In this business world of increased competition, quality of financial information provided by companies is considered to be the most important element in process of decision making. This financial information of companies can be gained through accounting information systems and more than all from financial statements (Kraft, 2014). It is important to have real and accurate information presented through financial statements as it is one of the significant assumptions in case of decision making. Accountants and finance managers are considered to be communicators present within the firm. Accountancy is the art to communicate financial information related to a business corporate to users like shareholders and managers. This communication is done through financial statements in which economic resources of company are depicted under the management control. The art lies in selection of information that is useful for the user and that has high level of reliability. There is a need of periodic financial information of company by shareholders. This information assists them in evaluating the performance of one company by comparing it with other companies (Juárez, 2014). Nowadays, organisations are not needed to publish forecasted financial statements on regular basis and due to this reason shareholders use past financial statements to make predictions (Dyson, 2010). This essay is related to the critical analysis of financial statements that are used by shareholders for making necessary decisions. This essay contains analysis of important elements of financial statements, processes used by companies to complete financial statements, areas of subjectivity in financial statements, analysis of international accounting standards regarding rules of comparability of statements and critical analysis for the use of ratio analysis for comparing financial statements of companies.
In the process of decision making, financial as well as non-financial information is required. The most significant financial information required in the decision making process is gained through financial statements of company. Accounting is considered to be service function to management as it provides financial information of the company. It helps in processing, gathering, studying raw data and converting that in to appropriate information in decision making process. The basic features of accounting are to gather, process and present financial information on the basis of business of company. There are different stages involved in the process of accounting through which financial statements are developed. The process of accounting involves conversion of input data in to output information (Johnson and Weggenmann, 2013).
First of all, all financial data related to business of company is collected. After collection of data, analysis of business events is done and then data is recorded in journal and general ledger accounts. In the end of accounting period, before preparation of financial statements, accuracy of data is checked in the books that help in preparing financial statements. It depicts the recapitulation of ledge accounts and all financial transactions. After coordination of all records and finding accuracy of data, financial statements are prepared. It is to be ensured by accountants of company that interests of users have to be satisfied through financial statements (De Franco, Kothari and Verdi, 2011).
Source: (Brochet, Jagolinzer and Riedl, 2013)
Figure 1 shows the accounting process of a company in which the final product is financial statements. The whole process of accounting is followed by accountants in order to prepare financial statements. These help the investors to make necessary decisions related to investment.
The most important financial statements that are taken into account by shareholders while comparing with others are balance sheet, income statement, cash flow statement and changes in owner’s equity (as shown in Figure 2).
Source: (Bohušová and Svoboda, 2014)
According to Kim et al (2013) the most fundamental financial statement is balance sheet through which financial position of company is represented and it is considered to be a basis to estimate security of business. The basic components of balance sheet are assets, liabilities and owners’ equity. In addition to the security of business, it is very important to focus on efficiency of business. Efficiency is defined as a capability of business to achieve particular goals. There can be different types of goals of different companies and these goals are served as basis for business’ efficiency. The profitability of business is considered to be most stated objective of a company. In this respect, efficiency is evaluated through profit and loss account. The performance of company for a specific period of time is represented through income statement. The basic components of income statement are revenues, expenses and profit or loss is calculated through their difference. It is not compulsory that only through profit and loss account, profitability of business can be measured. There is a possibility of having issues while using this account. Due to this reason, cash flow statement and statement of change in owner’s equity can be used. In cash flow statement information related to cash receipts and expenditures is included. In statement of change in owner’s equity, all transactions related to profit or loss for specific period of time are depicted (Drury, 2015).
For improving the utilisation of financial information for comparing performances of companies, there is a need of analysing financial statements of companies. The analysis of financial statements is a process that involves conversion of data from financial statements into some useful information for the company (Francis et al, 2013). This is done through different analytical tools and techniques. Therefore, for knowing the recent level of quality of business as compared to its competitors, comparison of financial statements by analysing them is important. The process of analysing financial statement comes before the process of management and planning. In effective financial planning, strengths and weaknesses of company have to be evaluated. By comparing financial statements of companies, good aspects as well as weaknesses of companies can be recognised (Horton et al, 2013).
Ahmed et al (2013) stated that one of the important requirements of preparing financial statements is presentation of financial statements as these documents are considered to be main tool of getting information related to the situation of companies. These subjects can have dependability on periodicity of financial statements. In this periodicity, interruption of regular flow of business management is required for assessing both income and capital. As a result of above mentioned discontinuity, a relationship is developed in between figure to be assessed and subject used to carry out that assessment due to subjective values. This is due to the reason that due to these values, a process of abstraction and forecasts is implied. In case of subjectivity, abstraction process is made compulsory due to the need of ignoring links between space and time that characterise the situation depicted in the financial statements.
