Financial statements, which are accounting reports, serve as the principal method of communicating financial information about a business entity or an individual to outside parties such as banks and investors. In a technical sense, financial statements summarize the accounting process and provide a tabulation of account titles and amounts of money. Furthermore, financial statements report the financial position or financial status of a business or an individual as well as financial changes at a particular time or during a period of time. The basic purpose of financial statements is to communicate to external and internal parties information about financial decisions that have been made.
General purpose financial statements are designed to meet the needs of many diverse users, particularly present and potential owners and creditors. Financial statements result from simplifying, condensing, and aggregating masses of data obtained primarily from the financial system. They are an output of the accounting system.
Companies release financial statements at least once a year for their accounting period. Companies either follow the calendar year beginning January 1 and ending December 31, or they follow their own fiscal year, which can be any complete 12-month period. Consequently, companies have either calendar-year accounting periods or fiscal-year accounting periods. In addition, businesses frequently prepare financial statements quarterly or whenever necessary, which are referred to as interim statements.
The Financial Accounting Standards Board, in its Statements of Financial Accounting Concepts, asserted that financial reporting includes not only financial statements but also other means of communicating information that relates, directly or indirectly, to the information provided by the accounting system. Financial reporting is the process of communicating financial accounting information about an enterprise to its external users. Financial statements provide information useful in investment and credit decisions and in assessing cash flow prospects. They provide information about an enterprise's resources, claims to those resources, and changes in the resources.
Financial reporting is a broad concept encompassing financial statements, notes to financial statements and parenthetical 'disclosures, supplementary information (such as changing prices), and other means of financial reporting (such as management discussions and analysis, and letters to stockholders). Financial reporting is but one source of information needed by those who make economic decisions about business enterprises.
Financial reporting focuses primarily on providing information about assets, liabilities, sales, and earnings. Information about earnings based on accrual accounting usually provides a better indication of an enterprise's present and continuing ability to generate positive cash flows than that provided by cash receipts and payments. Accrual accounting is an accounting method that reports sales and expenses when they occur, instead of when the actual cash transactions to take place.
MAJOR FINANCIAL STATEMENTS
The basic financial statements of businesses include the (1) balance sheet (or statement of financial position), (2) income statement, (3) cash flow statement, (4) the retained earnings statement, and (5) statement of changes in owner's equity. The balance sheet lists all the assets, liabilities, and owner's or stockholders' equity (the difference between assets and liabilities), of a company as of a specific date. Hence, the balance sheet is essentially a still picture of a company's financial position (see Figure 1). The income statement, on the other hand, is similar to a moving picture of a company's operations during a given period. The income statement presents a summary of the revenues, gains, expenses, losses, and net income or net loss of an entity for a specific period (see Figure 2).
The cash flow statement summarizes a business's cash receipts and cash payments relating to its operating, investing, and financing activities during a particular period (see Figure 3). Whereas the income statement reports a company's financial activities on an accrual basis, the cash flow statement reports this information on a cash basis.
Because retained earnings represent a company's earnings since it was founded minus any money deducted or distributed to the owners of the company, the statement of retained earnings reports a company's overall earnings. A statement of retained earnings presents the changes in retained earnings for a designated accounting period. Filed by corporations, this financial statement reconciles the balance of the retained earnings account as follows:
Retained earnings, January 1, 1997 $100,000
Net Income for 1997 $85,000
Minus: Dividends for 1997 $65,000
Net Increase in Retained Earnings 20,000
Ending retained earnings, December 31, 1997 $120,000
A statement of changes in owner's equity is the equivalent financial statement for sole proprietorships when a company is owned by a single person. This financial statement reports a company's growth or loss in equity during a designated period. The statement follows the same format as the statement of retained earnings, except for items pertaining only to corporations.
For an item to be recognized in the financial statements, it should meet four fundamental recognition criteria, subject to cost-benefit constraint and a materiality threshold. These criteria are:
- Definitions: The item meets the definition of an element of financial statements.
- Materiality: It has a significant attribute measurable in units of money with sufficient reliability.
