Definiton of Objectives of Financial Statements
Objectives of financial statements are the specific purposes or reasons (which may include the purpose of compliance, understanding the fundamentals of the company, measuring the financial strength of the business, reporting of the performance, results, financial stability, and liquidity to the various stakeholders of the organization, providing confidence of going concern to the creditors) for which the financial statements are prepared and presented to the owners of the business and other stakeholders.
- Every report around the world has a specific purpose. Your health report specifies your overall health issues as on date. Bank statements specifies the account balance in hand. Loan statement gives you information about pending EMIs. Credit card statements specifies the due date of your bills and your expenditure pattern for the latest months. Electricity bill gives you historic consumption of energy. And there are never-ending examples of statements with a “specific purpose”. Likewise, the “Financial Statements” also have objectives for its preparation.
- Objectives are the centric reasons as to why the financial statements are prepared by an organisation. The accounting standards, reporting frameworks, compulsion of periodic reporting by the law makers, etc. all these, are existing to satisfy those objectives.
- Balance sheet, income statement and cashflow statements (also notes accompanying these) are the components of financial statements. These three are the pillars for what we say “Financial Statements”. Each of these are reported with a specific objective.
- Balance sheet which lists down the assets, liabilities and net worth of the entity, are prepared with the objective to specify the financial position of the entity as on specific date.
- Income statement which specifies the revenue and expenses of the entity resulting in profit or loss made by the entity during a specific period, are prepared with objective to glorify financial performance of the entity on a year-on-year basis.
- Cashflow statement which specifies the cash flow from operating, investing and financing activities of the business, are prepared with the objective to specify the cash earnings and liquidity position of the entity during the period.
Top 8 Objectives of Financial Statements
Below are the 8 Objectives of Financial Statements:
1. True & Fair view of financial position
- Balance sheet shows the financial position of the business i.e. it enlists the assets and liabilities. The difference between those represents the net worth (i.e. book value of the business). Net worth includes the capital infused by the owners plus the profits earned till date.
- Decreasing in the net worth is bad indicator of growth. This gives the management various hints to improvise the financial position.
- Financial position is presented for current year and previous year. The increase is assets represents growth of the earning capacity and decrease in liabilities represents the repaying capacity of the entity.
- Thus, the utmost objective of true and fairness is very essential here.
2. True & fair view of financial performance
- Income statement shows the financial performance of the entity i.e. its revenue and its expenses. The difference between those represents the profit or loss earned during the period.
- Decrease in revenue has direct impact in decrease in profits. Increase in expense have reverse impact of decrease in profits.
- If the accounting standards are not followed appropriately, it shows that management can play with revenue & expenses figures.
- Thus, the true and fairness is essential objective in preparing the income statement.
3. To provide information about resources
- Another objective behind financial statements is to provide information about the resources available with business (i.e. production capacity, labour hours, cash reserves, inventory, WIP percentage, delivery mechanism, etc.) and its usage parameters. It also gives information about changes in the resources between two periods.
- This information helps in better understanding of the business as changes in the utilisation and acquisition of the resources helps the stakeholders to take financial decisions.
4. To provide Information about the earning potential
- Financial statements should also hint about earning potential of the business. This information is for the top management level of the organisation.
- With the economic assets and liabilities, the management can decide on the expansion levels.
- The three components of financial statements in together should provide information about the earning capacity of the entity.
- Earning potential is also linked with the utilisation of available resources.
5. To form basis for decisions of the stakeholders
- Stakeholders means the owners, directors, customers, suppliers, employees, workman, government, finance providers and the public at large.
- Employees needs to take decision whether to stay employed or not. Customer needs to take decision whether to give more orders. Suppliers needs to think about whether to supply or not. Finance providers also have to take decision whether it is feasible to give loans to the entity. Public at large needs to think whether to invest in the entity. Directors have to decide on the dividend pay-outs, raising finance, employing more staff, acquisition of resources and many other things to keep the business running.
- All such decisions are based primarily on the financial statements.
6. To report on the effectiveness and efficiency of the management
- Owners have no time to attend the daily operations of the business and thus, they appoint the management to look forward for the entity. The strong financials are the picture of the effectiveness and efficiency with which the decisions are taken by the management.
- Effectiveness means whether the purpose is served or not. So, owners can think whether the decision made by them in appointing the management is appropriate or whether it needs any change. It also shows whether the internal policies are strong.
- Efficiency means whether the target is achieved in reasonable time. Owners can think upon their decision by observing the gross profit ratio and the net profit ratios of recent years.
7. To increase the understandability of the end users.
- End users means the owners, for whom the financial statements are prepared. All the laws, regulations, accounting standards, accounting framework, etc. are here to ensure the understandability of the end users.
- Financial statements are summaries of the operations during the year and therefore it is required to provide various disclosures to help the owners understand the statements in a better manner.
- If the end users can arrive at correct decision with the help of financial statements, this objective is achieved.
8. Other Objectives
- To help settle disputes arising between various parties.
- To provide information about the credibility of the entity in the finance world.
- To decide on whether it is right time to replace the assets of the firm with new assets having increased capacities
- To decide whether to invest in other entities so to expand the empire.
- To help government with information about payment of taxes, etc.
All the objectives specified about are inter-linked to each other and no objective can be achieved in isolation. If the objectives for which the financial statements are prepared, are not satisfied, the purpose of preparing will not be met. For example, if there is no true and fairness in the preparation, the stakeholders will lose confidence in the entity itself. Lower confidence of the stakeholders (i.e. owners, employees, directors, creditors, financing providers, banks, government) has major impact of the business. Thus, the stakeholders demand the “AUDITED” financial statements. Auditor is a third person appointed by the “Shareholders” of the organisation, to understand the business and report on whether the financial statements are true and fair or not. Audit of financial statements provides a guarantee on the figures and ensures that the objectives are well achieved.
This is a guide to Objectives of Financial Statements. Here we discuss an introduction to Objectives of Financial Statements with explanation, and top 8 objectives in detail explanation. You can also go through our other related articles to learn more –