With respect to space dimension, the requirement of abstraction is made compulsory due to the unitary aspect of activities involved in management. There is different nature of these relations, like commonality, integration and so on. A modification in the situation depicted in the financial statements has to be entailed due to their intensity. The unitary feature discussed above needs a subjective allocation of figures between various items to be evaluated in financial statements. For example; calculating cost of inventories and subjective assignment of general cost. As a result, abstraction process is required by balance sheet through which one process can be evaluated (Cascino and Gassen, 2015).
In case of above mentioned cases, financial statements are required to be subjective to a certain extent of indefiniteness, whether they are dependent on interruption of linkages through which processes are linked or relations are broken down. Due to this indefiniteness, rational impossibility is translated in to attribute at the time of evaluating quantitative elements of a process (Barth, 2013). Due to this indefiniteness, problem of subjectivity arises in financial statements. Moreover, it is important to do forecast because there is a need of adopting a perspective view in preparation of financial statements for investigating the future potentials of company. This occurs due to the fact that value assigned to continuous process is used for translating the requirement of anticipating future events that has a direct or indirect impact on business (Christensen and Nikolaev, 2013).
It has been stated by Carraher and Van Auken (2013) in financial statements, the main root of the subjectivity is uncertainty. As, the foundation of subjectivity are the given factors (uncertainty and indefiniteness) paving the path for judgement of preparers of financial statements; on contrary to this; reliability can be termed as consistency in between fact and the representation of that fact, on the other hand the objective of representation is to reproduce fact for objectives of information. For the current objective, a fact can be termed as the dynamics which are linked with the management of business, while the depiction of this fact is the financial statements which targets to provide pictures of this dynamic for satisfying the given informative objectives. In some other words, it can be said that reliability is the link between an ‘accounting entity’ and ‘economic entity’. Therefore, the limit of reliability can be termed as the expression of consistency degree between the given factors of comparison: the dynamics linked with the management of business and figures present in the financial statement. Such consistence degree might be the by-product of components which are not linked with the subjectivity of figures (Weil et al, 2013).
Kim et al (2016) stated in literature of accounting, comparison of financial statement is the major topic of research. Different articles include discussion of how to do the measurement of comparability of financial statement and how to describe them. IASB also suffers from difficulty in explaining the comparability of financial statements. For acquiring comparable financial statements among different organizations, different debates are done for checking that whether uniformity, harmony or flexibility is the ideal process. In measurement approaches these debates are depicted, which are developed in order to evaluate that how come financial statements are sponsor of flexibility and uniformity.
In accordance with the framework of IASB, the major qualitative approaches are comparability which let the information to exist in the financial statements which in turn provides value to the users. IASB stated in the framework that user should do the comparison of the financial statements of individual with the passage of time for recognizing style in financial position and performance. Users should also do the comparison of financial statements of different organizations for determining the performance, alterations and financial position. The research is related to the comparability of financial statements (Siregar et al, 2016). However, Boards concluded that in draft of joint revelation they are supposed to give up such comparability for acquiring increased faithful of description through standards to recent standards or comparability to acquired increased faithful. Therefore; through termination of platform, amendments are made on stable bass through IFRS and different new standards and acknowledgements are published. These alterations based on consistency endanger the comparability while participants see such comparability as most important factor. It has been seen that IASB also emphasizes over the comparability of financial of scheduled organization. Therefore, such comparability seems to be less important when compared to the comparability of financial statements of those organizations that run with similar industry (Chen et al, 2015). Along with it; IASB is always trying hard to evade requirements which stress over kinds of methods of transaction. It is recommended by the study that owning similar standards of accounting are not enough able to acquire comparable financial statements. If accountants are given with the set of transactions through which they are needed to develop financial statements, they will be not be capable of making similar statements, even after implementation of IFRS. According to Chen and Li (2015) the standards of constant accounting can make improvement in the comparability. It actually does not happen. Organization in different countries and regions own their own objectives of reporting, various approach to do business, and own their economic factors and political factors.
Over the past few years, analysts and investors have made different tools of analysis, techniques and concepts for comparison of weaknesses and strengths of organizations. These techniques, concepts and tools develop the foundation important analysis. Ratio analysis can be termed as the tool that was designed for performing quantitative analysis on numbers present in the financial statements. Ratios assist in linking three of the financial statements with one another and provide figures that can be compared with other organizations, sectors and industries. Ratio analysis is the most widely used important technique of analysis. However, financial ratios are different for different sectors and industries and comparisons between different kinds of organizations are not valid. Along with it, it is significant to do the analysis of trends present in organization ratios (Dhole et al, 2015).
