Understanding Financial Reports

Introduction

Financial reports are the fundamental sources of information to the investors and other external parties for comprehending the profitability and financial position of any business concern. It gives information regarding the outcomes of a business throughout a stated period of time with respect to assets and liabilities, which provide the foundation for taking decisions. The key objective of financial statement is to support people for decision making by giving information regarding economic resources and obligations of business and also by giving information regarding the earning capability of business (Cascino & et. al., 2014). For students seeking business dissertation help, understanding all the intricacies of financial reporting is critical in evaluating the performance and potential of companies within their area of research. However, sometimes the financial reports unable to demonstrate the actual picture of financial performance of financial health of an organization, especially when a company went into liquidation or when an organization is facing serious financial issues. There are certain limitations of these financial reports which prevent proper decision making by people.

Theoretical Evidence

According to agency theory, financial information influence on investment decision through affecting information irregularity between the organization and the investors. It help to minimize the information irregularity, which can influence the negative selection expenses and accordingly the expenses of increasing the external capital. Financial information also impact on investment decision making by reducing the ethical threat expenses arising from agency engagements among different stakeholders of the organization. Use of financial information support the managers to accomplish the financial reporting benchmark by changing the investment decisions (Unegbu, 2014). There are two channels by which managers can learn new financial information regarding setting the investment decisions. First is that financial information revealed by peer organizations can assist minimize uncertainty regarding growth prospects associated with related organizations. Second is that in the existence of information acquisition and processing expenditures, disclosure requirements and financial reporting regulations can induce organizations to gather and process extra information that influence manager’s financial information sets and hence investment decisions (Roychowdhury & et. al., 2018). From theoretical perspective, there are many limitations of financial reporting which may hamper proper decision making. These limitations are as follows:

Reliance of historical expenses: In financial reporting, the transactions are recorded at their historical expenses. This is an important concern while evaluating balance sheet information, where the value of assets and liabilities can change over time. Many items like marketable shares can face significant changes in the market value (Bragg, 2019). Therefore, the balance sheet information can be misleading if bigger portion of it is amount presented on historical expenses.

Dependent on specific time period: A person analyzing financial reports can obtain inappropriate insight of financial performance of an organization by only observing at one reporting period, as it can differ from usual operating outcomes of the organization, possibly owing to an unexpected increase in sales or seasonality effects.

Economic effects: Financial reports cannot reveal the economic effects on business. Any kind of negative economic condition like recession can impact on the financial reports, while positive economic situation can increase the financial performance of a company. Furthermore, if the inflation rate is high, the amounts related with assets and liabilities will seem inordinately low, as they are not accustomed for inflation. Hence, it will not give fair result of financial reporting. Fraudulent accounting: The financial report on which decisions can be made is subject to fraudulent entries by the organizational members. The managerial team of an organization can intentionally manipulate the data presented in the financial reports in order to deceive people and to misrepresent the financial condition of the organization. This condition can appear when there is undue stress to demonstrate excellent performance in front of the key stakeholders, for personal intentions like obtaining more bonuses or attracting more investments (Yongkuy, 2013). This is the most important limitation of financial reporting which hampers the decision making for people.

No information on non financial aspects: The financial reports do not give or address non financial issues of the organization, which plays vital part in company business, such as environmental attentiveness, important financial events, operational issues or social issues it facing in the community among others (University of Pennsylvania., 2000). Even with having strong financial performance, an organization can fail in these aspects of business, which will eventually hamper the financial performance of the company in near future, but people might not be aware regarding these issues as these are not mentioned in financial reports.

No prediction: The information given by financial reports gives information regarding the financial status according to specified period. However, the reports do not essential give information regarding predicting value of what will be performance of the organization in future.

No verification by auditors: If the financial reports are not verified or audited by authorized people or organizations, this indicates that no one has evaluated if the company has maintained proper accounting policies or involved in proper accounting practices while making the financial reports. Therefore, without verification, the accuracy of financial reports cannot be ensured. Consequently, the managers can distort the financial information of the company by demonstrating false image, which will result in poor decision making by investors

Empirical Evidence

The limitations of corporate financial reporting and financial information on decision making can be observed from financial scandals of 21st century. Corporates like Enron, WorldCom, Tyco and Xerox among others are key events that occurred due to limitations of financial reporting. In these companies the financial reporting was inferior and ill practiced by the organizational members. With respect to Enron, the net income and investor’s equity were overstated by the financial statements by amount of about $405 million from the year 1997 to 2000.

Enron has failed to appropriately consolidate the financial statements with respect to JEDI and Chewco, two important business units related with the organization. Enron was failed to utilize the accounting standards, which lead to understatement of liabilities in the balance sheet of the company by amounts ranging from about $561 million to $711 million throughout the period of 1997 to 2000 (Camfferman & Wielhouwer, 2019).

