Qualitative Characteristics of Accounting Information
To satisfy the stated objectives,
information should possess certain characteristics. The purpose of SFAC
2 is to outline the desired qualitative characteristics of
accounting information.
Graphic 1-7 indicates
these qualitative characteristics, presented in the form of a hierarchy of
their perceived importance. Notice that the main focus, as stated in the
first concept statement is on decision usefulness—the
ability to be useful in decision making. Understandability means
that users must understand the information within the context of the
decision being made. This is a user-specific quality because users will
differ in their ability to comprehend any set of information. The first
stated financial reporting objective of SFAC 1 is to
provide comprehensible information to those who have a reasonable
understanding of business and economic activities and are willing to study
the information.
GRAPHIC 1-7
Hierarchy of Desirable Characteristics of Accounting Information
To be useful, information must make a
difference in the decision process.
PRIMARY QUALITATIVE CHARACTERISTICS
The primary decision-specific qualities
that make accounting information useful are relevance and reliability.
Both are critical. No matter how reliable, if information is not relevant
to the decision at hand, it is useless. Conversely, relevant information is
of little value if it cannot be relied on. Let’s look closer at each of
these two characteristics, including the components that make those
qualities desirable. We also consider two secondary qualities—comparability
and consistency.
To be useful for decision making,
accounting information should be relevant and reliable.
Relevance. To make a difference in
the decision process, information must possess predictive
value and/or feedback value. Generally,
useful information will possess both qualities. For example, if net income
and its components confirm investor expectations about future
cash-generating ability, then net income has feedback value for investors.
This confirmation can also be useful in predicting future cash-generating
ability as expectations are revised.
This predictive ability is central to the
concept of “earnings quality,” the ability of reported earnings (income) to
predict a company’s future earnings. This is a concept we revisit
frequently throughout this textbook in order to explore the impact on
earnings quality of various topics under discussion. For instance, in Chapter 4 we
discuss the contents of the income statement and certain classifications
used in the statement from the perspective of helping analysts separate a
company’s transitory earnings from its permanent earnings. This separation
is critical to a meaningful prediction of future earnings. In later chapters,
we look at how various financial reporting decisions affect earnings
quality.
Timeliness also is
an important component of relevance. Information is timely when it is
available to users early enough to allow its use in the decision process.
The need for timely information requires that companies provide information
to external users on a periodic basis. The SEC requires its registrants to
submit financial statement information not only on an annual basis, but
also quarterly for the first three quarters of each fiscal year.
Information is timely if
it is available to users before a decision is made.
Reliability.Reliability is the
extent to which information is verifiable, representationally
faithful, and neutral.Verifiability implies
a consensus among different measurers. For example, the historical cost of
a piece of land to be reported in the balance sheet of a company is usually
highly verifiable. The cost can be traced to an exchange transaction, the
purchase of the land. However, the market value of that land is much more
difficult to verify. Appraisers could differ in their assessment of market
value. The term objectivity often is linked to verifiability.
The historical cost of the land is objective but the land’s market value is
subjective, influenced by the measurer’s past experience and prejudices. A
measurement that is subjective is difficult to verify, which makes it more
difficult for users to rely on.
Representational faithfulness exists
when there is agreement between a measure or description and the phenomenon
it purports to represent. For example, assume that the term inventory in
a balance sheet of a retail company is understood by external users to
represent items that are intended for sale in the ordinary course of
business. If inventory includes, say, machines used to produce inventory,
then it lacks representational faithfulness.
Representational faithfulness means
agreement between a measure and a real-world phenomenon that the measure
is supposed to represent.
Several years ago, accountants used the
term reserve for doubtful accounts to describe anticipated
bad debts related to accounts receivable. For many, the term reserve means
that a sum of money has been set aside for future bad debts. Because this
was not the case, this term lacked representational faithfulness. The
description “reserve…” now has been changed to “allowance for uncollectible
accounts” or “allowance for doubtful accounts.” In FedEx Corporation’s financial statements,
the balance sheet in Appendix B reports Receivables, less
allowances of $151 million and $149 million at the end of 2004 and
2003, respectively.
FedEx Corporation
Reliability assumes the information being
relied on is neutral with respect to parties potentially affected. In that
regard, neutrality is highly related to the
establishment of accounting standards. You learned earlier that changes in
accounting standards can lead to adverse economic consequences to certain
companies, their investors and creditors, and other interest groups.
Accounting standards should be established with overall societal goals and
specific objectives in mind and should try not to favor particular groups
or companies.
Accounting standards should not favor
any particular groups or companies nor influence behavior in any specific
way.
