Financial Accounting Project

Income Statement

The income statement, sometimes called an earnings statement or profit and loss statement, reports the profitability of a business organization for a stated time. In accounting, we measure profitability for a period, such as a month or a year, by comparing the revenues earned with the expenses incurred to produce these revenues. The income statement is the first financial statement prepared, as you will need the information from this financial statement for the remaining financial statements. The income statement contains the following:

· Revenues are the inflows of cash resulting from the sale of products or the rendering of services to customers. We measure revenues by the prices agreed on in the exchanges in which a business delivers goods or renders services.

· Expenses are the costs incurred to produce revenues. Expenses are costs of doing business (typically identified as accounts ending in the word expense).

· Net income is often called the earnings of the company. When expenses exceed revenues, the business has a net loss.

revenues − expenses = net income

Below is a video that explains the single-step income statement: 

Transcript

Below is a sample income statement from the fictional company, Metro Courier Inc.

Metro Courier Inc. Income Statement Month Ended January 31
Revenue
Service revenue	$ 60,000
Total revenues		$ 60,000
Expenses
Salary expense	$900
Utility expense	$1, 200
Total expenses		$2,100
Net income ($60,000 – $2,100)	$ 57,900

The main content of an income statement is rather straightforward: a listing of all revenues earned and expenses incurred by the reporting organization during the period specified. Revenue figures disclose increases in net assets (assets minus liabilities) that were created by the sale of goods or services resulting from the primary operations of the organization. For IBM, revenues are derived from the sale and servicing of computers and the like (a total of nearly $104 billion in 2008) while, for Papa John’s International, the reported revenue figure (a bit over $1.1 billion) measures the sale of pizzas and related items.

Conversely, expenses are decreases in net assets incurred by a reporting company in hopes of generating revenues. For example, salaries paid to salespeople for the work they have done constitute an expense. The cost of facilities that have been rented is also an expense as is money paid for utilities, such as electricity, heat, and water.

For example, IBM reported selling, general, and administrative expenses for 2008 of $23.4 billion. That was just one category of its expenses disclosed within the company’s income statement. During the same period, Papa John’s reported salaries and benefits as an expense for its domestic company-owned restaurants of $158.3 million. Financial accounting focuses on providing information about an organization, and both of these figures should help decision-makers begin to glimpse a portrait of the underlying company. Accounting is often said to ensure transparency—the ability to see straight through the words and numbers to gain a vision of the company and its operations.

An income statement also reports gains and losses for the same time period. A gain is an increase in the net assets of an organization created by an occurrence outside its primary or central operations. A loss is a decrease in net assets from a similar type of incidental event.

When Apple sells a computer to a customer, it reports revenue, but if the company disposes of a piece of land adjacent to a warehouse, it reports a gain (if sold above cost) or a loss (if sold below cost). Selling computers fall within Apple’s primary operations, whereas selling land does not. If Pizza Hut sells a pepperoni pizza, the transaction brings in assets. Revenue has been earned and should be reported. If this same company disposes of one of its old stoves, the result is reflected as either a gain or loss. Pizza Hut is not in the business of selling appliances. This classification split between revenues and expenses, and gains and losses help provide decision-makers with a more precise portrait of what happened to the company during the reporting period.

Below is a video that explains the multi-step Income Statement:

Transcript

An example of an income statement for a small convenience store is shown in the figure below. Note that the name of the company, the type of financial statement, and the time period reflected are apparent. Although this is only an illustration, it is quite similar to the income statements created by virtually all business organizations in the United States and many other countries.

Income Statement: Davidson Groceries Income Statement for Year Ended December 31, 2XX4
Revenues
Sales of groceries		$1,400,000
Expenses
Cost of goods sold	$900,000
Salary	$120,000
Rent	$20,000
Advertising	$30,000+
Insurance	$15,000
Others	$25,000
Total expenses		($1,110,000)
Operating income		$290,000
Other gains and losses
Gain on sale of delivery truck	$5,000
Loss on sale of land behind building	($15,000)	($10,000)
Income before income taxes		$280,000
Income tax expense		($50,000)
Net income		$230,000

A review of this sample income statement raises several questions. The meaning of balances, such as salary expense, rent expense, advertising expense, and the like are relatively clear. These figures measure specific outflows or decreases in the company’s net assets that were incurred in attempting to generate revenue. 

