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Investers
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,

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