements include inaccuracies due to intentional manipulation of figures; cross-time or cross-company comparison difficulties if statements are prepared with different accounting methods; and an incomplete record of a firm's economic prospects, some argue, due to a sole focus on financial measures .
Consolidated financial statements: Financial statements can include a number of inaccuracies and limitations that affect the way a company can be viewed.
One limitation of financial statements is that they are open to human interpretation and error, in some cases even intentional manipulation of figures. In the United States, especially in the post-Enron era, there has been substantial concern about the accuracy of financial statements. High-profile cases in which management manipulated figures in financial statements to indicate inflated economic performance highlighted the need to review the effectiveness of accounting standards, auditing regulations, andcorporate governance principles.
As a result, there has been renewed focus on the objectivity and independence of auditing firms. An audit of the financial statements of a public company is usually required for investment, financing, and tax purposes, and these are usually performed by independent accountants or auditing firms and included in the annual report. Additionally, in terms of corporate governance, managing officials like the CEO and CFO are personally liable for attesting that financial statements are not untrue or misleading, and making or certifying misleading financial statements exposes the people involved to substantial civil and criminal liability.
Another set of limitations of financial statements arises from different ways of accounting for activities across time periods and across companies. This can make it difficult to compare a company's finances across time or to compare finances across companies. Different countries have developed their own accounting principles, making international comparisons of companies difficult. However, the Generally Accepted Accounting Principles (GAAP), a set of guidelines and rules, are one means by which uniformity and comparability between financial statements is improved. Recently there has been a push toward standardizing accounting rules made by the International Accounting Standards Board (IASB).
Another limit to financial statements as a window into the creditworthiness or investment attractiveness of an entity is that financial statements focus solely on financial measures of health. Even traditional investment analysis incorporates information outside of the financial statements to make organizational assessments. However, other methods such as full cost accounting (FCA) or true cost accounting (TCA) argue that an organization's health cannot just be determined by its economic characteristics. Therefore, one needs to collect and present information about environmental, social, and economic costs and benefits (collectively known as the "triple bottom line") to make an accurate evaluation.
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