The difference in revenue and cost of goods sold is often referred to as the company’s gross profit, gross margin, or markup. It is one of the reported figures studied carefully by decision-makers. For this year, Davidson Groceries earned a gross profit of $500,000 ($1.4 million in revenues less $900,000 cost of goods sold). Its gross profit was 35.7 percent of sales ($500,000/$1.4 million).

For the year ending January 30, 2009, Lowe’s Companies Inc., the home improvement company, reported net sales revenues of $48.2 billion along with the cost of sales of $31.7 billion. Thus, Lowe’s earned a gross margin (the company’s term) during that period of $16.5 billion. Sales of merchandise ($48.2 billion) exceeded the cost of those same goods ($31.7 billion) by that amount. Its gross profit percentage was 34.2 percent ($16.5 million/$48.2 million). Any potential investor or creditor will find such numbers highly informative, especially when compared with the company’s prior years or with competing enterprises. For example, for the year ending February 1, 2009, the Home Depot Inc., a major competitor of Lowe’s Companies, reported net sales of $71.3 billion, cost of sales of $47.3 billion, and gross profit (the company’s term) of $24.0 billion. Its gross profit percentage was 33.7 percent ($24.0 million/$71.3 million). Such information allows decision-makers to compare these two companies and their operations.

In the Income Statement table above, revenues and expenses are listed first to arrive at an operating income figure, which is followed by gains and losses. This sequencing is appropriate since revenues and expenses relate to the primary or central operations of the business and gains and losses are created by more incidental events. Why then is income tax expense listed last, by itself, on the income statement and not with the other expenses?

State and federal income taxes cost businesses in the United States considerable sums of money each year. Exxon Mobil Corporation reported income taxes of $36.5 billion at the bottom of its 2008 income statement. The income tax figure is segregated in this manner because it is not an expense in a traditional sense. As previously described, an expense—like cost of goods sold, advertising, or rent—is incurred to generate revenues. Income taxes do not create revenues at all. Instead, they are caused by the company’s revenues and related profitability. Although referring to income taxes as an expense is common, probably a more apt title is income taxes assessed by the government. The financial impact is the same as an expense (an outflow or decrease in net assets); thus, income tax expense is often used for labeling purposes. However, because the nature of this expense is different, the reported income tax figure is frequently isolated at the bottom of the income statement, separate from true expenses.

Balance Sheet

The primary purpose of a balance sheet is to report an organization's assets and liabilities at a specific point in time. The format is quite simple. All assets are listed first, usually in the order of liquidity, followed by the liabilities. A picture is provided of each future economic benefit owned or controlled by the company (its assets) as well as its debts (liabilities).

The balance sheet shows the company's financial condition on one specific date. All the other financial statements report events occurring over a period of time (often a year or a quarter). The balance sheet discloses assets and liabilities as of the one specified date.

The balance sheet will always balance unless a mistake is made. This is known as the accounting equation:

assets = liabilities + stockholders' equity.

Or if the stockholders' equity account is broken down into its parts,

assets = liabilities + capital stock + retained earnings.

This equation stays in balance for one simple reason: assets must have a source. If a business or other organization has an increase in its total assets, that change can only be caused by (1) an increase in liabilities such as money being borrowed, (2) an increase in capital stock such as additional money being contributed by stockholders, or (3) an increase created by operations such as a sale that generates a rise in net income. There are no other ways to increase assets.

Below is a video that explains the Balance Sheet:

Transcript

One way to understand the accounting equation is that the left side (the assets) presents a picture of the future economic benefits that the reporting company holds. The right side provides information to show how those assets were derived (from liabilities, from investors, or from operations). Because no assets are held by a company without a source, the equation (and, hence, the balance sheet) must balance:

assets = the total source of those assets.

