Preparing financial statements

If you're taking a financial accounting class, your entire course is centered on the proper preparation of financial statements: the income sheet, balance sheet, and statement of cash flows. Financial accountants can't just stick accounting transaction data on the statements wherever they feel like. Many, many rules exist that dictate how financial accountants must organize the information on the statements; these rules are called generally accepted accounting principles (GAAP), and I discuss them in Chapter 4. The rules pertain to both how the financial accountant shows the accounting transactions and on which financial statements the information relating to the transactions appears.

Curious about the purpose of each financial statement? (I know the mystery

is eating at you!) Here's the scoop on each:

For now (because I know the excitement is too much for you!), here are the basic facts on the four different income statement components: • Revenue: Gross receipts earned by the company selling its goods or services. • Expenses: The costs to the company to earn the revenue. • Gains: Income from non-operating-related transactions, such as selling a company asset. • Losses: The flip side of gains, such as losing money when selling the company car.

REMEMBER A lot of non-accountants call the income statement a statement of profit or loss or simply a P&L. These terms are fine to use because they address the spirit of the statement.

Showing historic performance

The information reflected on the financial statements allows its users to evaluate whether they want to become financially involved with the company. But the financial statement users cannot make educated decisions based solely on one set of financial statements. Here's why:

While the balance sheet shows results from the first day the company opens to the date on the balance sheet, it doesn't provide a complete picture of the company's operations. All three financial statements are needed to paint that picture.

REMEMBER

Savvy financial statement users know that they need to compare several years' worth of financial statements to get a true sense of business performance. Users employ tools such as ratios and measurements involving financial statement data (a topic I cover in Chapter 14) to evaluate the relative merit of one company over another by analyzing each company's historic performance.

Providing results for the annual report

After all the hoopla of preparing the financial statements, publicly traded companies (those whose stock and bonds are bought and sold in the open market) employ independent certified public accountants (CPAs) to audit the financial statements for their inclusion in reports to the shareholders. The main thrust of a company's annual report is not only to provide financial reporting but also to promote the company and satisfy any regulatory requirements.

The preparation of an annual report is a fairly detailed subject that your financial accounting professor will review only briefly in class. Your financial accounting textbook probably contains an annual report for an actual company, which you'll use to complete homework assignments. I provide a more expansive look at annual reports in Chapter 16.

Getting to Know Financial Accounting Users

Well, who are these inquisitive financial statement users I've been referring to so far in this chapter? If you've ever purchased stock or invested money in a retirement plan, you number among the users. In this section, I explain why certain groups of people and businesses need access to reliable financial statements.

Identifying the most likely users

Financial statement users fall into three categories:

And what other governmental agency is particularly interested in whether a company employs any hocus pocus when preparing its financial statements? The Internal Revenue Service, of course, because financial statements are the starting point for reporting taxable income.

Recognizing their needs

REMEMBER

All three categories of financial statement users share a common need: They require assurance that the information they are looking at is both materially correct and useful. Materially correct means the financial statements don't contain any serious or substantial misstatements. In order to be useful, the information has to be understandable to anyone not privy to the day-to-day activities of the company.

Investors and creditors, though sitting at different ends of the table, have something else in common: They are looking for a financial return in exchange for allowing the business to use their cash. Governmental agencies, on the other hand, don't have a profit motive for reviewing the financial statements; they just want to make sure the company is abiding by all tax codes, regulations, or generally accepted accounting principles.

Providing information for decision-making

REMEMBER

The onus is on financial accountants to make sure a company's financial statements are materially correct. Important life decisions may hang in the balance based on an individual investing in one stock versus another. Don't believe me? Talk to any individual close to retirement age who lost his or her whole nest egg in the Enron debacle.

Two of the three groups of financial statement users are making decisions based on those statements: investors and creditors.

Creditors look to the financial statements to make sure a potential debtor has the cash flow and potential future earnings to pay back both principal and interest according to the terms of the loan.

Investors fall into two groups:

Remember that there are two ways to make money: the active way (you work to earn money) and the passive way (you invest money to make more money). Passive is better, no? The wise use of investing allows individuals to make housing choices, educate their children, and provide for their retirement. And wise investment decisions can be made only when potential investors have materially correct financial statements for the businesses in which they're considering investing.

Respecting the Key Characteristics of Financial Accounting Information

Now that you understand who uses financial accounting information, I want to discuss the substantive characteristics of that information. If financial accountants don't assure that financial statement information has these characteristics, the statements aren't worth the paper on which they're printed.

The information a company provides must be relevant, reliable, comparable, and consistent. In this section, I define what each characteristic means.

Relevance

Relevance is a hallmark of good evidence; it means the information directly relates to the facts you're trying to evaluate or understand. The inclusion or absence of relevant information has a definite effect on a user's decisionmaking process.

Relevant information has predictive value, which means it helps a user look into the future. By understanding and evaluating the information, the user can form an opinion as to how future company events may play out. For example, comparing financial results from prior years, which are gleaned from the financial statements, can give investors an idea as to the future value of a company's stock. If assets and revenue are decreasing while liabilities are increasing, you have a pretty good indicator that investing in this company may not be such a hot idea.

Relevant information also has feedback value, which means that new relevant information either confirms or rebuts the user's prior expectations. For example, you review a company's financial statements for 2012, and your analysis indicates that the company's sales should increase two-fold in the subsequent year. When you later check out the 2013 income statement, the company's gross receipts have, indeed, doubled. Woohoo! With the relevant information in hand, you see that your prediction came true.

REMEMBER

Timeliness goes hand in hand with relevance. The best and most accurate information in the world is of no use if it's no longer applicable because so such time has elapsed that facts and circumstances have changed. Look at it this way: If you were in the market to replace your flat-screen TV, and you found out about a killer sale at the local electronics store the day after the sale ended, this information is utterly useless to you. The same thing is true with financial information. That's why the SEC requires publicly traded companies to issue certain reports as soon as 60 days after the end of the financial period. (See Chapter 16 for more about this reporting requirement.)

Reliability

Reliability means you can depend on the information to steer you in the right direction. For example, the information must be free from material misstatements (meaning it doesn't contain any serious or substantial mistakes). It also has to be reasonably free from bias, which means the information is neutral and not slanted to produce a rosier picture of how well the company is doing.

Here's an example of how a company would create biased financial statements. Say that a company has a pending lawsuit that it knows will likely damage its reputation (and, therefore, its future performance). In the financial statements, the company does not include a note that mentions the lawsuit. The company is not being neutral in this situation; it is deliberately painting a rosier picture than actually exists. (See Chapter 15 for my explanation of the purpose of financial statement notes.)

(Continues...)