The FASB faces a difficult task in
balancing neutrality and the consideration of economic consequences. A new
accounting standard may favor one group of companies over others, but the
FASB must convince the financial community that this was a consequence of
the standard and not an objective used to set the standard. Donald Kirk,
one of the members of the first group to serve on the FASB, stressed the
importance of neutrality in the standard-setting process.
The qualities of relevance and
reliability often clash. For example, a net income forecast provided by the
management of a company may possess a high degree of relevance to investors
and creditors trying to predict future cash flows. However, a forecast
necessarily contains subjectivity in the estimation of future events. GAAP presently
do not require companies to provide forecasts of any financial variables.
A trade-off often is required between
various degrees of relevance and reliability.
DONALD KIRK
If financial reporting is to be credible, there must be public confidence
that the standard-setting system is credible, that selection of board
members is based on merit and not the influence of special interests, and
that standards are developed neutrally with the objective of relevant and
reliable information, not purposeful manipulation.28
SECONDARY QUALITATIVE CHARACTERISTICS
Graphic 1-7 identifies
two secondary qualitative characteristics important to decision
usefulness—comparability and consistency. Comparability is
the ability to help users see similarities and differences between events
and conditions. We already have discussed the importance of the ability of
investors and creditors to compare information across companies to make
their resource allocation decisions. Closely related to comparability is
the notion that consistency of accounting practices
over time permits valid comparisons between different periods. The
predictive and feedback value of information is enhanced if users can
compare the performance of a company over time.29 In the
FedEx financial statements in Appendix B, notice that disclosure Note 1
includes a summary of significant accounting policies. A change in one of
these policies would require disclosure in the financial statements and
notes to restore comparability between periods.
Accounting information should be comparableacross
different companies and over different time periods.
elements of financial statements
The 10 elements are:
(1) assets, (2) liabilities, (3) equity, (4) investments by owners,
(5) distributions to owners, (6) revenues, (7) expenses, (8) gains,
(9) losses, and (10) comprehensive income. The 10 elements of
financial statements defined in SFAC 6 describe financial position
and periodic performance.
Elements of the
financial Statements
Elements of the
financial statements includeAssets,Liabilities,Equity,Income&Expenses. The first three elements relate to the
statement of financial position whereas the latter two relate to the income
statement.
The first three elements
relate to the statement of financial position while the latter two relate to
income statements.
Assets
Definition
Asset is a resource controlled
by the entity as a result of past events and from which future economic
benefits are expected to flow to the entity(IASB Framework).
Explanation
In simple words, asset
is something which a business owns or controls to benefit from its use in some way.
It may be something which directly generates revenue for the entity (e.g. a
machine, inventory) or it may be something which supports the primary
operations of the organization (e.g. office building).
Classification
Assets may be classified
into Current and Non-Current. The distinction is made on the basis of time
period in which the economic benefits from the asset will flow to the entity.
Current Assetsare ones that an entity expects to use within one-year
time from the reporting date.
Non Current Assetsare those whose benefits are expected to last more than
one year from the reporting date.
Types and Examples
Following are the most
common types of Assets and their Classification along with the economic
benefits derived from those assets.
Asset
Classification
Economic Benefit
Machine
Non-current
Used for the production
of goods for sale to customer.
Office Building
Non-current
Provides space to
employees for administering company affairs.
Vehicle
Non-current
Used in the
transportation of company products and also for commuting.
SFAC 6 defines
10 elements of financial statements. These elements are “the building
blocks with which financial statements are constructed—the classes of
items that financial statements comprise.”33 They
focus directly on items related to measuring performance and to reporting
financial position. The definitions of these elements operationalize the
resources, claims, and changes identified in the third objective of
financial reporting in SFAC 1.34 The accrual
accounting model actually is embodied in the element
definitions. The FASB recognized that accrual accounting produces
information that is more successful in predicting future cash flows than
is cash flow accounting.
The 10 elements are: (1) assets, (2)
liabilities, (3) equity, (4) investments by owners, (5) distributions to
owners, (6) revenues, (7) expenses, (8) gains, (9) losses, and (10)
comprehensive income.
The 10 elements of financial statements
defined in SFAC 6 describe financial position and periodic
performance.
You probably already know in general
terms what most of these elements mean. But as you will see when they are
discussed, it is helpful to have a deeper understanding of their meaning.
You may recognize the first three elements—assets, liabilities, and
equity—as those that portray the financial position of an enterprise.
Assets are
probable future economic benefits obtained or controlled by a particular
entity as a result of past transactions or events.
Assets represent
probable future economic benefits controlled by the enterprise.
