Free «Why Businesses Produce Financial Statements» Essay
Table of Contents
The practice of preparing financial reports is indispensable since it is necessary for the purposes of making management decisions. Decision making is important in every business undertaking. This would depend on the data and information available to support whatever deliberations are taken. Therefore, there is a need to maintain records (Berezin 20). An accounting system, on the other hand, is a set of methods of accounting. Accounting systems contain procedures and measures established with an aim to collect and maintain financial data for management decisions. Reasons for maintaining such a system include easy retrieval of information, when required. Additionally, another reason why financial accounting is important is that it can be used as a future reference, evidence, or proof in case of a need for confirmation of some transaction. It is also important to keep the system since it is useful in computing cash flows within the organization or another business enterprise. This is important since the concept of time value of money must be considered.
Users of Financial Statements and Their Information Needs
Investors put their resources in various sectors. Consequently, they are the primary users of financial information. Governmental authorities are another important users of financial information. Authorities use this information for the purposes of taxation. It should be noted that management teams are also users of financial information. Management needs this information in making important business decisions. Financial statements typically reflect assets, liabilities, and stockholder equity. Assets have been defined as economic resources. They are tangible or intangible items that give value, which is maintained for a positive economic value. Simply defined as holdings that can be converted into cash, assets are mainly classified into tangible and intangible assets. Tangible assets are those that are physical in nature and include current and fixed assets. Fixed assets mainly last for one-year period. They consist of items such as land, buildings, and equipment. Current assets include inventory. They usually last for a period of less than one year before they are converted into cash. Intangible assets are resources and rights of interests that are of nonphysical nature such as patents, goodwill, and financial assets like bonds, stocks, and accounts receivable. This type of information is of value to management teams and investors.
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In terms of financial accounting, liabilities are defined as rights and interests related to the past undertakings accruing to the firm or business enterprise that are owed to other persons. Liabilities are paid for, therefore, they constitute an expense to the firm. Liabilities are also described as any type of borrowing by the business that is payable and as certain duty that will involve any transfer of assets from the business. This information is also important for investors and management.
Stockholders’ equity is members’ contribution to a business. It is arrived at by subtracting all liabilities from the assets owned. The residual that remains once all the liabilities have been paid constitutes stockholders’ equity. When liabilities are higher than assets of a firm, stockholders’ equity is negative, implying a loss to stockholders. If liabilities are smaller than assets, stockholders’ equity is positive showing profits of the firm. This profit is later on converted into dividends to shareholders.
What Financial Statements Need to be Prepared and Their Content
Financial statements are formal records showing financial activities of the business or persons. They consist of relevant financial data and information that is presented in a structured manner, which can be easily understood by the users of such information (Steven 12-28). They often show a statement of financial position, a statement of comprehensive income, a statement of changes in equity, and a statement of cash flows. This kind of information is used by the management for various decisions.
A balance sheet is a statement that shows financial position of a business at a certain moment. It has information about the assets, liabilities, and owners’ equity of a business. An income statement is a document depicting revenues less expenses for a given period, usually one year. Statement of owners’ equity explains changes in retained earnings. It, therefore, shows a residual value that is due to owners or shareholders. A cash flow statement represents an analysis of all transactions of a business.
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Limitations of Financial Statements
There is no doubt that financial statements are important in business. However, they have limits in their usage. For instance, it is notable that financial statements are not easy to use (Johannes & Filippo 2009). This implies that an investor may not understand financial statements simply by reviewing them. Some knowledge is required for one to understand implications of financial statements. Consequently, lack of financial literacy of common people is an obstacle to sound decision-making. The solution would entail seeking the services of qualified personnel for assistance. In addition, financial statements are often subjected to manipulation of data. As such, accountants or financial experts may use deceiving methods to conceal some vital information. When important information is misrepresented, investors are likely to be misled into making unsound decisions.
In the first scenario, Mark Jennings, a plumber who has worked from home for 2 years intends to buy storage and office space. In this case, the business type is a sole proprietorship. Such entities do not have limited liability (Stein 2011). Hence, it is an unlimited liability enterprise. The most preferable sources of funds would be personal savings and loans from friends or business entities. Chosen source of finance, such as a personal contribution, is an internal one, while sourcing funds from other businesses is external. Preference for personal savings or friends as sources of income rests on the idea that sole proprietorships do not easily attract funding from outside sources.
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In the second scenario, Hinton Ltd, an entity that specializes in the production of designer t-shirts is aiming to upgrade its system. Focusing on the name of the entity, Hinton is a limited liability enterprise. Thus, it has limited liability. In this type of business, the number of financial sources is slightly higher (Stein 2011). The entity could seek funding from banks or other financial institutions. Preferred sources of funds are external, since the entity is in a position to attract funding from such organizations. Although being small, the looks promising and has a good chance to attract funding organizations.
The case of mike Randal reflects negative effects of redundancy. Since he intends to start an organic fruit and vegetable shop, then the business type is a sole proprietorship. Although he can find collaborates and commence a partnership type of business, the entity has unlimited liability. Like in the first scenario, the sources of funds are personal savings, friends' contributions, or bank loans. Preferred sources are internal since it is difficult to attract external investors. As such, Randal would prefer the first two sources.
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In the fourth scenario, Deslandes Ltd specializes in the production of bird boxes. As the name suggests, it is a limited liability entity. The entity has used retained profits. Hence, it should now get sources from external organizations such as banks, etc. Chosen sources of finance are external based on the type of business, which is a limited enterprise.
In the case of Ken Gilkes, the business type has no limited liability. In this case, the business is a sole proprietorship. These entities do not have limited liability. For this reason, it is an unlimited liability enterprise. Sources of funds would be personal savings and loans from friends or business entities. Preferred source of financing, which is personal contribution, is an internal one, while sourcing from other businesses is external.
In the sixth scenario, Kotecha Ltd has limited liability. This big business enterprise can attract funding from various stakeholders. The enterprise can explore looking for funds using internal sources such as family contributions. Alternatively, the business can explore external sources, such as taking bank loans.
The seventh scenario reflects a partnership group. A partnership does not have limited liability (Stein 2011). Since the partnership in question has ten partners, group members are the primary source of funds. This is an internal type of funding. Alternatively, the group could seek external sources of funding, such as from loaning institutions. However, contributions from members are preferred given the type of business.
The eighth scenario is about Swifty Ltd. As in previous occasions, the word ‘limited’ indicates that the business has limited liability. Since the business has been denied a bank loan, it should consider receiving funds from other sources such as cooperative societies. If this move fails, recruiting new members as partners could be a solution. Receiving funds from an external source, such as cooperative, is preferred since this entity may not satisfy demands of senior lending institutions.
Scenario number nine describes a sole proprietorship business arrangement. This is an enterprise with unlimited liability. In order to get new stock, using personal savings or profits is preferred. Internal sources of information are preferred owing to difficulties associated with attracting funding from external sources.
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The case of Sophie is no different from the one highlighted in number nine. The business is a sole proprietorship. It has unlimited liability. To fund the business, the owner should look for funds internally or ask assistance from friends. The inability of such entities to attract funding explains the need to look for funds internally.
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