The Objective of Financial Reporting 1

 Conceptual Framework for Financial Reporting

1: The Objective of Financial Reporting

INTRODUCTION

1. The first chapter of the conceptual framework establishes the objective of general purpose external financial reporting by business entities in the private sector. (Throughout the framework, the term entities [or entity] refers to business entities [or entity] in the private sector.) The objective of financial reporting is the foundation of the framework. Other aspects of the framework—qualitative characteristics, elements of financial statements, definition of a reporting entity, recognition and measurement, and presentation and disclosure—flow logically from the objective. Those aspects of the framework help ensure that financial reporting achieves its objective to the maximum extent feasible.

OBJECTIVE OF FINANCIAL REPORTING—PROVIDING INFORMATION USEFUL IN MAKING INVESTMENT AND CREDIT DECISIONS

2. The objective of general purpose external financial reporting is to provide information that is useful to present and potential investors and creditors and others in making investment, credit, and similar resource allocation decisions. (Paragraphs OB6–OB9 discuss the potential users of financial reporting information.)

Information Useful in Assessing Cash Flow Prospects

3. To help achieve its objective, financial reporting should provide information to help present and potential investors and creditors and others to assess the amounts, timing, and uncertainty of the entity’s future cash inflows and outflows (the entity’s future cash flows). That information is essential in assessing an entity’s ability to generate net cash inflows and thus to provide returns to investors and creditors.

4. An entity’s investors and creditors (both present and potential) are directly interested in the amounts, timing, and uncertainty of their cash flows from dividends, interest, and the sale, redemption, or maturity of securities or loans. However, the prospects for those cash flows depend on the entity’s present cash resources and, more importantly, on its ability to generate enough cash to pay its employees and suppliers and satisfy its other operating needs, to meet its obligations when due, to reinvest in operations, and to distribute cash to owners (for example, to pay cash dividends). The judgments of capital market participants about the entity’s ability to generate net cash inflows affect the values of debt or equity interests. Therefore, those judgments also may affect cash flows to investors and creditors through sale of their interests.

5. In a cash-based exchange economy like those that generally exist in parts of the world in which financial reporting is important, cash (or its equivalent) is the medium of exchange, as well as the store of value. In such an economy, most goods and services have money prices, and cash (including currency, coins, and money on deposit in financial institutions) is prized because of what it can buy. Members of the society carry out their consumption, saving, and investment decisions by allocating their present and expected cash resources. Thus, discussion of the objective focuses on an entity’s cash-generating ability and on cash returns to investors and creditors. However, an entity might provide a return in ways other than by distributing cash. One example is a dividend-in-kind, which is a dividend distributed to owners in the form of noncash resources such as inventory. Investors and creditors may be indifferent about whether a return to them is in the form of cash, another asset that can be converted into the same amount of cash, or in some other form. The objective of financial reporting could have been stated in terms of cash, cash equivalents, or other resources that can be converted to cash or the like. The role of cash as a medium of exchange and store of value, and therefore the ultimate interest of investors and creditors in cash, makes it unnecessary to use such an unwieldy term.

POTENTIAL USERS OF FINANCIAL REPORTS AND THEIR INFORMATION NEEDS

6. Financial reporting is not an end in itself. It is a means of communicating to the users of financial reports information that is useful in making choices among alternative uses of scarce resources. Thus, the objective stems largely from the needs and interests of those users. Potential users of financial reports and their information needs include:

a. Equity investors. Equity investors in an entity are interested in the entity’s ability to generate net cash inflows because their decisions relate to the amounts, timing, and uncertainties of those cash flows. To an equity investor, an entity is a source of cash in the form of dividends (or other cash distributions) and increases in the prices of shares or other ownership interests. Equity investors are directly concerned with the ability of the entity to generate net cash inflows and also with how the perception of that ability affects the prices of its equity interests.

b. Creditors. Creditors, including purchasers of traded debt instruments, provide financial capital to an entity by lending cash (or other assets) to it. Like investors, creditors are interested in the amounts, timing, and uncertainty of an entity’s future cash flows. To a creditor, an entity is a source of cash in the form of interest, repayments of borrowings, and increases in the prices of debt securities.