- Relevance: The information about it is capable of making a difference in user decisions pertaining to a company's value and its financial management.
- Reliability: The information is representational, faithful, verifiable, and neutral.
When accountants are unsure of whether to include certain items in financial reports they follow two constraints to these criteria: a benefit/cost constraint and the materiality constraint. The benefit/cost constraint asserts that the cost of collecting, processing, auditing, and communicating the information will not exceed the benefits to be derived from its use. The materiality constraint provides a quantitative threshold that defines the magnitude of an omission or misstatement of accounting information by its ability to mislead the judgment of a reasonable person relying on it.
In order for financial statements to be useful to analysts, the statements must provide information that is not only comparable to information in previous financial statements of a particular company, but also comparable among various companies. Consequently, accountants must consistently apply accounting rules when preparing financial statements.
Figure 1: Balance Sheet
General Company Balance Sheet Januray 2, 1999
Items currently reported in financial statements are measured by different attributes (for example, historical cost, current cost, current market value, net reliable value, and present value of future cash flows). While historical cost is the primary method of determining an asset's value, some accountants use other methods that take inflation into consideration. According to the historical cost, financial statements contain the cost paid for items listed at the time they were acquired. Consequently, the historical cost method does not make allowances for inflation, whereas other methods consider the current value of items listed.
Notes to financial statements are informative disclosures appended to financial statements. They provide information concerning such matters as depreciation and inventory methods used, details of long term debt, pensions, leases, income taxes, contingent liabilities, method of consolidation, and other matters. Notes are considered an integral part of the financial statements. Schedules and parenthetical disclosures are also used to present information not provided elsewhere in the financial statements.
Figure 2: Income Statement
General Company Income Statement
for Period Ending December 31, 1998
Each financial statement has a heading, which gives the name of the company, the name of the statement, and the date or time covered by the statement. The information provided in financial statements is primarily financial in nature and expressed in units of money. The information relates to a single business enterprise. The information often is the product of approximations and estimates, rather than exact measurements. Financial statements typically reflect the financial effects of transactions and events that have already happened (i.e. historical transactions and events).
Financial statements presenting economic data for two or more periods are called comparative statements.
Figure 3: Cash Flow Statement
General Company Cash Flow Statement
for Period Ending December 31, 1988
Comparative financial statements usually give similar reports for the current period and for one or more preceding periods. They provide analysts with significant information about trends and relationships over two or more years. Comparative statements are considerably more informative than are single-year statements. Comparative statements emphasize the fact that financial statements for a single accounting period are only one part of the continuous history of a company.
Financial statements are usually audited by independent accountants for the purpose of evaluating the data presented, determining if the financial statements conform to the rules of accounting, and improving the level of confidence in the reliability of the statements.
ELEMENTS OF FINANCIAL STATEMENTS
The Financial Accounting Standards Board (FASB) has defined the following elements of financial statements of business enterprises: assets, liabilities, equity, revenues, expenses, gains, losses, investment by owners, distribution to owners, and comprehensive income. According to the FASB, the elements of financial statements are the building blocks with which financial statements are constructed—the broad classes of items that financial statements comprise. In its "Elements of Financial Statements of Business Enterprises," the FASB defined the interrelated elements that are directly related to measuring performance and the financial position of a business enterprise as follows:
- Assets include any items of monetary value owned by a company with current or probable future economic benefits.
- Comprehensive income is the change in equity (net assets) of an entity, from transactions and other events and circumstances from nonowner sources, during a particular period. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners.
- Distributions to owners are decreases in net assets of a particular enterprise resulting from transferring assets, rendering services, or incurring liabilities to owners. Distributions to owners decrease ownership interest or equity in an enterprise.
- Equity refers to the value of a company after deducting a company's liabilities from its assets.
- Expenses are outflows or payments of assets, or obligations to pay liabilities, during a period, from delivering or producing goods or rendering services as well as from carrying out other activities that constitute part of a business's ongoing or central operation.
- Gains are increases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity during a period, except those that result from revenues or investments by owner.
