Accounting

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 include Assets, 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 Assets are ones that an entity expects to use within one-year time from the reporting date.

Non Current Assets are 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.
Inventory		Current		Cash is generated from the sale of inventory.
Cash		Current		Cash!
Receivables		Current		Will eventually result in inflow of cash.

Elements of Financial Statements (See related pages) 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. Distributions to owners are decreases in equity resulting from transfers to 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 Statements represent 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 the Profit 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.

View detailed explanation and Example of Income Statement

Cash Flow Statement 

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.

View detailed explanation and Example of Cash Flow Statement

Statement of Changes in Equity

Statement of Changes in Equity, also known as the Statement 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 the income statement

Share capital issued or repaid during the period

Dividend payments

Gains or losses recognized directly in equity (e.g. revaluation surpluses)

Effects of a change in accounting policy or correction of accounting error

View detailed explanation and Example of Statement of Changes in Equity

Link between Financial Statements

The following diagram summarizes the link between financial statements.

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 first step in learning how to prepare financial statements is understanding the accounting system, which is how you get transactions to show up on the financial statements.

Tom Grill/Photographer's Choice RF/Getty Images

1.  Income Statement

The income statement shows all items of income and expense for your arts or crafts business. It reflects a specific time period. So, an income statement for 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 statements are 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 a net profit. Expense more than income? You have a net loss. More »

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2.  Balance Sheet

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 pick the 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.

Microsoft Income Statement
Fiscal year	2001	2000	1999
Total Revenue	$28,365,000,000	$$25,296,000,000	$$22,956,000,000
Cost of Goods Revenue	$5,191,000,000	$3,455,000,000	$3,002,000,000
Gross Profit	$23,174,000,000	$21,841,000,000	$$19,954,000,000
Operating Expense
Research and Development	$4,307,000,000	$4,379,000,000	$3,775,000,000
Selling, General, and Administrative Expenses	$6,957,000,000	$5,742,000,000	$5,242,000,000
Non Recurring	N/A	N/A	N/A
Other Operating Expenses	N/A	N/A	N/A
Operating Income
Operating Income	$11,910,000,000	$11,720,000,000	$10,937,000,000
Total Other Income and Expenses Net	($397,000,000)	($195,000,000)	$3,338,000,000
Earnings Before Interest and Taxes	$11,513,000,000	$11,525,000,000	$14,275,000,000
Interest Expense	N/A	N/A	N/A
Income Before Taxes	$11,513,000,000	$11,525,000,000	$14,275,000,000
Income Tax Expense	$3,684,000,000	$3,804,000,000	$4,854,000,000
Equity Earnings or Loss Unconsolidated Subsidiary	N/A	N/A	N/A
Minority Interest	N/A	N/A	N/A
Net Income from Continuing Operations	$7,829,000,000	$7,721,000,000	$9,421,000,000
Nonrecurring Events
Discontinued Operations	N/A	N/A	N/A
Extraordinary Items	N/A	N/A	N/A
Effect of Accounting Changes	N/A	($375,000,000)	N/A
Other Items	N/A	N/A	N/A
Net Income	$7,829,000,000	$7,346,000,000	$9,421,000,000