According to the accounting framework financial statements are prepared for shareholders and potential investors who it argues are the main users of financial information. In a small entity business owners are the shareholders.
Accounting Is for Business Owners and not Accountants
Accountants and bookkeepers understand the numbers reported in financial statements such as the balance sheet, the profit and loss account and the cash flow statement, but the problem is they are not the main stakeholders of the accounting information.
Accounting is considered to be the language of business; therefore, accounting is for business owners, but the main problem is that business owners do not understand it. Many business owners are creative and have great investment ideas but most of them are overwhelmed when they are presented with a set of accounts or when they are asked to comment on or to interpret accounts.
Guide in Reading and Interpreting Accounts
It is important that business owners are educated about accounting so that they understand it for them to interpret and use financial information in making informed decisions. It is helpful for the users of financial information to know that accounting is not a science or math, rather it is an art. Just like arts the reader of accounting must exercise flair so they can develop their own methodology that can help them understand the information from the accounts better.
There is a no general rule that can be used to understand or interpret accounts because different people follow different approaches based on what works best for them. However as a guide, the business owners or readers of financial accounts should look at the following issues when trying to understand or to interpret the story being told by the accounts:
- The reader or business owner should look at directors’ shareholdings information first. Most directors own shares in companies they manage. Generally if directors’ shareholding decreases this should be interpreted as bad news. Since directors are involved in the day to day management they have the benefit of inside information which other readers of financial information do not have, therefore a decrease in their shareholding can be viewed as meaning directors do not have confidence about the future of the business.
It can also be viewed as a signal that directors believe the business’ share price has reached its peak and directors think share prices will be going south. An increase in shareholding by directors should be viewed as a positive signal because directors have confidence that the business will grow or will be more profitable in the future.
- The reader of accounting information should also look at the director’s report, chairperson’s report or operating review to glean if there is anything that has happened which would invalidate comparisons of financial information between the current year and the prior years.
- The reader should look at the profit and loss account by paying attention to increases or decreases in revenues, how the business manages its overheads and the profits the business is making from recurring business or ordinary activities. This information will show the reader how profitable the business, how efficient it is and how durable the business model is. On the balance sheet the reader must look at the financial structure of the business, the business’ working capital and cash positions. This information will highlight if the business has any liquidity problems or bankruptcy risk.
- The reader should also look at current trends within the business, for example; is it on an upward path or is the business on a downward path? Ratio analysis can also be used to understand the financial statements better and give the information a deeper meaning. It is also important that the reader of financial information has a general understanding of the industry of the reporting business. It is helpful to analyse a business by also considering how the industry as a whole or the competitors of the reporting firm are performing.
Business owners must develop skills to understand accounting because accounting is the medium through which the story of how well or how bad the business is doing financially is told. Accounting describes a business’ story or the path the business has taken in the past and this may be helpful in predicting how well or how bad the business will do in future.