Financial information is needed to predict, compare and evaluate a firm’s earning ability. It is also required to aid in economic decision making, investment and financial decision making. The financial information of an enterprise is contained in the financial statements.
Financial statement according to the Companies and Allied Matters Act (CAMA) 1990 is a document that consist the basic statements of accounts used to convey qualitative information of financial nature about a business to shareholders, creditors and others interested in the reporting company’s financial condition, results of operation, uses and sources of funds. Duru (2012) defined financial statement as a statement which conveys to management and to interested outsiders a concise picture of the profitability and position of a business. Faboyede & Mukoro (2012) supported that financial statements are the main source of information for major investment decisions including whether to lend money to a firm by investing in its bonds, or acquire an ownership stake in a firm by buying its preferred and common stock, or to buy warrant or options on a firm’s stock. Horngren & Harrison (2007) described financial
statement as documents that report on a business in monetary terms, providing information to help people make informed business decisions.
Financial statements are meant to communicate useful accounting information about the financial operations of a business to both internal and external users. The Nigerian Accounting Standard Board (NASB) describes the financial statement as the method of communicating to interested parties, information on the resource obligations and performance of the reporting entity. Pandy (2007) asserted that financial statements are important means of communicating the utilization of scarce economic resources by an enterprise as such need to contain all relevant information to be reliable and be readily understood by the users of the information.
Concurring with the above definitions, we can generally define financial statement as the audited annual report and accounts of an organisation which gives a synopsis of results of operations and the financial condition of an organisation for the period represented to the interested users.
2.2.2 Importance of Financial Statement
Owole (2009) pointed out that the typical set of financial statements prepared by publicly held companies contains useful information as regard the success of operation of the firm, the financial position of the firm, the policies and strategies of management and insight into its future performance. However, financial statement can only be useful if they are well understood. Financial statement is the information source that is most directly related to items of interest to both existing and potential investors.
According to Ekwe (2013), the satisfaction of the needs of the various users of accounting information as contained in the financial statement can be accepted as the objective of financial statement. The objective of accounting information is emphasized by the various accounting principles because investors and creditors use them in making rational investment and credit decisions.
Financial statement fairly represents the business and economic situation of a company, which if studied carefully can lead to enhance and better decision making by various users. For instance, the balance sheet provides the observant with a clears picture of the financial condition of the company as a whole. It lists in detail the tangible and intangible assets that the company owns and owes, while the income statement summarises the income and expenditure of a company in a
given period of time. It shows the result of operation during these accounting periods. Also, the cash flow statement shows how cash is predicted to move around at a particular period of time. It is useful for planning future expense. It shows whether or not there will be enough cash to carry out the planned activities and whether or not the cash coming in will be enough to cover the expenses. It is useful in the determination of a company’s liquidity in a given period of time. Finally, Elis & Thacker (1998) averred that the most important purpose of the financial statement is to get the shareholders informed about the financial status of a company, especially as to its income and financial position.
2.2.2 Users of Financial Statements
The persons who receive accounting reports are termed the users of financial statements. The type of information a specific user requires from financial statements depends upon the kind of decision that the person intends to make. This is why financial statement is said to be user oriented (Olabisi, 2009; Olowe, 2009). The various users of financial statement can be grouped into two broad divisions, internal and external users.
The internal users include;
i. Management: They require financial statements to manage the affairs of the company by assessing its financial performance and position so as to take important business decisions. They are concerned about the overall financial worth of the enterprise.
ii. Employees: They use financial statement for assessing the company’s profitability and its consequence on their future remuneration and job security.
The external users of financial statements include;
i. Shareholders: They use financial statements to assess the risk and return of their investment in the company and make investment decision based on their analysis. They use financial statements to determine the profitability, growth potential, stability and dividend policy of a firm.
ii. Prospective investors: They need financial statements to asses the viability of investing in a company. Investors may predict future dividends based on the profits disclosed in the financial statements. Investors who wish to become shareholders of the firm are more concerned about the firm’s long run survival and earnings. They bestow more confidence in those firms that show steady growth in earnings. Therefore, financial statements provide a basis for the investment decision of potential investors.
iii. Creditors: They are interested in the ability of the business to pay interest and repay the principal sum on due dates and as such rely on the financial statements.
iv. Customers: They use financial statements to assess whether a supplier has the resources to ensure steady supply of goods in future. This is especially vital where a customer is dependent on a supplier for a specific component.
v. Banks and other Financial Institutions: Use Financial statements to assess the credit worthiness of a business and ascertain whether to grant a loan or credit to a business. Any decision to lend must be supported by a sufficient asset base and liquidity.
vi. Competitors: They compare their performance with rival companies to earn and develop strategies to improve their competitiveness.
vii. The general public: They may be interested in the effects of a company on the economy, environment and local community.