According to Cascino and Gassen (2015) ratio is relative or rational number which implies that one economic value is linked with the other economic value. As there is no sense in linking two types of economic values, therefore accuracy of ratio can be discussed. The division of financial ratio can be done into two groups by considering the time dimension. One group involves the business of organization in the specific time period (generally a year). This group is dependent over the data from loss and profit account and statement of cash flow. The other group deals with the defined moments which are linked with the balance sheet and are related to the financial position of organization. Ratio involves concentrated information that is required for decision making process and measurement of business quality. Ratio does the measurement of quality level of specific process of economy which is involved in the financial statements.
Source: (Young and Zeng, 2015)
Ratio analysis gives tools to the provider for analysing the financial statement of organization. Ratios are used by investors for evaluation of one stock in region comparable to other organizations present in the similar industry. Utilizing ratio analysis, the simplification of financial statements of different organizations can also be done. Some of the major ratios that can be utilized by investor for evaluation of organization are price to earnings ratios (P/E) and profit margins (Jung et al, 2016).
Ball et al (2015) claimed that profit margin is a ratio that can be used by investors for comparing the profitability of organization in the similar sector. Its calculation is done by division of net income of organization through revenues. Instead of dissecting financial statements for comparing the profitability of organizations, this ratio can be used by investor. For instance, suppose organization ABC and other organization DEF are present in the similar region with margins of 10% and 50% approximately. An investor can easily done the comparison of these organizations and can state that ABC was enough able to convert 50% revenues into profits, while DEF only converted 10%.
Another ratio that can be utilized by the investor is the P/E ratio. This is a ratio which is termed as valuation and it does the comparison of current shared price of organization with the earnings on each share. It does the measurement like how sellers and buyers price the stock per earning (Fang et al, 2015). The ratio provides an easy way to investor to do the comparison of the earning of organization with the other ones. Using the organizations from the given instance, suppose ABC owns P/E ratio of 100, while DEF own 10 ratio. An investor can state that investors want to pay $100 for $1 earning.
Ratio analysis can be used by investors, and ratio should be calculated by each figure. Companies of different sizes use the financial ratios for providing numerical information over profitability, direction of business and health. Financial ratio gives beneficial analysis and can assist drive management regarding better decision if they are understood correctly. However, there are some of the disadvantages over depending upon such metrics. Financial ratios are the most beneficial tool for tracking alteration made in business with the passage of time. For instance, if the ratio of liquidity is less this year than the last one, there may be an issue that requires more investigation. However, ratios are not good at comparing one organization with the other one; however they are utilized this way. A choice of organization of accounting policies utilized in financial statement influence the ratios (Lang and Stice-Lawrence, 2015).
Ratios tell the owner of business that what has happened but do not tell that what is the reason of this happening. Owners of business should dig deeper into numbers for identifying that why ratio change from time to time. Accounts Receivable Turnover gives a good instance of this. This ratio depicts that how quickly receivable of accounts are collected. If turnover slows down, it implies a development of receivables compared with the sales. Different factors can results into this build-up involving developing dissatisfaction of customer with product, loosened credit policies, and inexperience of employee. A business manager requires identifying the basis of issue before solving it. Financial ratio are based on the financial statements, they do not capture all of the required information that informs stakeholders that how business is going and assists them to assume that what will happen in the future. One of the major determinants of success of business is the experience and quality of management team. Such information cannot be achieved directly through financial ratios. The analysis shows that ratios can or cannot be used for the purpose of comparing financial statements of two or more companies. There is a need of taking necessary and effective steps in order to analyse financial statements successfully (Lee et al, 2016).
The analysis can be concluded in terms that financial statements depict the degree to which economic resources of a company have increased or diminished during a specific period of time. Future performance of a company is also predicted through financial statements and shareholders usually compare financial statements of two or more companies before taking important investment decisions. There are different types of financial statements like balance sheet, income statement, cash flow statement and statement of change in owner’s equity. Forecasts provides space to the power of the preparer of financial statements, incrementing the issue of evaluation degree of subjectivity of the values which anticipate – in an assumed approach – the dynamics linked with the business environment and organization. The degree of reliability of financial statements is not reflected by the degree of subjectivity. In order to make effective investment decisions, investors can use ratio analysis for comparing financial statements of two or more companies.
Ahmed, A.S., Neel, M. and Wang, D., 2013. Does mandatory adoption of IFRS improve accounting quality? Preliminary evidence. Contemporary Accounting Research, 30(4), pp.1344-1372.
Ball, R., Li, X. and Shivakumar, L., 2015. Contractibility and transparency of financial statement information prepared under IFRS: Evidence from debt contracts around IFRS adoption. Journal of Accounting Research, 53(5), pp.915-963.
Barth, M.E., 2013. Global comparability in financial reporting: What, why, how, and when?. China Journal of Accounting Studies, 1(1), pp.2-12.
Bohušová, H. and Svoboda, P., 2014. Comparability of financial statements prepared according to IFRS and IFRS for SMEs in the field of intangible assets. Acta Universitatis Agriculturae et Silviculturae Mendelianae Brunensis, 58(6), pp.67-78.
