The basic objective of financial statements is to communicate useful and meaningful information that meets the needs of the users of the financial statements.
Qualitative characteristics of useful and meaningful financial statements include:
- Understandability – financial statements that are unduly complicated can send up a red flag to banks, surety companies and potential investors; transparency is key to success in today’s business environment.
- Relevance – financial statements provide feedback on a company’s performance (normally over 1 to 5 years) and are used by banks and surety companies to predict the future success of acompany; timeliness of the preparation of financial statements is also important as outdated information may not be useful to users in assessing a bond or loan application.
- Reliability – financial statements are management’s responsibility and to be reliable, representational faithfulness is key – the substance of a transaction must be consistent with how it is presented in the financial statements; the underlying transactions in financial statements must normally be verifiable to an economic event and neutral or free from bias; external users also subscribe to the concept of conservatism in management judgments where uncertainty exists or estimates have to be made.
- Comparability – financial statements that are comparable allow users to compare a company to another similar company or to compare a company’s performance over a period of time; both are techniques used by banks, surety companies and potential investors to evaluate a company’s performance.
Financial statements provide financial information at a point in time and changes to assets, liabilities and equities covering a certain period of time. The following makes up a set of traditional financial statements:
- Balance sheet (a statement of financial position at a specific date, including assets, liabilities and equity);
- Income statement (a statement of operations covering a period such as a month, quarter or year, showing revenues, expenses, income taxes, gains/losses, net income/loss);
- Statement of changes in retained earnings (changes in retained earnings from the previous period, adding in net income/loss for the year and deducting dividends);
- Statement of changes in cash flow (changes in cash balances from the previous period, which shows sources and uses of cash); and
- Notes to the financial statements, which provide additional information for users for clarification purposes.
With the implementation of the new accounting standards for financial instruments, comprehensive income and its components, when applicable, are displayed with the same prominence as the other statements.
Internal users such as management, owners and shareholders of private companies rely on financial statements to:
- Assess the appropriateness of the company’s policies (pricing, credit, payment) to improve profitability and evaluate success by comparing its financial benchmarks to those of its competitors; for example, gross profit comparisons to industry standard (note that these are more meaningful if everyone in the industry prepares their financial information in the same way).
- Determine net income after taxes, which results from recognizing revenue when it has been earned and matching the corresponding expenses against that revenue in the same period; this enables management to determine how profitable the company was in a given year and measure return on equity invested.
- Measure the company’s true growth from year to year, avoiding fluctuations in net income due to the inconsistent application of accounting principles (i.e. changing from one to another in the following year) or the application of a principle that skews financial results in a particular industry.
External users such as potential partners, investors or shareholders rely on financial statements to:
- Assess the financial health of a company and its ability to generate long term returns on investment, including a risk premium reflecting the nature of the industry; for example, a private company may want to grow without adding debt by admitting another partner or shareholder, or an owner may want to sell the company as a going concern and retire.
- Assess the company’s exposure to liability through lawsuits, commitments and contingent liabilities.
External users such as banks and surety companies rely on financial statements to:
- Assess the credit worthiness of the contractor, as well as ongoing credit worthiness once the initial position is established (i.e. credit risk);
- Determine the price for which lines of credit, long term debt and surety bonds will be offered (i.e. premiums, interest rates);
- Determine the terms and conditions (set out in covenants) and security requirements based on an overall assessment of risk (i.e. financial risk);
- Assess the company’s exposure to foreign exchange fluctuations which may negatively impact net income (exchange risk); and
- Assess overall company liquidity and its ability to handle any difficult situations that may arise.
- Determine the debt load or bonding capacity that a potential customer can carry and ability to service debt and meet its obligations (i.e. liquidity risk);
For example, through an in-depth review of a contractor’s financial statements, a bank assesses the company’s ability to consistently maintain positive cash flow, collect its receivables, pay its employees and suppliers and meet its obligations to the government and other creditors. Surety companies do the same, as they want to ensure that a contractor can meet its obligations while waiting for progress payments to be made to them on a contract. Surety companies want to see that a contractor has adequate lines of credit to finance (multiple) contracts for which they are providing surety bonds. Surety companies and banks also assess a company’s profitability as compared to others in the same industry, the stability of historical profits and the company’s capacity to grow and be profitable.
Establishing and maintaining good supplier credit is also essential to a contractor. External users such as credit rating agencies rely on financial statements to assess the credit worthiness of a company, compiling this information and providing it to their subscribers. These subscribers use the agency’s rating in determining supplier credit to be given to or withheld from a particular contractor. This can be very important to a contractor who is starting up and is trying to establish credit with various suppliers when it has no track record to demonstrate its credit worthiness. So although the financial statements are provided to these agencies by a contractor on a voluntary basis, it is normally in the contractor’s best interests to do so.
External users such as the CRA rely on financial statements to collect tax that is owing by a company. In general, under the Income Tax Act, companies are expected to follow GAAP in the preparation of financial statements.
Source: Construction Accounting Best Practices by Canadian Construction Association