Davidson Groceries Balance Sheet, December 31, 2XX4
Assets
Current assets
Cash	$22,000
Accounts receivable	$24,000
Inventory	$103,000
Prepaid rent	$12,000
Total current assets		$161,000
Noncurrent Assets
Land	$210,000
Equipment (land)	$155,000
Buildings (net)	$680,000
Total noncurrent assets		$1,045,000
Total assets		$1,206,000
Liabilities and stockholders’ equity
Liabilities
Current liabilities
Accounts payable	$33,000
Salaries payable	$9,000
Insurance payable	$15,000
Total current liabilities		$57000
Noncurrent liabilities
Note payable—Third National Bank	$300,000
Note payable—State Bank	$220,000
Total current liabilities		$520,000
Total liabilities		$577,000
Stockholders’ equity
Capital stock	$179,000
Retained earnings	$450,000
Total stockholders’ equity		$629,000
Total liabilities and stockholders’ equity		$1,206,000

Statement of Cash Flows

The statement of cash flows is one of the four primary financial reports that is used to evaluate a company's operating performance. Primary financial reports include the income statement, balance sheet, retained earnings report, and the statement of cash flows. The statement of cash flows is organized into three types of cash flows: operating, investing, and financing cash flows. This financial statement is a financial snapshot of a company's performance based on the operating, investing, and financing cash flows.

Preparing a Statement of Cash Flows

We will look at each section of the statement of cash flows and put them all together at the end. The Dells Company is preparing their annual financial statements for the year ended June 30, 2015. They have prepared the income statement, statement of retained earnings, and balance sheet. Now we need to prepare the statement of cash flows.

Operating Section

For the operating section, we need the income statement. Dells Company's income statement is below.

Dells Company Income Statement For Year Ended June 30, 2015
Sales		$1,000,000.00
Cost of goods sold	$600,000.00
Salaries and wages expense	$200,000.00
Rent expense	$40,000.00
Depreciation expense	$20,000.00
Interest expense	$3,000.00
Loss on sale of equipment	$7,000.00
Total expenses		$870,000.00
Income before federal taxes		$130,000.00
Less: Federal income taxes		$(60,000.00)
Net Income		$ 70,000.00

To start the operating section, we need net income, depreciation expense, and any gains or losses (do not make this harder than it is—you must see the words gain or loss, or do not consider it a gain or loss). The following items summarize the needed calculations:

· net income is $70,000

· add depreciation expense of $20,000

· add loss on sale of equipment of $7,000

Our statement of cash flows appears in the table below:

Dells Company Statement of Cash Flows For Year Ended June 30, 2015
Cash flows from operating activities:
Net income		$ 70,000.00
Adjustments to reconcile net income to net cash:
Depreciation expense	$ 20,000.00
Loss on sale of equipment	7,000.00

Now we move on to the balance sheet for the current assets and liabilities. Notice the increase (or decrease) has already been calculated for you, but if it were not, you would take the current year amount minus the previous year amount. If the current year is more, there is an increase and if the current year is less that is a decrease.

Dells Company Comparative Balance Sheet June 30 2015 and 2014
	2015	2014	Increase (Decrease)
Assets
Current assets:
Cash	$30,000.00	$80,000.00	$(50,000.00)
Accounts receivable, net	160,000.00	100,000.00	60,000.00
Merchandise inventory	100,000.00	70,000.00	30,000.00
Prepaid rent	20,000.00	10,000.00	10,000.00
Total current assets	$310,000.00	$260,000.00
Property, plant, and equipment:
Equipment	$400,000.00	$200,000.00	$200,000.00
Accumulated depreciation—equipment	(60,000.00)	(50,000.00)	(10,000.00)
Total property, plant, and equipment	$340,000.00	$150,000.00
TOTAL ASSETS	$650,000.00	$410,000.00
Liabilities and equity
Current liabilities:
Accounts payable	$50,000.00	$40,000.00	$10,000.00
Notes payable—bank	0	50,000.00	(50,000.00)
Salaries payable	10,000.00	20,000.00	(10,000.00)
Federal income taxes payable	30,000.00	20,000.00	10,000.00
Total current liabilities	$ 90,000.00	$ 130,000.00
Stockholder’s equity:
Common stock, $10 par	$300,000.00	$100,000.00	$200,000.00
Paid in capital in excess of par, common	50,000.00	0	50,000.00
Retained earnings	210,000.00	180,000.00	30,000.00
Total Stockholder’s Equity	$560,000.00	$280,000.00
TOTAL LIABILITIES AND EQUITY	$650,000.00	$410,000.00

