3 Main Purposes of Financial Statements (Explained)

Overview:

Financial statements report the entity’s financial transactions, position, and events, for a specific period of time and they are prepared and used for many different purposes including full filing the requirement of regulators, tax authorities, shareholders, board of directors, management of the entities and many others purposes.

In general, there are five types of financial statements, and those statements contain five elements on these statements. These statements and elements are prepared and presented for their own different purposes and provide users with different information.

In this article, we will explain to you the detail of the purpose of Financial Statements according to the financial frameworks issued by IASB and real-world practice.

Before going into detail on the purpose of financial statements, let’s see what the five types and elements of financial statements are. Being aware of these things could help you better understand why entities establish these kinds of statements.

The five types of Financial Statements are:

  1. Income Statement or Statement of Financial Performance
  2. Balance Sheet or Statement of Financial Position
  3. Statement of cash flow
  4. Statement of change in equity
  5. Notes to financial statement

Check here for detail, Five types of Financial Statements (Completed Set)

Five elements of Financial Statements are:

  1. Assets
  2. Liabilities
  3. Equity
  4. Revenues
  5. Expenses

Check here for detail, 5 Main Elements of Financial Statements: Assets, Liabilities, Equity, Revenues, and Expenses

  • Income Statement: the individual statement and element tell the users different information. For example, the purpose of the income statement is to tell users whether the entity makes a profit or loss.

It is detailed to total sales revenues that the entity makes during the period, the cost of goods sold or services that are incurred as well as the other important profit and losses items.

  • Balance sheet: the purpose of the balance sheet is to inform the users about the number of assets that an entity has, the liabilities that the entity owes, and the amount of its equity. In other words, it lets users know the entity’s financial situation and position of the entity.

This financial information is essential to many users because it helps them better understand the company to make the right decision.

And to make sure that users received the right information, there is much enforcement from the accounting body and the law.

Now, let’s move to the purpose of financial statements and what kind of information the users could obtain to help them make the correct decision.

Here are the three main purposes:

1) Provide an entity’s financial information:

The main purpose of Financial Reporting is to provide the entity’s financial information. This is the first objective of financial statements that have been stated in the conceptual framework.

Generally, if the entity’s financial statements are prepared based on IFRS, then the entity is required to prepare and present these five statements of its financial statements.

  1. Statement of Financial Position
  2. Income Statement
  3. Statement of Cash Flow
  4. Statement of Change in Equity
  5. Related Note to Financial Statements

Individual Purpose of these Statements:

The above financial statements will help the users obtain the importance of financial information that could help them in decision making.

These statements will be shown the important information of the entity like assets, liabilities, equity, profile or loss during years, and much other useful information.

Such information is also presented in the Annual Report or sometimes highlights in CEO and Chairman Statements. The conceptual Framework required the entity to prepare all of these statements along with the explanation if required.

Related article  What Is A Compilation Financial Statement? Explained!

The individual statement offers the users different information and value;

  1. For example, in the statements of financial position, the users could see and understand about entity’s assets, liabilities, and equities. With that information, the users can primarily assess how financially healthy the entity is.
  2. Income Statement provides the users about how much the entity generates the sales revenues for the reporting period and other important information like the cost of goods sold, gross profits, and net incomes for that period of time.
  3. Statement of change in equity, on the other hand, tells the users about the entity’s equity information along with the changing of equity for the period as the result of the entity’s performance. This statement also informs the users how much the shareholders injected their funds into the entity.
  4. The cash flow statement by the ways helps the users understand the cash flow of the entity and cash balance at the end of the period.

Okay, now let’s move to the second purpose of financial statements,

2) Assist existing and potential investors:

There is so much information related to the target companies that investors need to obtain and assess whether they should invest in, increase the existing investment, or withdraw their investment.

Financial Statements are the primary sources of information that could help investors to get most of the financial information for their assessments and decision.

If they want to know how financially stable the company is, financial statements are probably the primary sources of information that could help your assessment.

Both existing and potential investors normally use the financial statements to analyze and break down into potential investment decisions.

For example, investors can assess the entity’s profitability against the entity’s competitors. They also use the entity’s financial leverages to assess the likelihood of return on debtors and shareholders.

Investors can also use the entity’s financial information to assess the going concern. For these reasons, IASB is working so hard to make sure that all of the necessary information is disclosed in the financial statements.

3) Oversee the entity’s prospective future net cash inflows:

The purpose of financial statements does not only to provide the users to know how well or bad the entity’s financial position is or how big or small the entity is.

They also prepare for the purpose of helping the user, especially the investors in predicting the entity’s future cash flow.

The potential and existing investors could use the financial statements to assess the potential adverse effect on the company’s perspective on cash flow.

And how management and directors use the company’s resources effectively and efficiently. That is the reason why there are so many disclosures required on the financial statements.

Financial Reports could not tell everything about the company to its existing and potential investors or its related stakeholders.

But IASB tries to make sure that the minimum information of the company that those stakeholders should know is available for them.

In the paragraph OB11 of The Conceptual Framework, it said that

“To a large extent, financial reports are based on estimates, judgments, and models rather than exact depictions. The Conceptual Framework establishes the concepts that underlie those estimates, judgments, and models. The concepts are the goal towards which the Board and preparers of financial reports strive”.

