What Are the Primary Objectives of Financial Reporting?
Understand the guiding principles of financial reporting and how they enable stakeholders to assess a company's financial health for decision-making.
General purpose financial reporting is how companies communicate financial information to external parties. These reports provide transparency about a business’s activities and performance. They are designed to serve a broad audience rather than being tailored to the specific demands of any single group.
The Primary Objective of Financial Reporting
The central objective of financial reporting is to provide financial information about a company that is useful to its existing and potential investors, lenders, and other creditors. This purpose is established by accounting standard-setting bodies, such as the Financial Accounting Standards Board (FASB). The usefulness of this information is tied to making decisions about providing resources to the entity.
This objective guides the entire financial reporting process. The decisions made by these capital providers include choices to buy, sell, or hold equity and debt instruments, and decisions related to providing loans or other credit. The information is intended to help these users assess the amount, timing, and uncertainty of future net cash inflows to the company, which impacts their return on investment. The focus is on the common information needs of this group, as they cannot demand private data and must rely on public reports.
Key Information for Decision Making
To fulfill the primary objective, financial reports provide specific information through the main financial statements. Users need data about a company’s economic resources and the claims against it to understand its financial position. This is the function of the Balance Sheet, which presents a snapshot of assets, liabilities, and equity at a single point in time.
Information about transactions that change a company’s resources and claims reflects its financial performance. This is the focus of the Income Statement and the Statement of Comprehensive Income, which show revenues and expenses over a period. This performance data helps users evaluate how a company uses its resources to generate profits.
Information about a company’s cash flows is detailed in the Statement of Cash Flows. This statement categorizes cash movements into operating, investing, and financing activities. Understanding the sources and uses of cash is important for assessing a company’s ability to generate future cash and meet its obligations.
This collection of information allows users to perform analysis. For instance, a creditor can assess solvency by examining the balance sheet, while an investor can gauge growth prospects from the income statement. The information is interconnected, allowing for a more robust analysis than any single report could offer.
Identifying the Primary Users
The primary users of general purpose financial reports are existing and potential investors, lenders, and other creditors. Standard-setters like the FASB focus on this group because their decisions directly impact the allocation of economic resources. These capital providers lack the access to internal records or the authority to demand private information.
Other parties also find value in these reports. Management uses them for internal decisions, government agencies like the Securities and Exchange Commission (SEC) use them for oversight, and the public may use them to understand a company’s stability. However, the information provided is not primarily shaped by the needs of these other stakeholders, but for the group whose capital is at risk.
Qualitative Characteristics of Useful Information
For financial information to be useful, it must possess certain qualities. The conceptual framework for financial reporting outlines two fundamental characteristics: relevance and faithful representation. Information is relevant if it can make a difference in a user’s decisions. Materiality is an aspect of relevance; information is material if omitting or misstating it could influence user decisions.
Faithful representation means the information accurately reflects the economic phenomena it purports to represent. A faithful representation is complete, including all necessary information; neutral, meaning without bias; and free from error.
Several enhancing characteristics also improve the usefulness of information:
- Comparability allows users to identify similarities and differences among items.
- Verifiability helps assure users that information is faithfully represented.
- Timeliness means having information available before it loses its capacity to influence decisions.
- Understandability requires that information be presented clearly and concisely.
These characteristics are subject to a cost constraint. The benefit of providing information should justify the cost of providing and using it. Companies must balance the drive for ideal reporting against the real-world costs of preparing the data.