We will use the current assets (other than cash) and the current liabilities (other than the notes payable—bank, which we will report in financing). Remember, we add decreases and subtract increases in current assets, but in current liabilities we will add increases and subtract decreases:

· Accounts receivable increased $60,000 so we will subtract $60,000 since this is a current asset.

· Merchandise inventory increased $30,000 so we will subtract $30,000.

· Prepaid rent increased $10,000 so we will subtract $10,000.

· Accounts payable increased $10,000 but we will add $10,000 since this is a current liability.

· Salaries payable decreased $10,000 so we will subtract $10,000.

· Federal income Taxes payable increased $10,000 so we will add $10,000.

With this information, we can finish the operating section as follows:

Dells Company Statement of Cash Flows For Year Ended June 30, 2015
Cash flows from operating activities:
Net income		$70,000.00
Adjustments to reconcile net income to net cash:
Depreciation expense	$20,000.00
Loss on sale of equipment	7,000.00
Increase in accounts receivable	(60,000.00)
Increase in merchandise inventory	(30,000.00)
Increase in prepaid rent	(10,000.00)
Increase in accounts payable	10,000.00
Decrease in salaries payable	(10,000.00)
Increase in federal income taxes Payable	10,000.00
Total adjustments		$(63,000.00)
Net cash provided by operating activities			$7,000.00
[$70,000 net income + (-63,000) in adjustments]

What does this tell us about the company? It tell us the company was able to generate $7,000 of cash from its day-to-day business operations. This could cause a concern, since the company owes $90,000 in the next year (see current liabilities on the balance sheet). But let's look at the other sections to see what else we can learn.

Investing Section

For the investing section, we will use the balance sheet and any additional information provided. On the balance sheet, the only long-term asset we have comes from property, plant, and equipment and is the equipment account. During 2015, equipment was sold for $3,000 cash with an original cost of $20,000 and $10,000 of accumulated depreciation. Additional equipment was purchased for $220,000 cash. Let's look at these transactions:

· Equipment was sold for $3,000 cash (we do not need to know the rest of the information as the important part is the amount of cash). Notice how the $10,000 book-value of the equipment ($20,000 cost – $10,000 accumulated depreciation) less the $3,000 cash received is the loss reported on the balance sheet of $7,000. If we sold equipment, we receive cash, so we will add the $3,000 cash.

· Dells purchased additional equipment for $220,000 cash, so they paid cash. We will subtract the $220,000 cash paid.

As such, he investing section would look like this:

Cash flows from investing activities:
Cash received from sale of equipment	$3,000.00
Cash paid for new equipment	$ (220,000.00)
Net cash used by investing activities		$(217,000)

Notice how the net cash heading changed from provided by in the operating section to used by investing, since the number is negative. We have a negative cash flow for investing—is that good or bad? Dells Company sold old equipment and purchased new equipment with cash, not with a loan! This is a good thing. 

When analyzing this section, you really want to see the asset sold, because you are purchasing new ones—it is not a good sign to sell assets without replacing them. Since Dells was able to pay cash for the equipment and not take out a loan, how did they pay for it? We know it was not from the day to day business because the operating activities cash was pretty low. So, we will look to the financing section for answers.