c. Suppliers. Suppliers provide goods or services rather than financial capital. They are interested in assessing the likelihood that amounts an entity owes them will be paid when due.

d. Employees. Employees provide services to an entity; employees and their representatives are interested in evaluating the stability, profitability, and growth of their employer. They are interested in information that helps them to assess the entity’s continuing ability to pay salaries and wages and to provide incentive payments and retirement and other benefits.

e. Customers. To its customers, an entity is a source of goods or services.

Customers are interested in assessing the entity’s ability to continue to provide those goods or services, especially if they have a long-term involvement with, or are dependent on, the entity.

f. Governments and their agencies and regulatory bodies. Governments and their agencies and regulatory bodies are interested in the activities of an entity because they are in various ways responsible for seeing that economic resources are allocated efficiently. They also need information to help in regulating the activities of entities, determining and applying taxation policies, and preparing national income and similar statistics.

g. Members of the public. An entity may affect members of the public in a variety of ways. For example, an entity may make a substantial contribution to the local economy by providing employment opportunities, patronizing local suppliers, paying taxes, and making charitable contributions. Financial reporting may assist members of the public and their representatives by providing information about the trends and recent developments in the entity’s prosperity and the range of its activities, as well as the entity’s ability to continue to undertake those activities.

7. As used in the framework, the term investors refers to equity investors and includes present and potential holders of equity securities, holders of partnership interests, and other owners; as well as their advisors. The term creditors as used in the framework includes present and potential institutional and individual lenders and their advisors. (Investors and creditors include both those who obtain their interests from the entity and those who obtain their interests from other holders of the entity’s equity or debt instruments. In other words, a party may become an entity’s investor or creditor either directly or indirectly.)

8. Both investors and creditors generally provide cash to an entity with the expectation of receiving a return on, as well as a return of, the cash provided; in other words, they expect to receive more cash than they provided. Suppliers, employees, customers, governmental agencies, or others also often have claims to cash payment by the entity. For example, at a given date, a supplier might have a right to payment for goods delivered, a customer might have a right to a cash refund, or a governmental agency might have a right to payment for taxes due. However, claims by such parties are not included in the category creditors because those parties have dual roles in relation to an entity. For instance, customers’ rights to receive goods or services may be more important to them than any right to receive a cash refund or other cash payment. Nevertheless, information that satisfies the needs of investors and creditors is likely to be useful to those parties as well.

9. Management and the governing board of an entity are also interested in the entity’s ability to generate net cash inflows because that is a significant part of management’s responsibility and accountability to the entity’s owners. However, management is responsible for preparing financial reports; management is not their intended recipient. In addition, management is able to prescribe the form and content of the information it needs in satisfying its responsibility to owners. (Paragraphs OB27 and OB28 discuss how the objective of financial reporting relates to assessing management’s accountability for its stewardship responsibilities.)

GENERAL PURPOSE EXTERNAL FINANCIAL REPORTING

10. The information provided by general purpose external financial reporting is directed to the needs of a wide range of users rather than only to the needs of a single group. (Throughout the framework, the terms financial reports or financial reporting refer to general purpose external financial reports or reporting.) Accordingly, financial reports reflect the perspective of the entity rather than only the perspective of the entity’s owners (existing common shareholders or common shareholders of the parent entity in consolidated financial statements) or any other single group of users. However, adopting the entity perspective as the basic perspective underlying financial reporting does not preclude also including in financial reports information that is primarily directed to the entity’s owners or to another group of users. For example, financial reports include earnings per (common) share, which may be of interest largely to holders and potential purchasers of those shares. Financial statements generally also report separately the amount of earnings, which may be termed comprehensive income, profit or loss, or the like, attributable to holders of common shares in the parent entity and the amount attributable to holders of noncontrolling interests in subsidiaries. That information, however, is in addition to—not a replacement for—information prepared in accordance with the entity perspective.