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(PDF) Research on Limitations of Financial Statement

   

Added on  2021-04-17

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Running Head: Uses and Limitations of financial statementsFinancial Statements of an Entity

Uses and Limitations of financial statements 1Introduction:Every entity has to prepare the financial statements, on a regular basis, to communicate thefinancial results of the business operated by it. These financial statements contain thesummarised information expressed in financial terms about all the transactions and eventsthat are entered into during the course of business. All the financial information that helps thereaders to assess the financial health of business of an entity is compiled in the financialstatements and shared with the intended users by the way of annual report. There areprimarily three types of financial statements that are prepared by almost every businessentity. They are: Income Statement, Balance Sheet and Cash Flow Statement. All thesefinancial statements convey different but related information about the business. Therefore, itis important for the users of financial reports of the company to study all the three financialstatements to evaluate the performance of the business. Preparation and presentation offinancial statements is called the financial reporting function which is performed by theentities to comply with the corporate governance requirements as applicable to the entities.The basic objective behind the following the practices of financial reporting is to disseminatethe relevant and necessary financial information about the business to allow the keystakeholders to make sound economic decisions relating to the reporting entity.Critical evaluation of financial statements:The first and foremost financial statement that is required to be prepared by the entities is theincome statement which is traditionally termed as profit and loss account. This statementmainly reflects the profitability position of the reporting entity. It is mainly composed of twoimportant elements of the business i.e. income and expense. Income is something that thebusiness earns over a period of time. There are various types of income that forms part ofincome statement of the entity such as sales revenue, interest and dividend income etc. On the

Uses and Limitations of financial statements 2other side expenses of the business are the costs that are incurred in the course of businessover a period of time. The examples of expenses of the business are: depreciation, rent,salaries and wages, interest and tax payments. The income statement enables the users todetermine whether the company has made profits or losses during the reported period in thecourse of business. The expenses that are reported in the income statement are chargedagainst the revenues generated in the concerned period by following the matching principleof accounting. Income statement represents the financial performance of the business duringa period of time and not at a particular moment of time (Van Auken & Carraher, 2013). Theincome statements render the important portion of financial reports of the entity as they forman important basis in the preparation of statement of financial position since net profit isearned during the year by the entity is transferred to the general reserves of the company thatbecomes the key component of its statement of financial position. Not only operatingincomes and expenses are reported in the income statement of an entity but also the non-operating incomes and expenses (De Franco, Kothari & Verdi, 2011). Income statement of an entity possesses various features that make it an important documentto assess the financial position of the business. They provide detailed information about theways in which net profits of the business are ultimately derived as it not only covers theinformation of revenues earned by the business but also the information regarding the cost ofgoods sold and other expenses that are incurred while operating the business. Moreover, theincome statements help the owners to determine their tax obligation on the profits earned as apart of business. There are various parties for whom income statement act as an ideal sourceof information to make various economic decisions such as the potential investors, lenders offinance, governmental agencies etc. (Boundless Finance, n.d.)The Earning per share as depicted by the income statements of the entity enables the potentialinvestors to evaluate the return potential of the reporting entity. It shows them the current

Uses and Limitations of financial statements 3return that the company is paying to its existing investors and the potential of the company topay them the desired returns in the subsequent periods (Penman & Penman, 2007). Further,the net income shown in the income statement helps the lenders of finance such as bank andfinancial institutions to assess the profitability position of the business that will in turn allowthem to decide as to whether they should provide the company the required financialassistance or not. Furthermore, the net income reflected in the income statement allows thetax regulatory bodies to calculate the tax obligations of the reporting entity on the basis ofsuch book profits (Hanlon, 2003). In spite of these many uses of income statement, suchstatements suffer from certain limitations that affect their usefulness for the intended users.Such limitations are discussed in the further section.There are multiple types of profits reported in the income statement such as gross profit andnet profit and these profits have different interpretations. Since each profit reflected in theincome statement carries different meaning it becomes tough for the readers to understandand interpret each profit separately and to identify the reasons for the differences in thevalues of different sort of profits. In order to evaluate the overall profitability of the business,the readers are therefore required to possess requisite knowledge of all the concepts ofbusiness profits (Accounting Coach, 2018). Further, the income statements of any entity areusually prepared on the accrual basis and hence it reports all the transactions that are enteredinto, by the business managers in the normal course of business, irrespective of theinvolvement of cash in such transactions. The preparation of income statement on accrualbasis does not allow the closing cash balance of business to match with the net profits earnedover the period of time. The amount of revenue from sales shown in the income statementincludes those amounts also that are not even collected till the end of reporting year and alsothe amounts that are actually not paid during the reporting period. Even the non-cashexpenses such as goodwill amortisation expenses, depreciation expenses and so on are

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