Financing Section

For the financing section, we will use the balance sheet and the statement of retained earnings. On the balance sheet, we are looking at the notes payable—bank, from the current liability section and any other long-term liabilities. If these balances increased, we can assume we received cash, and if the balances decreased, we can assume we paid on the debt unless we are given additional information on the subject. Notes payable is the only liability we haven't already accounted for on the balance sheet. Next, we look at the equity section of the balance sheet. We have common stock, paid in capital and retained earnings. Common stock and paid in capital both increased—why does this account increase?

 It increases when we issue shares of common stock. We will assume Dells issued the stock for cash unless we are given additional information to the contrary. In our case, we are given no additional information, so we will assume all increases or decreases involve cash. Lastly, we have retained earnings. What is involved in retained earnings? Let's look at the statement of retained earnings to find out.

Dells Company Statement of Retained Earnings For Year Ended June 30, 2015
Retained Earnings, June 30 2014	$180,000.00
Add: 2015 net income	70,000.00
	$250,000.00
Deduct: Cash dividends	(40,000.00)
Retained Earnings, June 30, 2015	$210,000.00

Retained earnings include the beginning retained earnings + net income – dividends to get the ending retained earnings balance. 

What do we need for the statement of cash flows? We already accounted for net income in the operating section, but we need to know dividends. We will assume cash dividends unless the information given tells us otherwise. In this case, it shows we paid cash dividends:

· Notes payable—bank decreased by $50,000; we assume we paid cash of $50,000 in 2015 and we will subtract cash.

· Common stock increased $200,000 and, paid in capital increased $50,000, so the total cash received was $250,000 ($200,000 + $50,000), which will be added.

· Cash dividends of $40,000 were paid, and we will subtract cash.

The financing section will look as follows:

Cash flows from financing activities:
Cash paid for notes payable	$ (50,000.00)
Cash received from issuing stock	250,000.00
Cash paid for dividends	(40,000.00)
Net cash provided by financing activities			$160,000.00

Now we know how Dells was able to purchase new equipment with cash, by issuing stock. This helped Dells in the current year, but what about next year when they owe $90,000? We need to put all three sections together to finish the picture.

Net Increase (or Decrease) in Cash

The final part of the statement of cash flows is to calculate a net increase (or decrease if negative) in cash by adding the net cash from operating, investing, and financing. Cash flows from operating is $7,000 + Investing $(217,000) + Financing $160,000, which gives a net decrease in cash of $(50,000). We then take this increase (or decrease) and add it to the beginning cash balance (which is the previous year cash balance from the balance sheet) to calculate ending cash balance, which should agree to the cash balance reported on the balance sheet for the current year. We can always check our work with a built-in check figure of ending cash! This last section would look like this:

Net increase (or decrease) in cash	$(50,000.00)
Cash balance, 2014	$80,000.00
Cash balance, 2015	$30,000.00
[ $80,000 2014 cash balance + (50,000 decrease) ]

Accounting Conventions and Standards

Standard-Setting Groups: FASB, SEC, AICPA

There are three main organizations whose work in supporting certified public accountants (CPAs) and upholding standard accounting practices are inextricably linked with the careers of professionals in this field:

· The Financial Accounting Standards Board (FASB) is a private, nonprofit organization whose primary purpose is to develop generally accepted accounting principles (GAAP) within the United States in the public’s interest.

· The US Securities and Exchange Commission (SEC) is a federal agency that holds primary responsibility for enforcing the federal securities laws and regulating the securities industry, the nation’s stock and options exchanges, and other electronic securities markets in the United States.

· Founded in 1887, the American Institute of Certified Public Accountants (AICPA) is a professional organization of CPAs in the United States. The AICPA has nearly 386,000 CPA members in 128 countries in business and industry, public practice, government, education, student affiliates and international associates.

The Financial Accounting Standards Board (FASB)

The Financial Accounting Standards Board (FASB) is a private, nonprofit organization whose primary purpose is to develop generally accepted accounting principles (GAAP) within the United States in the public’s interest.