They are interested in the social responsibility and environment protection policies of an enterprise.
viii. Government: They require financial statements to determine correctness of tax declared in the tax returns. Government also
keeps track of economic progress through analysis of financial statements of business from different sectors of the economy.
2.2.3 Qualities of an Ideal Financial Statement
Qualitative characteristics of financial statements are attributes that enhance their meaningfulness to various users. According to Okpe (2005), published financial statements must possess the following qualities;
i. Relevance: For information that is disclosed in the financial statement to be useful at all, it is legally relevant. That is, it must be associated with the decisions it is designed to aid and facilitate. What is relevant for one group of financial statements users may not be relevant for another group of financial statement users, thus, there is no such thing as all-purpose financial statement in the context.
ii. Consistency: Financial statements should be able to ensure a consistent evaluation of companies working in a particular
industry. It should be consistent in the presentation and disclosure of accounting policies including their method of depreciation.
iii. Reliability: The financial statement should be free from error or bias. Users must have confidence in the financial statement without it being misleading or deliberately constructed in a manner that presents the entity in a favourable position.
iv. Comparability: Users of financial statement will want to compare the account with the previous account of their company and possibly with the account of other companies. Comparability adds a degree of transparency to financial statement by allowing comparison over time among entities.
v. Understandable: Financial statement can be somehow complicated for the uninformed to understand, but users must be able to understand the information within them. This applies to the format or layout of the statement, the terms used in the statement and the policies, methods and assumptions utilized in preparing the statement.
vi. Timeliness: Users of financial statement make use of current or up to-date information more than out dated information. The data of the publication of any financial statement or report should be
soon after the end of the period to which the report relates, as corporation is geared towards the provision of information for decision making. Unnecessary delay in the preparation of financial statement may lose their relevance.
vii. Objectivity: Information that is free from bias will increase the reliance people have on financial statements. Therefore, it is essential that the information is prepared as objectively as possible.
viii. Accuracy: The financial statement should disclose correct and accurate information about the profitability and financial position of a business. They should only factual information. No false information is to be included. False information could lead to wrong decision making.
ix. Uniformity: Accounting practices should be uniform both within the corporations and other organizations. Ideal financial statement of one enterprise should be readily comparable with those of another in the same industry. Nevertheless, adoption of different accounting policies like in the method of depreciation and stock pricing has made this difficult.
x. Verifiability: Financial statement should disclose information which can be verified from the records of the company. Qualified
individuals working independently of one another should be able, upon examination of the same data or to derive similar conclusion.
2.2.5 Components of Financial statements
According to Faboyede & Mukoro (2012) the components of financial statement in Nigeria are specified by two bodies including the Company and Allied Matters Act (CAMA) and Statement of Accounting Standards SAS N0.2 issued by the Nigerian Accounting Standard Board (NASB). The bodies state that “all accounting information of an entity should be disclosed and presented in a logical, clear and understandable manner”. Therefore, the components of financial statement include; as highlighted by the Statement of Accounting Standard SAS N0. 2, the components of a financial statement include;
i. Balance sheet ii. Income Statement iii. Cash flow statement iv. Value added statement
v. Five year financial summary vi. Notes on the accounts
vii. Statement of accounting polices
According to Popoola, et al (2014), the most essential components of financial statements to look when investigating the quality of entire business or making decision for the future are; balance sheet, income statement, cash flow statement, value added statement and five year financial summary.
i. Balance Sheet: This is the fundamental financial statement that represents company’s financial position and the basis for estimating the security of a business (Zager & Zager, 2006). This is a financial statement showing the assets, liabilities and net equity of a company at a given point in time usually at the end of the year. It shows the financial position of a business hence the reason why most authors refer to it as statement of financial position.
ii. Income Statement: Aborde (2005) stated that, income statement can cover any period of time, but is usually prepared monthly, quarterly or annually for the planning and controlling purposes. It is a financial statement that gives a company’s operating results for a specific period of time. It is also referred to as earnings reports operating statement. Statements normally cover a year of operations. Its objectives include the measurement of capital maintenance and income distribution. In
this statement, operations are divided into two categories of transactions, sales and revenue.
iii. Cash Flow Statement: Olabisi (2009) asserted that cash flow statements can be prepared from the information contained in the balance sheet at the start and period in conjunction with the profit and loss account, bank and cash account, supplemented by additional information and data. Simply stated, cash flow statement means a statement showing changes or movement of cash or cash equivalent during a given period. Briefly it may be stated as showing various sources of cash inflows and various heads of cash outflows. It is prepared from income statement and changes in the working capital (current assets less current liabilities). Some of the objectives of cash flow statement is to reveal inflow of cash from various activities, to reveal actual cash position of a firm, to help in short term planning, to Reveal the liquidity of the firm and to Forecast weakness Comparison with budget.
iv. Value Added Statement: This is a statement highlighting on the performance of a firm in wealth creation. The importance of value added statement relies extensively upon its value to a
potential user. It provides a sound base for more realistic decision making (Akinsoyime, 1990).
v. Five Year Financial Summary: According to Akinadewo (2012), five year financial summary is an extraction of financial information in the balance sheet and profit and loss account.
