What Are The Advantages And Disadvantages Of Financial Statements

Financial statements are key elements for potential investors and existing shareholders when making decisions about investing or lending to a company. EM is used to improve the appearance of financial statements to attract investors and retain incumbent shareholders. According to Ziv (1998), it is used to smooth out income, which helps companies to reduce excessive fluctuations in their profits leading to continuous growth of their stock. Companies with smooth earnings growth are rewarded with a high share price, thereby boosting the confidence of investors in the long term. Investors analyse the earnings of a company to evaluate the attractiveness of a stock. Therefore, smoothed earnings help lower risk which is associated with a lower discount

According to Healy and Palepu (1995) managers have superior knowledge to outside investors on their firm’s expected future performance and they are likely to conceal this knowledge of the firm’s financial position from investors. The lack of transparency will diminish the quality of the financial reports and therefore lead to less valuable and riskier investment. However, EM can be considered as an ineffective short term solution which neglects the long term performance of the business. For example, firms will reduce research and development (R&D) (as seen in the Sainsbury’s example) and marketing expenditure in order to achieve higher short-term profits which will satisfy shareholders especially short-term investors. However this hinders future development and growth and causes net present value (NPV) to fall because future cash flows are reduced, adversely affecting the returns on longer-term investments. Therefore, EM can be both advantageous and disadvantageous, depending on the nature of the

It can be seen as an attempt to replicate the previous year’s success, during 2014 Sainsbury’s cut the R&D grants which were used to support British farming from £1.2 million (Sainsbury’s, 2013) to £1 million (Sainsbury’s, 2014). However, the reduction of R&D has the potential to jeopardise Sainsbury’s future performance and reduce their market share in the long run. Reducing R&D could be seen as managers’ attempt to meet shareholders’ expectations of continuous profit growth. Profit from 2013 to 2014 increased by 18.9 percent compared to previous profit growth of 2.7 percent. According to Joosten (2012), if firms have reported increases in earnings between zero and ten percent EM is suspected. Although 18.9 percent is not within the range, it is unclear what proportion of the growth in earnings was caused by EM. Therefore it is questionable to what extent investors can rely on these