Brochet, F., Jagolinzer, A.D. and Riedl, E.J., 2013. Mandatory IFRS adoption and financial statement comparability. Contemporary Accounting Research,30(4), pp.1373-1400.
Cascino, S. and Gassen, J., 2015. What drives the comparability effect of mandatory IFRS adoption?. Review of Accounting Studies, 20(1), pp.242-282.
Carraher, S. and Van Auken, H., 2013. The use of financial statements for decision making by small firms. Journal of Small Business & Entrepreneurship, 26(3), pp.323-336.
Cascino, S. and Gassen, J., 2015. What drives the comparability effect of mandatory IFRS adoption?. Review of Accounting Studies, 20(1), pp.242-282.
Chen, J.V. and Li, F., 2015. Discussion of “Textual analysis and international financial reporting: Large sample evidence”. Journal of Accounting and Economics, 60(2), pp.181-186.
Chen, C.W., Collins, D.W., Kravet, T.D. and Mergenthaler, R., 2015. Financial statement comparability and the efficiency of acquisition decisions. Available at SSRN 2169082.
Christensen, H.B. and Nikolaev, V.V., 2013. Does fair value accounting for non-financial assets pass the market test?. Review of Accounting Studies,18(3), pp.734-775.
De Franco, G., Kothari, S.P. and Verdi, R.S., 2011. The benefits of financial statement comparability. Journal of Accounting Research, 49(4), pp.895-931.
Dhole, S., Lobo, G.J., Mishra, S. and Pal, A.M., 2015. Effects of the SEC's XBRL mandate on financial reporting comparability. International Journal of Accounting Information Systems, 19, pp.29-44.
Drury, 2015. Management and Cost Accounting. Cengage Learning
Dyson, 2010. Accounting for Non-Accounting Students, 8th Edition. FT Prentice Hall
Fang, V.W., Maffett, M. and Zhang, B., 2015. Foreign institutional ownership and the global convergence of financial reporting practices. Journal of Accounting Research, 53(3), pp.593-631.
Francis, J.R., Pinnuck, M.L. and Watanabe, O., 2013. Auditor style and financial statement comparability. The Accounting Review, 89(2), pp.605-633.
Horton, J., Serafeim, G. and Serafeim, I., 2013. Does mandatory IFRS adoption improve the information environment?. Contemporary Accounting Research, 30(1), pp.388-423.
Juárez, F., 2014. Review of the principles of complexity in business administration and application in financial statements. African Journal of Business Management, 8(2), p.48.
Johnson, G.G. and Weggenmann, J., 2013. Exploratory Research Applying Benford's Law to Selected Balances in the Financial Statements of State Governments. Academy of Accounting and Financial Studies Journal, 17(3), p.31.
Jung, W.O., Park, S.O. and Chung, H., 2016. Debt Financing and Voluntary Adoption of the International Financial Reporting Standards: Evidence from Korean Unlisted Firms. Emerging Markets Finance and Trade, 52(1), pp.39-51.
Kim, S., Kraft, P. and Ryan, S.G., 2013. Financial statement comparability and credit risk. Review of Accounting Studies, 18(3), pp.783-823.
Kim, J.B., Li, L., Lu, L.Y. and Yu, Y., 2016. Financial statement comparability and expected crash risk. Journal of Accounting and Economics, 61(2), pp.294-312.
Kraft, P., 2014. Rating agency adjustments to GAAP financial statements and their effect on ratings and credit spreads. The Accounting Review, 90(2), pp.641-674.
Lang, M. and Stice-Lawrence, L., 2015. Textual analysis and international financial reporting: Large sample evidence. Journal of Accounting and Economics, 60(2), pp.110-135.
Lee, M.G., Kang, M., Lee, H.Y. and Park, J.C., 2016. Related-party transactions and financial statement comparability: evidence from South Korea. Asia-Pacific Journal of Accounting & Economics, 23(2), pp.224-252.
Siregar, S.V., Djakman, C.D., Maharani, A., Farahmita, A. and Ningrum, A.S., 2016. Financial Instruments Disclosure: Comparison of Indonesian and UK Banks. International Journal of Finance and Accounting, 5(1), pp.62-66.
Weil, R.L., Schipper, K. and Francis, J., 2013. Financial accounting: an introduction to concepts, methods and uses. Cengage Learning.
Young, S. and Zeng, Y., 2015. Accounting comparability and the accuracy of peer-based valuation models. The Accounting Review, 90(6), pp.2571-2601.
Get in touch with our dedicated team to discuss about your requirements in detail. We are here to help you our best in any way. If you are unsure about what you exactly need, please complete the short enquiry form below and we will get back to you with quote as soon as possible.