Chapter 1
The Demand for Financial Statement Information
Financial Statement
A financial statement is a formal record that shows the financial activities and position of a
business, organization, or individual. It provides important information about income,
expenses, assets, and liabilities. These statements help users understand how well a business is
performing financially. Example: A company prepares a Balance Sheet showing assets (cash,
equipment) and liabilities (loans), and an Income Statement showing profit or loss for the year.
Types of Financial Statements (Short Overview)
1. Income Statement: Shows profit or loss over a period. Example: Sales revenue –
expenses = net profit.
2. Balance Sheet: Shows financial position at a specific date. Example: Assets =
Liabilities + Equity.
3. Cash Flow Statement: Shows cash inflows and outflows. Example: Cash received
from customers and paid for expenses.
Parties Demanding Financial Statement Information
1. Shareholders, Investors, and Security Analysts: These users need financial
statements to make investment and monitoring (stewardship) decisions. They analyze
risk, return, and future cash flows to decide buying, holding, or selling shares.
Example: An investor studies financial statements to predict future profits before
buying company shares.
i. Investment Focus: Investors choose a portfolio based on risk, return, and
liquidity preferences. Financial statements help in predicting future cash flows
and detecting undervalued securities. Example: Using financial reports to
identify a company with high growth potential (fundamental analysis).
ii. Stewardship Focus: Shareholders monitor management performance and
ensure resources are properly used. Financial statements show how effectively
management uses company resources. Example: Shareholders review annual
reports to check if managers increased company profits.
2. Managers: Managers use financial statements for decision-making and performance
evaluation. Their compensation and contracts often depend on financial statement
variables. Example: A manager receives a bonus based on company profit shown in
financial statements.
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3. Employees: Employees use financial statements to assess job security and company
stability. They also monitor profit-sharing plans and pension viability. Example:
Workers check company profits to estimate their bonus under a profit-sharing plan.
4. Lenders and Other Suppliers: Lenders use financial statements to evaluate
creditworthiness and loan terms. They monitor ratios like debt-equity and profitability
to reduce risk. Example: A bank reviews financial statements before approving a loan
to a company.
5. Customers: Customers analyze financial statements to ensure long-term reliability of
a firm. This is important when they depend on a company for continuous supply.
Example: A customer checks financial reports to avoid dealing with a company near
bankruptcy.
6. Government / Regulatory Agencies: Government uses financial statements for
taxation, regulation, and policy decisions. They monitor company performance for legal
and economic purposes. Example: Tax authorities use financial statements to calculate
corporate taxes.
7. Other Parties: Other groups like researchers and environmental organizations also
demand financial data. They use it for analysis, policy-making, and advocacy purposes.
Example: An environmental group studies financial reports to analyze company
spending on sustainability.
Conflicts Among Diverse Parties
Different parties (shareholders, managers, employees, etc.) have different interests. Actions by
one group can increase their wealth while reducing others’ wealth. Example: Managers may
increase their salary by expanding the company, even if it reduces shareholder profit.
• Example 1: Shareholders vs Managers: Managers may take decisions (like expensive
acquisitions) that benefit themselves. This may reduce shareholder wealth due to poor
investment decisions. Example: A company buys another firm at a very high price,
increasing manager power but reducing shareholder value.
• Example 2: Shareholders vs Creditors: Shareholders may prefer high dividends,
reducing assets available to creditors. This increases risk for lenders. Example: A firm
pays large dividends, leaving less money to repay bank loans.
• Example 3: Shareholders vs Customers: Shareholders benefit from higher prices,
while customers pay more. Regulatory decisions can shift wealth between them.
Example: Electric companies increase rates, increasing profit but raising customer
bills.
1. Different Disclosure Preferences: Each party wants different information based on their
self-interest. Some may support or oppose disclosure depending on its impact. Example: Bank
managers may hide bad loans, but depositors want full disclosure.
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2. Role of Financial Statements in Monitoring: Financial statements help monitor actions
and prevent unfair wealth transfer. They increase transparency and accountability. Example:
Audited reports help shareholders ensure managers are not misusing company funds.
Legal Recognition of Conflicts: Courts recognize conflicts and may intervene when unfair
actions occur. They can adjust financial results to ensure fairness. Example: A court forced a
company to restate profits and pay interest to bondholders after hiding earnings.
Role of Contracts in Reducing Conflict: Contracts include rules to limit unfair actions
between parties. These rules protect interests and reduce risk. Example: Loan agreements
restrict companies from taking actions that harm lenders.
Self-Interest Behavior: Most parties act based on their own benefit or self-interest. This helps
explain many financial decisions and conflicts. Example: Managers may prioritize bonuses
linked to profits rather than long-term growth.
Factors Affecting Demand for Financial Statement Information
The demand for financial statement information arises because it improves decision-making or
monitoring. Two main factors determine this demand:
A. Potential of the Information to Reduce Uncertainty: Financial statements are valuable
when they help reduce uncertainty in decisions.
1. Level of Uncertainty and Expected Gains: Decision makers face uncertainty about
future profitability, management quality, or supplier reliability. Financial statements are
useful when they can reduce this uncertainty. Example: A lender assessing a stable firm
can use past and current profitability records to forecast future loan repayment ability.
2. Role in Revising Beliefs: Financial statements can revise expectations about uncertain
events. However, for areas where financial statements provide little insight (like oil
exploration or tech start-ups), their role is indirect. In such cases, financial statements
may help evaluate management reputation. Example: Past financial performance of a
start-up’s management team can indicate their track record, even if the firm’s products
are untested.
B. Availability of Competing Information Sources: Financial statements compete with
other sources of information, such as company releases, industry reports, and economy-wide
announcements. Their comparative advantages include:
1. Direct Relevance: Financial statements directly report the variable of interest in
decisions or contracts. Example: In a business sale where payment depends on future
earnings, financial statements provide exact figures for earnings, unlike general market
reports.
2. Reliability: Auditors certify financial statements, making them more credible than
other sources that may have public relations biases. Example: Investors trust audited
statements over press releases about product launches.
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3. Low Cost: Financial statements are usually freely available, while external databases
may charge fees. Example: Shareholders can access a company’s annual report without
extra cost, unlike subscription-based financial services.
4. Timeliness: Financial statements can sometimes provide more timely information than
competing sources, especially for future-oriented releases. Example: Early
management forecasts or interim financial statements can give faster insights than
analysts’ reports.
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