- Investments by owners are increases in net assets of a particular enterprise resulting from transfers to it from other parties of something of value to obtain or increase ownership interest (or equity) in it.
- Liabilities are current or probable future debts arising from present obligations of a company to transfer assets or provide services to other entities in the future as a result of past transactions or events.
- Losses are decreases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity during a period, except those that result from expenses or distributions to owners.
- Revenues are sales or other enhancements of assets of a company or settlement of its liabilities (or a combination of both) during a period from delivering or producing goods, rendering services, or other activities that constitute the entity's ongoing major or central operations.
Accountants prepare financial statements on the assumption that each enterprise is a separate entity, that all transactions can be expressed or measured in dollars, that the enterprise will continue in business indefinitely, and that statements will be prepared at regular intervals using consistent methods. These assumptions provide the foundation for the structure of financial accounting theory and practice, and explain why financial information is presented in a given manner.
PROCEDURES, AND POLICIES
Generally accepted accounting principles (GAAP) are the conventions, rules, and procedures necessary to define accounting practice at a particular time. The Financial Accounting Standards Board (FASB), created in 1972, is currently the independent nongovernmental body in the United States that develops and issues standards of financial accounting. Pervasive accounting principles include the recording of assets and liabilities at cost, and recognizing revenue when it is realized and when a transaction has taken place (generally at the point of sale), and recognizing expenses according to the matching principle (costs to revenues). Modifying conventions include conservatism and materiality. Conservatism requires that uncertainties and risks related to a company be reflected in its accounting reports. Materiality requires that anything that would be of interest to an informed investor be fully disclosed in the financial statements.
Accounting procedures are those rules and practices that are associated with the operations of an accounting system and that lead to the development of financial statements. Accounting procedures include the methods, practices, and techniques used to carry out accounting objectives and to implement accounting principles.
Accounting policies are those accounting principles followed by a specific company. Information about the accounting policies adopted by a reporting enterprise is essential for financial statement users and should be disclosed in the financial statements. Accounting principles and their method of application in the following areas are considered particularly important: (1) a selection from existing alternatives, (2) areas that are peculiar to a particular industry in which the company operates, and (3) unusual and innovative applications of GAAP. Significant accounting policies are usually disclosed as
the initial note or as a summary preceding the notes to the financial statements.
A subsequent event is an important event that occurs between the balance sheet date and the date of issuance of the annual report. Subsequent events must have a significant or material effect on the financial statements. A subsequent event does not include the recurring economic fluctuations associated with the economy and with free enterprise, such as a strike or management change. A subsequent event is considered to be important enough that without such information the statement would be misleading if the event were not disclosed. The recognition and recording of these events requires the professional judgment of an accountant or external auditor.
Events that effect the financial statements at the date of the balance sheet might reveal an unknown condition or provide additional information regarding estimates or judgments. These events must be reported by adjusting the financial statements to recognize the new evidence.
Events that relate to conditions that did not exist on the balance sheet date but arose subsequent to that date do not require an adjustment to the financial statements. The effect of the event on the future period, however, may be of such importance that it should be disclosed in a footnote or elsewhere.
A segment of a business is a part whose activities represent a major line of business or class of customer. A segment is a part of an enterprise that sells primarily to outsiders for a profit. Examples of a segment include a subsidiary, a division, a department, a product, a market, or other separations where the activities, assets, liabilities, and operating income can be distinguished for operational and reporting purposes. Accountants require that financial statements be supplemented with information concerning the industries and geographic areas in which an enterprise operates. Information about segments of a business is useful to those who invest in large, complex, heterogeneous, publicly traded enterprises in evaluating risks, earnings, growth cycles, profit characteristics, capital requirements, and return on investments, which can differ among segments of a business. The need for segment information is the result of many environmental factors, including the growth of conglomerates, acquisitions, diversifications, and foreign activities or enterprises.
A reportable segment is determined by the following procedures: (1) identifying the enterprise's products and services, (2) grouping the products and services into industry segments, and (3) selecting the significant industry segments by applying various tests established for this purpose.