A key characteristic of this definition
is that an asset represents probable future economic
benefits. A receivable is an asset only if it is probable that future
benefits will result, that cash will be collected. The controlled
byaspect of the definition also is important. The employees of a
company certainly represent future economic benefits to a company. However,
they are not owned or controlled by the company and do not qualify as
assets.
Liabilities are
probable future sacrifices of economic benefits arising from present
obligations of a particular entity to transfer assets or provide services
to other entities in the future as a result of past transactions or events.35
Liabilities represent
obligations to other entities.
Most liabilities require the future
payment of cash, the amount and timing of which are specified by a legally
enforceable contract. Actually, though, a liability need not be payable in
cash. Instead, it may require the company to transfer other assets or to
provide services. For example, a warranty liability is created for the
seller when a product is sold and the seller guarantees to fix or replace
the product if it proves defective and it is probable that a material
amount of product sold will, in fact, prove defective. A liability also
need not be represented by a written agreement, nor be legally enforceable.
For example, a company might choose to pay a terminated employee’s salary
for a period of time after termination even though not legally required to
do so. The commitment creates a liability at the date of termination.
Equity or net
assets, called shareholders’ equity or stockholders’
equity for a corporation, is the residual interest in the
assets of an entity that remains after deducting liabilities.
Assets and liabilities are measured
directly; equity is not. Equity is simply a residual amount. The accounting
equation illustrates financial position.
Equity is
a residual amount, the owners’ interest in assets after subtracting
liabilities.
For a corporation, equity arises
primarily from two sources: (1) amounts invested by
shareholders in the corporation and (2) amounts earned by
the corporation on behalf of its shareholders. These two sources are
reported as (1) paid-in capital and (2) retained
earnings. We discuss this classification of shareholders’ equity
in more depth in Chapter 18.
The next two elements defined in SFAC
6 deal with changes in equity from owner transactions.
Investments by owners are
increases in equity resulting from transfers of resources (usually cash) to
a company in exchange for ownership interest.
Investments by owners and distributions
to owners are transactions describing any owner contribution to
and withdrawal from the company.
A corporation’s issuance of ownership
shares of stock in exchange for cash represents an investment by owners.
A cash dividend paid by a corporation to
its shareholders is the most common distribution to owners.
Revenues, gains, expenses, and losses
describe changes in equity due to profit-generating transactions.
Revenues are
inflows or other enhancements of assets or settlements of liabilities from
delivering or producing goods, rendering services, or other activities that
constitute the entity’s ongoing major, or central, operations.
A key characteristic is that revenues are
inflows. The enterprise is acquiring something in exchange for providing
goods and services to customers. Also, providing these goods and services
represents a major operation of the enterprise.
Revenues are
gross inflows resulting from providing goods or services to customers.
On the other hand, if selling the item is
not part of the central operations of the business but instead is only an
incidental result of those operations, the inflow of assets would produce a
gain rather than a revenue.
Gains are
increases in equity from peripheral, or incidental, transactions of an
entity.
FedEx earns revenue by providing a
service, delivering packages, to its customers. If FedEx sold a piece of
machinery used to deliver packages for an amount greater than its book
value (original cost less depreciation recorded up to the date of sale), a
gain would result. Gains are net inflows, the difference between the amount
received and book value. Revenues are gross inflows, measured as the amount
received or to be received for the goods or services without regard to the
cost of providing the goods or services.
Expenses are
outflows or other using up of assets or incurrences of liabilities during a
period from delivering or producing goods, rendering services, or other
activities that constitute the entity’s ongoing major, or central,
operations.
Expenses are
gross outflows incurred in generating revenues.
A key characteristic is that expenses
represent outflows of resources incurred in the process of generating
revenues.
Losses represent
decreases in equity arising from peripheral, or incidental, transactions of
an entity.
If FedEx sold that piece of machinery
used to deliver packages for less than its book value, a
loss would result. So, losses are the opposite of gains—they are net outflows rather
than net inflows. They differ from expenses by being net rather than gross
outflows and by being peripheral, or incidental, transactions rather than
major, or central, operations. Revenues plus gains less expenses and losses
for a period equals net income or net
loss, the so-called bottom line of the income statement.36
You should note that the definitions of
these nine elements are in basic agreement with those used in practice. But, SFAC
6 also introduced a new term, the 10th element, called comprehensive
income.
Comprehensive income is
the change in equity of a business enterprise during a period from
transactions and other events and circumstances from nonowner sources. It
includes all changes in equity during a period except those resulting from
investments by owners and distributions to owners.
Comprehensive income
often does not equal net income.
Under present GAAP, net income as
reported in the income statement often doesn’t equal comprehensive income.
