The basics of financial statements

By Ben R. Punongbayan

For many business executives, understanding financial statements (FS) has become a challenge. To some, it may even be intimidating especially considering the many recent changes introduced in the requirements for financial reporting. This should not be the case.

The FS I refer to are those issued by business enterprises and other entities for general purposes, i.e., for owners, lenders, suppliers, customers, employees, government regulators, and the public at large. These FS provide information about the financial position (balance sheet), performance (income statement) and changes in financial position (cash flow statement) of an entity, which are useful to the users in making economic decisions.

But clearly, the various users of general purpose FS do not have the exact same needs. What FS try to do is to serve users’ common needs; aside from these needs, the respective users will have to source the information elsewhere.

To be useful, the FS should provide a fair presentation of an entity’s financial position, performance, and changes in financial position. Otherwise, the FS may give users misleading inferences that may prompt them to make wrong economic decisions.  

But what is fair presentation? There is no direct definition of fairness of presentation as it relates to FS. But fair presentation is normally achieved when the principal qualitative characteristics of the FS and appropriate accounting standards (now more often referred to as financial reporting standards) are applied in their preparation and presentation.

The prescribed qualitative characteristics of FS are many but just to note, the principal qualitative characteristics of the FS are understandability, relevance, reliability and comparability. Most readers understand these terms intuitively. In any case, these qualitative characteristics are for the most part embedded in the various financial reporting standards that are applied in preparing the FS.

What are financial reporting standards? Expressed simply, financial reporting standards are the mandatory principles and related requirements that need to be followed when preparing the FS. These standards are promulgated by the standards setters, which in the Philippines is the Financial Reporting Standards Council (FRSC), an independent body organized by the Philippine accounting profession.

Currently, the financial reporting standards promulgated by the FRSC are not uniquely of Philippine origin. These financial reporting standards are in fact an exact copy of International Financial Reporting Standards adopted by the international accounting standards setters. The FRSC’s adoption of these international financial reporting standards is in line with the harmonization of financial reporting standards around the world. These international/Philippine financial reporting standards have also been accepted by Philippine regulatory bodies, such as the Securities and Exchange Commission (SEC), the Bureau of Internal Revenue, the Bangko Sentral ng Pilipinas, and the Insurance Commission for mandatory adoption by covered Philippine entities.

FS prepared by Philippine business enterprises are generally required by government regulatory bodies to be audited by external auditors before these are issued to users. Here is where an important misconception still exists among many concerned parties, although it is encouraging to note that such misconception is gradually fading.

Who bears the primary responsibility for the preparation and presentation of the FS?  International practice and international financial reporting standards are very clear in this respect – it is the management of the business entity that bears this primary responsibility. Our own SEC has also made this important matter very clear. But many still feel that the primary responsibility lies with the external auditors who examine and express an opinion on the FS. It is important that this distinction is clear to all, especially to management. To carry out this primary responsibility faithfully, management must exercise due care and diligence in preparing and presenting the entity’s FS in accordance with financial reporting standards.

But what about the external auditors? What do we need them for? As with any activity where assurance is necessary or required with regard to the quality of the output, the external auditors are appointed to provide assurance that the FS was, in fact, prepared and presented in a fair manner and, therefore, in accordance with financial reporting standards. Such assurance is necessary so that users can confidently rely on audited FS in making their economic decisions.

Of course, this does not mean that external auditors are responsibility-free. On occasions when external auditors do not do their job properly and material misstatements are subsequently discovered in the FS they audited, the external auditors, of course, could be held accountable for the failure to detect such material misstatements. The probability of these occasions occurring is greatly feared by external auditors and makes them work diligently to avoid them.

With the management and the external auditors duly accepting – and diligently performing – their respective responsibilities over the FS, the reliability of the FS, as these are relied upon by the users, is greatly enhanced.

(As published in BusinessWorld, 4 June 2012. This article is the first in Mr. Punongbayan’s monthly series designed to help interested parties, particularly business executives who are involved in preparing financial statements and who use these statements for various purposes, gain a better understanding of FS.)