Under the direction of the SEC, the Committee on Accounting Procedure was created by the AICPA in 1939. It was the first private-sector organization that had the task of setting accounting standards in the United States. In 1959, the Accounting Principles Board (APB) was formed to meet the demand for more structured accounting standards. The APB issued pronouncements on accounting principles until 1973, when it was replaced by the Financial Accounting Standards Board (FASB). The APB was disbanded in the hopes that the smaller, fully independent FASB could more effectively create accounting standards. The APB and the related SEC were unable to operate completely independently of the US government.

The FASB’s mission is to establish and improve standards of financial accounting and reporting for the guidance and education of the public, including issuers, auditors, and users of financial information.

To achieve this mission, FASB has five goals:

1. Improve the usefulness of financial reporting by focusing on the primary characteristics of relevance, reliability, comparability, and consistency.

2. Keep standards current to reflect changes in methods of doing business and in the economy.

3. Consider promptly any significant areas of deficiency in financial reporting that might be improved through standard setting.

4. Promote international convergence of accounting standards concurrent with improving the quality of financial reporting.

5. Improve common understanding of the nature and purposes of information in financial reports.

The FASB sets standards based on their conceptual framework. In addition, they offer guidance on how to implement these standards, but they do not monitor companies for violations of the financial reporting standards. That is left to the SEC.

The US Securities and Exchange Commission (SEC)

The US Securities and Exchange Commission (SEC) is a federal agency that holds the primary responsibility for enforcing the federal securities laws and regulating the securities industry, the nation’s stock and options exchanges, and other electronic securities markets in the United States. The SEC was created by Section 4 of the Securities Exchange Act of 1934 (now codified as 15 U.S.C. § 78d and commonly referred to as the 1934 Act).

The SEC was established by President Franklin D. Roosevelt in 1934 as an independent, quasi-judicial regulatory agency during the Great Depression. The main reason for the creation of the SEC was to regulate the stock market and prevent corporate abuses relating to the offering and sale of securities and corporate reporting. The SEC was given the power to license and regulate stock exchanges, the companies whose securities were traded on exchanges, and the brokers and dealers who conducted the trading.

Currently, the SEC is responsible for administering seven major laws that govern the securities industry:

1. The Securities Act of 1933

2. The Securities Exchange Act of 1934

3. The Trust Indenture Act of 1939

4. The Investment Company Act of 1940

5. The Investment Advisers Act of 1940

6. The Sarbanes–Oxley Act of 2002

7. The Credit Rating Agency Reform Act of 2006

The enforcement authority given by Congress allows the SEC to bring civil enforcement actions against individuals or companies alleged to have committed accounting fraud, provided false information, or engaged in insider trading or other violations of the securities law. The SEC also works with criminal law enforcement agencies to prosecute individuals and companies alike for offenses that include a criminal violation.

To achieve its mandate, the SEC enforces the statutory requirement that public companies submit periodic reports. Quarterly and biannual reports from public companies are crucial for investors to make sound decisions in the capital markets.

The American Institute of Certified Public Accountants (AICPA)

Founded in 1887, the American Institute of Certified Public Accountants (AICPA) is the national professional organization of CPAs in the United States. The AICPA has nearly 386,000 CPA members in 128 countries in business and industry, public practice, government, education, student affiliates and international associates. It sets ethical standards for the profession and US auditing standards for audits of private companies, nonprofit organizations, and federal, state, and local governments. It also develops and grades the Uniform CPA Examination.

The AICPA’s founding established accountancy as a profession distinguished by rigorous educational requirements, high professional standards, a strict code of professional ethics, and a commitment to serving the public interest. While the AICPA sets the professional standards for the professional conduct of accountants, it plays no role in setting the standards for financial accounting.

Generally Accepted Accounting Principles (GAAP)

Generally Accepted Accounting Principles (GAAP) is the standard framework for financial accounting used in any given jurisdiction.

GAAP refers to the standard framework of guidelines for financial accounting used in any given jurisdiction; generally known as accounting standards. GAAP includes the standards, conventions, and rules accountants follow in recording and summarizing accounting transactions and in the preparation of financial statements.