Financial summary gives the benefit of understanding the movements of the financial analysis of a firm, which will aid the investor to decide on either to invest on short term or long term basis. Five year financial summary enables users to have some ideas of trends in a company over a period of time. It is also used to asses and forecast future performance of a company (John, 1986).
2.2.5 Ratio Analysis
Financial ratio is the relationship between two or more financial or statistical data in a financial statement or management account (Aborde, 2005). It may be expressed as another figure percentage of or in relation to another figure or group of figures in the same financial statement.
Ratio analysis involves comparison of useful interrelated figures over a number of years to establish a trend. In assessing the financial statement of any particular firm, investors try to know how the firm had been operating over the years. From the answer they get by using ratio
analysis, they would then be able to know whether things are going well with the firm or not. In line with this argument, the kind of ratio used will reflect the nature of the business that is being treated. Weston and Brigham (1984) divided the ratios into five fundamental types, which are;
i. Liquidity Ratio: This ratio measures the firm’s ability to meet its maturing short-term (current) obligations.
ii. Leverage Ratio: This ratio measures the proportion of debt and equity in financing the firm’s assets. It relates to the study of proportions of various types of capital in the structure of the firm.
iii. Activity Ratio: This ratio measures how efficiently and effectively the firm is utilizing its resources management overall effectiveness as shown by the returns generated on sales and investment.
iv. Growth Ratio: measures the firm’s ability to maintain its economic position in the growth of the economy and industry.
v. Valuation Ratio: which are the most complete measures of performance because they reflect risk ratios and return ratios.
Valuation ratios are of great importance since they related directly to the goal of maximizing the value of the firm and shareholders wealth.
The list of ratios is not exhaustive rather it is tailored to the nature of the problem, which it is intended to help in solving. According to Olabisi (2009), the needs of financial statement users are not normally the same. This depends largely on the type of user and the purpose for which the information is required. However, the various needs for which ratio analysis and financial statement analyses are required include;
i. Performance measurement: This includes appraising the performance of an organisation, a division, product or services.
ii. Investment and divestment decision: This allows a potential investor to analyse the financial statements to guide in either investing in a particular business or not. However, an existing investor does that to either invest or divert shares in a particular company.
iii. Liquidation and reorganisation decision: This helps to determine either to liquidate a business or to reorganise the business in form of business combination, merger, acquisition or internal reconstruction.
iv. To measure the strengths, weaknesses, opportunities and threats of an economic unit or business entity.
2.2.7 Concept of Investment Decision
As postulated by Pandey (2007), investment decisions or analysis has to do with an efficient allocation of capital. It involves a decision to commit the funds to the long-term assets. Such decisions are of considerable importance to the firms and investors since they tend to determine its value size by influencing its growths, profitability and risk.
The investment decisions of a firm are generally known as the capital budgeting decision which may be defined as the firm’s decision to invest its current funds most efficiently in the long-term assets in anticipated of an expected flow of benefits over a series of years. Any situation where capital expenditure decisions are made or taken, they are based primary with measurement of capital productivity which provides an objective means of measuring the economic worth of individual investment proposals in order to have a realistic basis for choosing among the firm’s long run property (Pandey 2007). The long-term asset is those which affect the firms operation beyond one year period. The firm’s investment decision would generally include expansion acquisition, modernization and replacements of the long-term assets.
Future benefits of investment are difficult to measure and cannot be predicted with certainty. Risk in investment arises because of the uncertain returns. Investment proposals should therefore, be evaluated in terms of expected return and risk. Beside the decision to commit funds in
new investment proposals, capital budgeting also involves replacement decisions that are decision of recommitting funds when an asset becomes less productive or non-profitable. The correct cut-off rate in investments is the opportunity cost of capital which is the expected rate of return that an investor could earn by investing in financial assets of equivalent risk.
It is significant to emphasize that expenditures and benefits or an investment should be measured in cash. In an investment analysis, it is cash flow which is important, not the accounting profit. It may also be pointed out that investment decisions affect the firm’s value. The firm’s value will increase if investments are profitable and add to the shareholder’s wealth. These increases are reflected in the financial statement of the firm, which invariably are used as tool for investment decisions owing to certain analysis inherent in them.
2.3 Theoretical Framework
In the 1960s, the emphasis of value relevance of accounting information was on the usefulness of accounting to individual users-which is also synonymous with information perspective. This perspective
In the 1960s, the emphasis of value relevance of accounting information was on the usefulness of accounting to individual users-which is also synonymous with information perspective. This perspective