From the general limitations, it can be stated that the reason for the failure for Enron is fraudulent accounting. In many financial transactions, Enron’s financial reporting treatment was unsuccessful to conform to the existing accountant principles. It has significantly violated GAAP standards. The influence of these failures was not demonstrated in the financial statements unless the organization collapsed. Throughout the period of 1997 to 2000, Enron’s exaggerated net revenue in the income statement of the company by about $1.577 billion (Catanach & Rhoades-Catanach, 2007). This violation of reporting procedure resulted in improper decision making by the investors and key shareholders. These exaggerations influenced the demonstration of financial health of the company to a large extent. Furthermore, these false financial reporting misrepresented the key ratios like debt equity ratio and ROE ratio of the company in the four years, making investors to take improper decisions.

Another important empirical evidence for limitation of financial reporting and financial information is WorldCom. It has also involved in unfair practices of financial reporting which lead to poor decision making by the investors. The company has taken the line expenditures, which are mostly charges related with the utilization of third party network service and facilities and incorrectly recorded them as capital expenditures. This transfer of expenditures into capital outflow is fraudulent and was not been disclosed in financial statements by the investors.

After auditing, it was discovered that WorldCom has inappropriately recorded profit worth $3.3 billion in the financial reports and accounts from the year 1999 to 2002. The expenses of about $3.8 billion was demonstrated as capital investments (Tran, 2002). Therefore, in the similar context, fraudulent accounting and no verification by auditors are key limitations for the causes of financial statement unable to demonstrate true picture of the company performance. Such information is useful for people to make any kind of investment decision in a company.

One recent example of limitation of corporate financial accounting can be observed with respect to Punjab & Maharashtra Co-operative Bank (PMC) bank which has faced significant financial issues in the year 2019. After audit, it has been exposed that the bank has its 75% loan exposure to one organization namely HDIL, amounting Rs.65 billion, which has presently become insolvent. The financial reporting unable to reveal the bad financial health of the organization as the managers in PMC has replaced about 44 loan accounts with about 21049 dummy accounts in the financial statements and balance sheet (Rebello, 2019).

For PMC bank, the key limitation is observed as no information on non financial aspects like loaning to one organization HDIL, which is vital information that cannot be revealed from financial reports. Such improper financial reporting has blindsided the investors for about a decade, letting them making bad investment decisions. The financial irregularities and under reporting of its lending amount has changed the financial numbers in balance sheet and income statements, therefore unable to provide the real picture of the financial health of PMC.

Conclusion

There is commonly held perception that financial reporting and financial information help to understand the financial health of an organization and therefore investors can take better decisions. Although the procedures of financial reporting is created in such a way so that it can help to predict the actual financial performance, there are many limitations which hampers making such prediction and make the objective of financial reporting ineffective to a certain extent. Various limitations like fraudulent accounting, hidden important non financial information and no verification by auditors as observed in the empirical evidences can hampers the corporate financial reporting and information for decision making, using financial statements of organizations like PMC. These limitations naturally raise concern about the effectiveness of financial reporting and financial information in making faulty decision. Therefore, strong vigilance and corporate governance is required in order to make financial reporting accurate and appropriate so that managers and other organizational members unable to involve in putting false data in financial reports. In this way most limitations of financial reporting can be diminished and will reduce the risk of improper decision making by investors.

References

Bragg, S., 2019. Limitations of Financial Statements. [Online] available at:

Camfferman, K. & Wielhouwer, J. L., 2019. 21st century scandals: towards a risk approach to financial reporting scandals. Journal of Accounting and Business Research, Vol. 49, No. 5, pp. 503-535.

Cascino, S. & et. al., 2014. Who uses financial reports and for what purpose? Evidence from capital providers. Accounting in Europe, Vol. 11, No. 2. pp. 185-209.

Catanach, A. H. & Rhoades-Catanach, S., 2007. Enron: A Financial Reporting Failure? [Online] available at:

Enron, 2000. Enron Annual Report 2000. [Online] available at:

Rebello, J., 2019. The collapse of PMC exposes the fault lines in the financial system. [Online] available at:

Roychowdhury, S., & et. al., 2018. The Effects of Financial Reporting and Disclosure on Corporate Investment: A Review. Boston College.

Tran, M., 2002. WorldCom accounting scandal. [Online] available at:

Unegbu, A. O., 2014. Theories of Accounting: Evolution & Developments, Income Determination and Diversities in Use. Research Journal of Finance and Accounting, Vol. 5, No. 19, pp. 1-15.

University of Pennsylvania., 2000. Non-financial Performance Measures: What Works and What Doesn’t. [Online] available at:

Yongkuy, Z., 2013. Limitations of Financial Statements and Disclosure of Core Information. Journal of Applied Sciences, Vol. 13, No. 13, pp. 2505-2511.

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