Financial statements provide the major means by which the objective of accounting is achieved - by communicating the financial results and financial position of an entity to its stakeholders, management, owners and other interested users. However, unless these statements are understood, their message will be missed, and accounting will have failed in its primary objective.
To understand the financial picture of a firm, the reported result must be put in context: in relation to the resources used to achieve the result, by comparison with forecasts, competitors' performance, alternative investment opportunities, or investors' expectations. Also, the financial strengths and weaknesses of the entity should be clearly identified for management, investors and lenders.
Hence the role of financial statement evaluation can be seen in relation to the primary objectives of accounting:
(i) To support decision-making by management, investors and other stakeholders.
(ii) To discharge accountability - to senior management and the providers of funds - and to society for the use of public resources.
A firm's financial statements only report economic events according to the accounting model adopted. This immediately limits the scope of the evaluation of the methods of recognition, measurement and disclosure used in the model. For general purpose financial reports, this is usually modified historical cost. The analyst must be familiar with the accounting model used and the specific accounting policies adopted by the reporting entity.
The accounting model adopted by an entity imposes limitations on the analysis by:
(i) Failing to record incomplete transactions, such as orders placed or received.
(ii) Omitting key business assets, such as internally generated assets, or the availability of specialized skills in the firm's workforce.
(iii) Eliminating many current and foreseeable events, such as changes in economic conditions and competition.
In addition to the accounting techniques, it is also important for the analysis to know about such items as:
(i) The impact of potential changes in economic indicators, such as interest rates, commodity prices and business confidence surveys.
(ii) Present and anticipated conditions affecting the firm's industry, for example, current and potential competition, possible product substitution, developments in technology and changing patterns of demand.
(iii) The many non-business events affecting the firm, for example, changes in environmental regulations, and the impacts of government programmers on investor or consumer intentions.
Armed with this background information, the analyst approaches an evaluation of financial statements in a structured manner.