The difference is the treatment of certain changes in assets and
liabilities not included in the determination of net
income for the period in which they are recognized but instead reported collectively
as a separate component of shareholders’ equity in the balance sheet called
accumulated other comprehensive income. For example, in your study of
investments in Chapter 12, you will
learn that for certain types of investments valued at fair values in the
balance sheet, the changes in those values are not included in net income
but rather in a separate component of shareholders’ equity. Comprehensive
income is discussed in Chapter 4.
In the FedEx Corporation financial statements
in Appendix B, the income statement for the most recent fiscal year reports
net income of $838 million. The balance sheet for the most recent fiscal
year shows accumulated other comprehensive income of $(46 million), and the
statement of changes in stockholders’ investment and comprehensive income provides the details of the change in this
figure from the prior year.
Definition - What are
Financial Statements?
Financial Statementsrepresent a formal record of the
financial activities of an entity. These are written reports that quantify the
financial strength, performance and liquidity of a company. Financial
Statements reflect the financial effects of business transactions and events on
the entity.
Four Types of
Financial Statements
The four main types of
financial statements are:
Statement of Financial Position
Statement of Financial Position, also known as the Balance Sheet, presents the
financial position of an entity at a given date. It is comprised of the
following three elements:
Assets:Something a business owns or controls
(e.g. cash, inventory, plant and machinery, etc)
Liabilities:Something a business owes to someone
(e.g. creditors, bank loans, etc)
Equity:What
the business owes to its owners. This represents the amount of capital that
remains in the business after its assets are used to pay off its outstanding
liabilities. Equity therefore represents the difference between the assets and
liabilities.
Income Statement
Income Statement, also known as theProfit
and Loss Statement, reports the company's financial performance in terms of
net profit or loss over a specified period. Income Statement is composed of the
following two elements:
Income:What
the business has earned over a period (e.g. sales revenue, dividend income,
etc)
Expense:The
cost incurred by the business over a period (e.g. salaries and wages,depreciation, rental
charges, etc)
Net profit or loss is
arrived by deducting expenses from income.
Cash Flow Statement, presents the movement in cash and bank balances over a
period. The movement in cash flows is classified into the following segments:
Operating Activities:
Represents the cash flow from primary activities of a business.
Investing Activities:
Represents cash flow from the purchase and sale of assets other than
inventories (e.g. purchase of a factory plant)
Financing Activities:
Represents cash flow generated or spent on raising and repaying share capital
and debt together with the payments of interest and dividends.
Statement of Changes in Equity, also known as theStatement of Retained Earnings,
details the movement in owners' equity over a period. The movement in owners'
equity is derived from the following components:
Net Profit or loss
during the period as reported in theincome statement
Share capital issued or
repaid during the period
Dividend payments
Gains or losses
recognized directly in equity (e.g. revaluation surpluses)
It has been my
experience that all watchful business owners have an innate sense of how well
their business is doing. Almost without thinking about it, these business
owners can tell you any time during the month how close they are to hitting
budgeted figures. Certainly, cash in bank plays a part, but it's more than
that.
Helpful
is the routine review of financial statements. There are three types of
financial statements. Each will give you important info about how efficiently
and effectively your business is operating.
The income statement shows all items of
income andexpensefor your arts or crafts
business. It reflects a specific time period. So, anincome statementfor the quarter ending March 31, shows
revenue and expenses for January, February and March; if the income statement
is for the calendar year ending December 31, it would contain all your
information from January 1 to December 31.
Income statementsare also known as statements of profit
and loss or P&Ls. The bottom line on an income statement is income less
expenses. If your income is more than expense, you have anet profit. Expense more than income? You have
a net loss.More »
Accounting is based upon a double entry
system - for every entry into the books there has to be an opposite and equal
entry. The net effect of the entries is zero, which results your books being
balanced. The proof of this balancing act is shown in the balance sheet when
Assets = Liabilities + Equity.
The balance sheet shows the health of a
business from day one to the date on the balance sheet. Balance Sheets are
always dated on the late day of the reporting period. If you’ve been in
business since 1997 and your balance sheet is dated as of December 31 of the
current year, the balance sheet will show the results of your operations from
1997 to December 31.More »
3. Statement of Cash
Flows
The statement of cash flows shows the ins and
outs of cash during the reporting period. You may be thinking – well who needs
that type of report? I’ll just look at the checkbook. Good point, unless you’re
reporting things that don’t immediately affect cash such as depreciation,
accounts receivable and accounts payable.
If I could only choose one of those three
financial statements to evaluate the ability of a company to pay dividends and
meet obligations (indicating a healthy business) I would pickthe statement of cash flows. The statement of
cash flows takes aspects of the income statement and balance sheet and kind of
crams them together to show cash sources and uses for the period.