Segment information that must be disclosed in financial statements includes a business's operations in different industries, foreign operations, export sales, and major customers. Detailed information relating to revenues, the segment's operating profit or loss, and identifiable assets must be disclosed, along with additional information. Segment information primarily separates a company's basic financial statements, revealing the performance and financial information of each segment.
Consolidated financial statements are produced by the parent company when the financial statements of a parent and a subsidiary or subsidiaries are added together so that they portray the resulting financial statements as if they were the financial statements of a single company, i.e. a single business entity. A subsidiary is a separate legal entity whose outstanding common stock is more than 50 percent owned by another company.
Consolidated financial statements are prepared primarily for the benefit of the shareholders and creditors of the parent company. Banks and analysts often consider consolidated statements more meaningful than the separate statements of members of the affiliation. Nevertheless, subsidiary creditors, minority shareholders, and regulatory agencies must rely on the statements of the subsidiary to assess their claims. The usual condition for consolidating the statements of an affiliated group of companies is ownership, directly or indirectly, of more than 50 percent of the outstanding voting shares of another company. Generally accepted accounting principles (GAAP) in the United States require that all subsidiaries be consolidated unless control is lacking or is likely to be temporary.
Accounting for consolidations requires (1) the summation of the parent and subsidiary accounts when preparing the parent's consolidated statements and (2) the elimination of intercompany transactions, i.e. transactions between parent and subsidiary companies. When a parent company owns less than 100 percent of the subsidiary's stock, the part owned by outside investors is referred to as minority interest.
INTERNATIONAL TRANSACTIONS AND
International business transactions and operations relate to activities across national boundaries. When business occurs between companies in different countries, a common problem is the translation of foreign currency amounts into dollars, accomplished through a foreign currency exchange rate. Changes in exchange rates can cause companies to have foreign currency transaction gains and losses on credit transactions. These gains and losses must be accounted for and disclosed in the financial statements.
Consolidation of a foreign subsidiary's financial statements maintained in a foreign currency requires that they be translated into the parent company statements and be adjusted to reflect GAAP in the United States. The translation process can create a translation adjustment that must be reported in stockholders' equity.
PERSONAL FINANCIAL STATEMENTS
The reporting entity of personal financial statements is an individual or a group of related individuals. Individuals prepare or have accountants prepare personal financial statements for obtaining bank loans, income tax planning, retirement planning, gift and estate planning, and the public disclosure of financial affairs.
For each reporting entity, a statement of financial position is required. The statement presents assets at estimated current values, liabilities at the lesser of the discounted amount of cash to be paid or the current cash settlement amount, and net worth. A provision should also be made for estimated income taxes on the differences between the estimated current value of assets. Comparative statements for one or more periods should be presented. A statement of changes in net worth is optional.
Personal financial statements should be presented on the accrual basis. A classified balance sheet is not used. Assets and liabilities are presented in the order in which they can be converted into cash (i.e. liquidity) and maturity, respectively. A business interest that constitutes a large part of an individual's total assets should be shown separate from other assets. Such an interest would be presented as a net amount. A statement of changes in net worth would disclose the major sources of increases and decrease in net worth. Increases in personal net worth arise from income, increases in estimated current value of assets, decreases in estimated current amount of liabilities, and decreases in the provision for estimated income taxes. Decreases in personal net worth arise from expenses, decreases in estimated current value of assets, increases in estimated current amount of liabilities, and increases in the provision for income taxes.
The preparation and presentation of a company's financial statements are the responsibility of a company's management. The Securities and Exchange Commission, however, requires independent certified public accountants to audit the financial statements of all publicly traded companies. In other words, an accountant who is not an employee of a company and who is a licensed accountant must examine a public company's financial records for accuracy. During an audit, the auditor reviews and evaluates a company's accounting system, records, internal controls, and financial statements in accordance with generally accepted auditing standards. The auditor then expresses an opinion concerning the fairness of the financial statements in conformity with GAAP.
