The Objective of Financial Reporting 2

1: The Objective of Financial Reporting 2

11. The objective of financial reporting stems from the information needs of external users who lack the ability to prescribe all the financial information they need from an entity and therefore must rely, at least partly, on the information provided in financial reports. Information needed to satisfy the specialized needs of management and other potential users, such as tax authorities or other governmental agencies that are able to prescribe the information they need from an entity is beyond the scope of the framework.

12. Investors and creditors (and their advisors) are the most prominent external groups who use the information provided by financial reporting and who generally lack the ability to prescribe all of the information they need. Investors’ and creditors’ decisions and their uses of information have been studied and described to a greater extent, and thus are better understood, than those of other external groups. In addition, information that meets the needs of investors and creditors is also likely to be useful to members of other groups who are interested in an entity’s ability to generate net cash inflows. Thus, the primary users of general purpose financial reports are present and potential investors and creditors (and their advisors). (Throughout the framework, the term investors and creditors refers to investors and creditors and their advisors.)

13. Present and potential investors and creditors have a common interest in the ability of an entity to generate net cash inflows. Accordingly, information about that ability is the primary focus of financial reporting because it helps satisfy the needs of investors and creditors. Other potential users of financial reports discussed in paragraph OB6 also have either a direct interest or an indirect interest in an entity’s ability to generate net cash inflows. For example, although an entity is not a direct source of cash flows to its customers, an entity can continue to provide goods or services to customers only by generating sufficient cash to pay for the resources it uses and to satisfy its other obligations. Thus, information that meets the needs of investors and creditors is also likely to be useful to members of other groups who are interested in an entity’s ability to generate net cash inflows. By focusing primarily on the needs of present and potential investors and creditors, the objective of financial reporting encompasses the needs of a wide range of users.

Limitations and Evolution of General Purpose External Financial Reporting

14. Financial reporting is but one source of information needed by those who make investment, credit, and similar resource allocation decisions. Users of financial reports also need to consider pertinent information from other sources, for example, information about general economic conditions or expectations, political events and political climate, or industry outlook.

15. Users of financial reports also need to be aware of the characteristics and limitations of the information in them. To a significant extent, financial reporting information is based on estimates, rather than exact measures, of the financial effects on entities of transactions and other events and circumstances that have already happened or that already exist. The framework establishes the concepts that underlie those estimates and other aspects of financial reports. The concepts are the goal or ideal toward which standard setters and preparers of financial reports should strive. Like most goals, the framework’s vision of the ideal financial reporting is unlikely to be achieved in full, at least not in the short term, because of considerations of technical feasibility and cost. In some areas, users of financial reports (and standard setters) may need to continue to accept estimates based more on accounting conventions than on the concepts in the framework. Nevertheless, establishing a goal toward which to strive is essential if financial reporting is to evolve in a common direction that improves the information provided to investors, creditors, and others for use in making resource allocation decisions.

Financial Statements and Financial Reporting

16. Financial statements, including the accompanying notes, are a central feature of financial reporting. However, the objective pertains to all of financial reporting, not just financial statements, because some types of both financial and nonfinancial information may best be communicated by means other than traditional financial statements. Corporate annual reports, prospectuses, and annual reports filed with governmental agencies in some jurisdictions are common examples of reports that include financial statements, other financial information, and nonfinancial information. News releases, management’s forecasts or other descriptions of its plans or expectations, and descriptions of an entity’s social or environmental impact are examples of reports giving financial information other than financial statements or giving only nonfinancial information.

17. Paragraphs OB18–OB26 describe the financial reporting information that has long been considered useful in assessing an entity’s ability to generate net cash inflows and why the information is useful for that purpose. Discussion of that information does not imply that other information might not also be useful in achieving the objective of financial reporting.

INFORMATION ABOUT AN ENTITY’S RESOURCES, CLAIMS TO THOSE RESOURCES, AND CHANGES IN RESOURCES AND CLAIMS

18. To help present and potential investors and creditors and others in assessing an entity’s ability to generate net cash inflows, financial reporting should provide information about the economic resources of the entity (its assets) and the claims to those resources (its liabilities and equity). Information about the effects of transactions and other events and circumstances that change resources and claims to them is also essential.

19. Most of the information provided in financial statements about resources and claims and the changes in them results from the application of accrual accounting, although information about cash flows during a period is also important (paragraph OB24). Accrual accounting attempts to reflect the financial effects of transactions and other events and circumstances that have cash (or other) consequences for an entity’s resources and the claims to them in the periods in which they occur or arise. The buying, producing, selling, and other operations of an entity during a period, as well as other events that affect its economic resources and the claims to them, often do not coincide with the cash receipts and payments of the period. The accrual accounting information in financial reports about an entity’s resources and claims and changes in resources and claims generally provides a better basis for assessing cash flow prospects than information solely about the entity’s current cash receipts and payments. Without accrual accounting, important economic resources and claims to resources would be excluded from financial statements.

Economic Resources and Claims to Them

20. Information about an entity’s economic resources and the claims to them—its financial position—can provide a user of the entity’s financial reports with much insight into the amounts, timing, and uncertainty of its future cash flows. That information helps investors, creditors, and others to identify the entity’s financial strengths and weaknesses and to assess its liquidity and solvency. Moreover, it indicates the cash flow potentials of some economic resources and the cash needed to satisfy most claims of creditors. Some of an entity’s economic resources, such as accounts receivable or investments in debt instruments, are direct sources of future cash inflows. In addition, many creditors’ claims, such as accounts payable or outstanding debt instruments, are direct causes of future cash outflows. However, many of the cash flows generated by an entity’s operations result from combining several of its economic resources to produce or provide and market goods or services. Although those cash flows cannot be identified with individual economic resources (or claims), investors and creditors need to know the nature and quantity of the resources available for use in an entity’s operations, which is provided by information about its financial position. That information is also likely to help those who wish to estimate the value of the entity, but financial reports are not designed to show the value of an entity. Estimating the value of an entity would require taking into account information in addition to that provided in financial reports, for example, general economic conditions in the industry in which the entity operates.

