Financial reporting is the method a firm uses to convey its financial performance to the market, its investors, and other stakeholders. The objective of financial reporting is to provide information on the changes in a firm's performance and financial position that can be used to make financial and operating decisions.
In addition to being a management aid, this information is used by analysts to forecast the firm's ability to produce future earnings and as a means to assess the firm's intrinsic value. Other stakeholders, such as creditors, will use financial statements as a way to evaluate the company's economic and competitive strength.
The timing and the methodology used to record revenues and expenses may also impact the analysis and comparability of financial statements across companies. Financial statements are prepared in most cases on the basis of three basic premises:
1. The company will continue to operate (going-concern assumptions).
2. Revenues are reported as they are earned within the specified accounting period (revenues-recognition principle).
3. Expenses should match generated revenues within the specified accounting period (matching principle).
Furthermore, financial statements are prepared using one of two basic accounting methods:
1. Cash-basis accounting - This method consists of recognizing revenue (income) and expenses when payments are made (when checks are issued) or when cash is received (and deposited in the bank).
2. Accrual accounting - This method consists of recognizing revenue in the accounting period in which it is earned, that is, when the company provides a product or service to a customer, regardless of when the company gets paid. Expenses are recorded when they are incurred instead of when they are paid for.
The Balance Sheet
Financial statements don't fit into a single mold. Many articles and books on financial statement analysis take a one-size-fits-all approach. The less-experienced investor then gets lost when he or she encounters a presentation of accounts that falls outside the so-called "typical" company. Remember that the diverse nature of business activities results in different financial statement presentations.
The balance sheet is particularly likely to be presented differently from company to company; the income and cash flow statements are less susceptible to this phenomenon.
Knowing how to work with the numbers in a company's financial statements is an essential skill. The meaningful interpretation and analysis of balance sheets, income statements and cash flow statements to discern a company's investment qualities is the basis for smart investment choices.
(To learn more, read 12 Things You Need To Know About Financial Statements, our Basic Financial Statement Analysis tutorial and our Advanced Financial Statement Analysis tutorial.)