Auditors issue unqualified reports or unqualified opinions when they find financial statements fair and accurate after examination. The unqualified report contains three paragraphs: an introductory paragraph, a scope paragraph, and the opinion paragraph. In addition to the unqualified opinion, an auditor may issue a qualified opinion, an adverse opinion, or a disclaimer opinion. If auditors conclude that financial statements are accurate and in accordance with GAAP except for a few items, they issue qualified opinions. Auditors issue adverse opinions when they deem financial statements inaccurate or not in accordance with GAAP. When accountants lack sufficient information to give an unqualified opinion or when they are not independent of the companies they are auditing, they issue disclaimer opinions.
An auditor's report typically states that:
- The auditor is independent.
- The audit was performed on specified financial statements.
- The financial statements are the responsibility of the company's management.
- The opinion of the auditor is the auditor's responsibility.
- The audit was conducted according to generally accepted auditing standards.
- The audit was planned and performed to obtain reasonable assurance about whether the financial statements are free of material misstatements.
- The audit included examination, assessment, and evaluation stages.
- The audit provided a reasonable basis for an expression of an opinion concerning the fair presentation of the audit.
DEVELOPMENT STAGE COMPANIES
An enterprise is a development stage company if it devotes the majority of its efforts to establishing a new business and either of the following is present: (1) principal operations have not begun, or (2) principal operations have begun but revenue is insignificant. Activities of a development stage enterprise frequently include financial planning, raising capital, research and development, personnel recruiting and training, and market development.
A development stage company must follow GAAP applicable to operating enterprises in the preparation of financial statements. In its balance sheet, the company must report cumulative net losses separately in the equity section. In its income statement it must report cumulative revenues and expenses from the inception of the enterprise. Likewise, in its cash flow statement, it must report cumulative cash flows from the inception of the enterprise. Its statement of stockholders' equity should include the number of shares issued and the date of their issuance, as well as the dollar amounts received. The statement should identify the entity as a development stage enterprise and describe the nature of development stage activities. During the first period of normal operations, the enterprise must disclose in notes to the financial statements that the enterprise was but is no longer in the development stage.
COMPANIES IN FINANCIAL DISTRESS
Businesses can experience financial distress reflecting both financing and operating problems. Financing problems can result from situations where the company experiences liquidity deficiency, equity deficiency, debt default, and funds shortage. Operating problems take the form of continued operating losses, doubtful prospective revenues, jeopardization of the ability to operate, incapable management, and poor control over operations. An examination of the financial statements along with evidence obtained from management and other sources can provide a person with a basis for evaluating the going-concern condition of an enterprise. The going-concern principle assumes that a company will continue to operate indefinitely. As a general rule, analysts assume that a company is a going concern in the absence of evidence to the contrary. When accountants are certain, however, that a company will go bankrupt, they use different accounting principles.
During the auditing process, auditors may raise questions concerning the going-concern possibilities of a company. The auditor considers whether management's plans for dealing with the conditions and events concerning the uncertainty are likely to negate the problem. If, after evaluating management's plans, substantial doubt still exists, auditors either qualify their reports or provide a disclaimer. The audit report must explicitly include the phrase "substantial doubt about the entity's ability to continue as a going concern."
FRAUDULENT FINANCIAL REPORTING
Fraudulent financial reporting is defined as intentional or reckless reporting, whether by act or by omission, that results in materially misleading financial statements. Fraudulent financial reporting can usually be traced to the existence of conditions in either the internal environment of the firm (e.g. inadequate internal control), or to the external environment (e.g. poor industry or overall business conditions). Excessive pressure on management, such as unrealistic profit or other performance goods, can lead to fraudulent financial reporting.
The accounting profession generally is of the opinion that it is not the responsibility of the auditor to detect fraud, beyond what can be determined with the diligent application of generally accepted auditing standards. Because of the nature of irregularities, particularly those involving forgery and collusion, a properly designed and executed audit may not detect a material irregularity. The auditor is not an insurer and the auditor's report does not constitute a guarantee that financial statements do not contain fraudulent information.
[ Charles Woelfel.
updated by Karl Hell ]
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