Recall that the primary goal of financial accounting is to provide decision makers with useful information. This section identifies the major users of financial statements and describes the decisions they make.
Present and potential owners (investors) are prime users of financial statements. They continually assess and compare the prospects of alternative investments. The assessment of each investment is often based on two variables: expected return and risk. Expected return refers to the increase in the investor’s wealth that is expected over the investment’s time horizon. This wealth increase is comprised of two parts: (1) increases in the market value of the investment and (2) dividends (periodic cash distributions from the firm to its owners). Both of these sources of wealth depend on the firm’s ability to generate cash. Accordingly, financial statements can improve decision making by providing information that helps current and potential investors estimate a firm’s future cash flows. Risk refers to the uncertainty surrounding estimates of expected return. The term expected implies that the return is not guaranteed. For most investments, numerous alternative future returns are possible. For example, an investor may project that a firm’s most likely return for the upcoming year is $100,000. However, the investor recognizes that this is not the only possibility. There is some chance that the firm might generate returns of $90,000 or $110,000. Still other possibilities might be $80,000 and $120,000. The greater the difference among these estimates, the greater the risk. Financial statements help investors assess risk by providing information about the historical pattern of past income and cash flows. Investment selection involves a trade-off between expected return and risk. Investments with high expected returns generally have a high risk. Each investor must assess whether investments with greater risk offer sufficiently higher expected returns.
To illustrate the trade-off between risk and expected return, assume that an investor has two choices: Investment A and Investment B. Each investment costs $100. The return provided by the investments during the next year depends on whether the economy experiences an expansion or recession. The following chart summarizes the
The lending decision involves two issues: whether or not credit should be extended, and the specification of a loan’s terms. For example, consider a bank loan officer evaluating a loan application. The officer must make decisions about the amount of the loan (if any), interest rate, payment schedule, and collateral. Because repayment of the loan and interest will rest on the applicant’s ability to generate cash, lenders need to estimate a firm’s future cash flows and the uncertainty surrounding those flows. Although investors generally take a long-term view of a firm’s cash generating ability, creditors are concerned about this ability only during the loan period. Lenders are not the only creditors who find financial statements useful. Suppliers often sell on credit, and they must decide which customers will or will not honor their obligations.
Financial analysts and advisors
Many investors and creditors seek expert advice when making their investment and lending decisions. These experts use financial statements as a basis for their recommendations.
The customers of a business are interested in a stable source of supply. They can use financial statements to identify suppliers that are financially sound.
Employees and labor unions
These groups have an interest in the viability and profitability of firms that employ them or their members. As described in Reality Check 1-1, unions in the airline industry have recently made several important decisions based, in part, on financial statements.
Regulatory authorities (Government)
Federal and state governments regulate a large array of business activities. The Securities and Exchange Commission (SEC) is a prominent example. Its responsibility is to ensure that capital markets, such as the New York Stock Exchange, operate smoothly. To help achieve this, corporations are required to make full and fair financial disclosures. The SEC regularly reviews firms’ financial statements to evaluate the adequacy of their disclosures. Reality Check 1-2 describes another regulatory use of accounting information.