21. Information about an entity’s financial structure, as reflected in its financial position, helps users to assess its needs for additional borrowing or other financing and how successful it is likely to be in obtaining that financing. It also helps users to predict how future cash flows will be distributed among those with a claim on the entity’s economic resources.

Changes in Economic Resources and Claims to Them

22. Information about effects of transactions, other events, and circumstances that change an entity’s economic resources and the claims to them also helps a user of the entity’s financial reports to assess the amounts, timing, and uncertainty of its future cash flows. That information includes quantitative measures (and other information) about an entity’s financial performance measured by accrual accounting, its cash flows during a period, and changes in economic resources and claims that do not directly affect cash.

Financial Performance Measured by Accrual Accounting

23. Information about an entity’s financial performance during a period measured by changes in its resources and the claims to them other than claims resulting from transactions with owners as owners, as well as the components of the total change, is critical in assessing the entity’s ability to generate net cash inflows. Therefore, information about financial performance measured by accrual accounting rather than only by the entity’s cash transactions during the period is essential to users of financial reports (paragraph OB19). That information indicates the extent to which the entity has increased its available economic resources, and thus its capacity for generating net cash inflows, through its operations rather than by obtaining additional financing from investors or creditors. An entity’s financial performance provides information about the return it has produced on the economic resources it controls. In the long run, an entity must produce a positive return on its economic resources if it is to generate net cash inflows and thus provide a return to its investors and creditors. The variability of that return is also important, especially in assessing the uncertainty of future cash flows, as is information about the components of that return. Investors and creditors usually find information about an entity’s past financial performance helpful in predicting the entity’s future returns on its resources, which will be its future financial performance.

Financial Performance Measured by Cash Flows during a Period

24. Information about an entity’s cash flows during a period is another aspect of its financial performance that helps users to assess the entity’s ability to generate future net cash inflows. Information about an entity’s cash flows during a period indicates how it obtains and spends cash, including information about its borrowing and repayment of borrowing, its capital transactions, including cash dividends or other distributions to owners, and other factors that may affect the entity’s liquidity or solvency. Investors, creditors, and others use information about cash flows to help them understand an entity’s business model and operations, evaluate its financing and investing activities, assess its liquidity or solvency, or interpret information provided about financial performance. Cash flow information provides a perspective on the entity’s economic activities that is different from the one provided by accrual accounting—a perspective that is largely free from the measurement and related issues inherent in accrual accounting.

Changes in Resources and Claims That Do Not Affect Cash

25. Financial reporting should also provide information about changes in an entity’s economic resources and claims to them that do not affect cash. Examples include acquiring economic resources in exchange for creditors’ claims, settling creditors’ claims by transfers of noncash resources, and converting creditors’ claims into ownership claims. Investors, creditors, and others need that information to understand fully information about an entity’s financial position and financial performance. It also helps users understand the information provided about cash flows during a period.

Management’s Explanations

26. Financial reporting should include management’s explanations and other information needed to enable users to understand the information provided. The usefulness of financial reports to investors, creditors, and others in forming expectations about an entity is enhanced by management’s explanations of the information in them. Management knows more about the entity and its affairs than external users do and can often increase the usefulness of financial reports by identifying particular transactions and other events and circumstances that have affected the entity or may affect it in the future and by explaining their financial effects on the entity. In addition, financial reporting often provides information that depends on, or is affected by, management’s estimates and judgments. Investors, creditors, and others are aided in evaluating estimates and judgmental information by explanations of underlying assumptions or methods used, including disclosure of significant uncertainties about principal underlying assumptions or estimates.

THE OBJECTIVE OF FINANCIAL REPORTING AND ASSESSING MANAGEMENT’S STEWARDSHIP

27. Management of an entity is accountable to owners (shareholders) for the custody and safekeeping of the entity’s economic resources and for their efficient and profitable use. Management’s stewardship responsibilities include protecting the entity’s economic resources, to the extent possible, from unfavorable economic effects of factors in the economy such as inflation or deflation and technological and social changes. Management is also accountable for ensuring that the entity complies with applicable laws, regulations, and contractual provisions. Because management’s performance in discharging its stewardship responsibilities significantly affects an entity’s ability to generate net cash inflows, management’s stewardship is of significant interest to users of financial reports who are interested in making resource allocation decisions.

28. Users of financial reports who wish to assess how well management has discharged its stewardship responsibilities generally are interested in making resource allocation decisions, which include, but are not limited to, whether to buy, sell, or hold the entity’s securities or whether to lend money to the entity. Decisions about whether to replace or reappoint management, how to compensate management, and how to vote on shareholder proposals about management’s policies and other matters are also potential considerations in making resource allocation decisions in the broad sense in which that term is used in the framework. Thus, the objective of financial reporting stated in paragraph OB2 encompasses providing information useful in assessing management’s stewardship. In addition, the information discussed in paragraphs OB18–OB26 is useful in assessing how well management has discharged its stewardship responsibilities because management is responsible for the entity’s resources and related claims and changes in resources and claims.