4) Additional Purposes Financial Statements:

  • Help creditors assess the creditworthiness of the entity. Normally, the process of evaluating the credit score requires both financial and non-financial information. From a financial perspective, financial statements contain much beneficial information to assist this.
  • Help employees assess the stability of its entity. Employees want to see the company that they are working on running forever. They want to secure their job. If they could assess the company’s financial statements, they will access
  • Help the government agency to assess the tax return. Most of the entity requires to pay corporate tax, and General Tax Department needs the financial statements of an entity to assess whether tax has been completely collected.
  • Help bankers make risks assessment. Bankers and creditors need the entity’s financial statements to assess the ability to pay the debt.
  • Users by competitors to assess the competitiveness in terms of financial straight.
Related article  Single-step Income Statement: Definition, Example, and Template

5) Users of Financial Statements:

  • Shareholders: Shareholders can be individuals who have 100% shares in the company or the group of people who own the company’s shares. They use the financial statements for investment assessment.
  • Potential Investors: Some of the companies publish their audit report
  • Board of directors
  • Managements
  • Employees
  • Bankers
  • Creditors
  • Government body (tax division)
  • Suppliers
  • Customers
  • Competitors

How Important is the Financial Statements for These Users?

Shareholders: Shareholders, whether individuals or groups, utilize financial statements to assess the investment potential of a company. 

By reviewing financial reports such as the balance sheet, income statement, and cash flow statement, shareholders can evaluate the company’s financial health and performance. 

They analyze factors such as revenue growth, profitability, debt levels, and liquidity to make informed decisions about buying, selling, or holding shares in the company.

Potential Investors: Potential investors rely on financial statements, including audit reports, to evaluate the viability of investing in a company. 

These statements provide insights into the company’s financial position, ability to generate profits, and the risks associated with the investment.

Investors analyze financial ratios, such as return on investment (ROI) and earnings per share (EPS), to assess the company’s profitability and compare it with industry peers. 

They use this information to determine whether investing in the company aligns with their investment goals and risk tolerance.

Board of Directors: The board of directors oversees the company’s strategic direction and is responsible for making critical decisions.

Financial statements help the board monitor the company’s financial performance, assess the effectiveness of management’s strategies, and evaluate the company’s compliance with financial regulations. 

By analyzing financial statements, the board can identify areas of improvement, address potential risks, and make informed decisions regarding dividend distributions, capital expenditures, and other financial matters.

Management: The management team, including executives and managers, uses financial statements to gauge the company’s financial performance and make operational decisions. 

They assess revenue and expense trends, analyze cost structures, and monitor cash flows to ensure the company’s financial stability. 

Financial statements also help management identify areas where operational efficiency can be improved and make informed decisions regarding budgeting, investments, and resource allocation.

Employees: While employees may not have direct access to detailed financial statements, they may receive summarized financial information or key performance indicators (KPIs) related to the company’s financial performance. 

This information can give employees insights into the overall health of the organization and its ability to sustain employment and provide financial rewards. 

Understanding the company’s financial standing can also impact employee morale and job security.

Related article  What Are the Key Balance Sheet Items? 3 Key Items You Should Know

Bankers: Banks and financial institutions use financial statements to evaluate a company’s creditworthiness when considering loan applications or extending credit. 

By analyzing the financial statements, banks assess the company’s ability to repay debts, evaluate its liquidity position, and analyze its collateral value. 

This information helps bankers determine the terms and conditions of loans, credit limits, and interest rates.

Creditors: Creditors, such as suppliers and lenders, review financial statements to assess a company’s financial stability and creditworthiness before extending credit or establishing payment terms. 

They analyze financial ratios, liquidity positions, and debt levels to evaluate the company’s ability to meet its financial obligations. 

Based on the information provided in financial statements, creditors make decisions regarding credit limits, payment terms, and the level of risk associated with providing goods or services on credit.

Government Body (Tax Division): Government tax divisions use financial statements to ensure companies comply with tax regulations. 

They review financial records to verify income, expenses, and deductions claimed by the company. 

Financial statements help tax authorities assess the accuracy of tax returns and detect any potential tax evasion or non-compliance. 

Additionally, financial statements provide information for calculating taxes owed, issuing tax assessments, and conducting audits.

Suppliers: Suppliers analyze financial statements to assess the financial stability of their customers. 

They evaluate liquidity, payment history, and creditworthiness to determine whether to extend credit terms or adjust pricing. 

Financial statements help suppliers decide the level of credit to offer and manage the financial risks associated with supplying goods or services to the company.

Customers: Although customers may not have direct access to financial statements, they may indirectly consider a company’s financial health when purchasing. Customers may look for

What is the difference between the general and special purpose of financial statements?

Financial statements are essential to an organization’s financial reporting process, providing stakeholders with critical information about the entity’s financial performance and position.

In general, financial statements are prepared with two main purposes in mind: general purpose and special purpose.

General purpose financial statements, or external financial statements, are designed to meet the needs of a wide range of users, including investors, creditors, and other stakeholders.

These statements typically include a balance sheet, income statement, statement of cash flows, and statement of changes in equity, as well as related notes and disclosures. 

The information presented in these statements is intended to provide a comprehensive view of the entity’s financial position, performance, and cash flows and to enable users to make informed decisions about investing, lending, or transacting with the entity.

On the other hand, special-purpose financial statements are prepared for a specific user or group of users, typically for a particular purpose or objective.

These statements may be tailored to meet the user’s needs and include only selected information or data. Examples of special-purpose financial statements include tax returns, management reports, and regulatory filings.

While general-purpose financial statements provide a broad view of an entity’s financial performance and position to various stakeholders, special-purpose financial statements are tailored to meet specific user needs or objectives.

Conclusion:

In summary, the main purposes of financial statements are to provide entity financial information to the group of potential stakeholders to help them make the correct decision.

The correct entity financial information is provided to the users only if they are present in true and fair view and in accordance with the relevant accounting framework.

Sinra