GAAP is a codification of how CPA firms and corporations prepare and present their business income and expense, assets, and liabilities in their financial statements. GAAP is not a single accounting rule, but rather an aggregate of many rules on how to account for various transactions.

Like many other common-law countries, the United States government does not directly set accounting standards by statute. However, the US Securities and Exchange Commission (SEC) requires that US GAAP be followed in financial reporting by publicly traded companies. Currently, FASB establishes generally accepted accounting principles for public and private companies, as well as for nonprofit organizations.

History

Historically, accounting standards have been set by the AICPA subject to Securities and Exchange Commission regulations. The AICPA first created the Committee on Accounting Procedure in 1939, and replaced it with the Accounting Principles Board in 1951.

In 1973, the Accounting Principles Board was replaced by the FASB under the supervision of the Financial Accounting Foundation with the Financial Accounting Standards Advisory Council serving to advise and provide input on the accounting standards.

Circa 2008, the FASB issued the FASB Accounting Standards Codification, which reorganized the thousands of US GAAP pronouncements into roughly 90 accounting topics. In 2008, the SEC issued a preliminary roadmap that may lead the US to abandon GAAP in the future and to join more than 100 countries around the world already using the London-based International Financial Reporting Standards (IFRS).

As of 2010, the convergence project was underway with the FASB meeting routinely with the International Accounting Standards Board (IASB). The SEC expressed its resolve to fully adopt IFRS in the US by 2014. As the highest authority over IFRS, the IASB is becoming more important in the US.

The table below demonstrates the differences in accounting standards between GAAP and IFRS regarding classifying cash flows.

GAAP vs. IFRS Cash Flow Classification
Transaction US GAAP	Classification	IFRS Classification
Interest received	Operating	Operating or investing
Dividends received	Operating	Operating or investing
Interest paid	Operating	Financing or operating
Dividends paid	Financing	Financing or operating
Income taxes	Operating	Operating unless specifically associated with financing or investing activity

Basic Objectives

Financial reporting should provide information that satisfies the following criteria:

· useful to present to potential investors and creditors and other users in making rational investment, credit, and other financial decisions

· helpful to present to potential investors and creditors and other users in assessing the amounts, timing, and uncertainty of prospective cash receipts

· about economic resources, the claims to those resources, and the changes in them helpful for making financial decisions

· helpful in making long-term decisions

· helpful in improving the performance of the business

· useful in maintaining records

Four Basic Assumptions

GAAP are established on the following four basic assumptions:

1. accounting entity—Assumes that the business is separate from its owners or other businesses. Revenue and expense should be kept separate from personal expenses.

2. going concern—Assumes that the business will be in operation indefinitely. This validates the methods of asset capitalization, depreciation, and amortization. In cases when liquidation is certain, this assumption is not applicable. The business will continue to exist in the unforeseeable future.

3. monetary unit principle—Assumes a stable currency is going to be the unit of record. The FASB accepts the nominal value of the US Dollar as the monetary unit of record unadjusted for inflation. This is also known at the stable dollar principle.

4. time-period principle—Implies that the economic activities of an enterprise can be divided into artificial time periods.

Four Basic Principles

Likewise, four basic principles govern GAAP standards:

1. historical cost principle—Requires companies to account and report based on acquisition costs rather than fair market value for most assets and liabilities.

2. revenue recognition principle—Requires companies to record when revenue is (1) realized or realizable and (2) earned, not when cash is received. Also, under this principle a company should establish an allowance for bad debt account. This way of accounting is called accrual based accounting.

3. matching principle—Expenses have to be matched with revenues as long as it is reasonable to do so. Expenses are recognized not when the work is performed, or when a product is produced, but when the work or the product actually makes its contribution to revenue. Only if no connection with revenue can be established, cost may be charged as expenses to the current period (e.g., office salaries and other administrative expenses).

4. full disclosure principle—Amount and kinds of information disclosed should be decided based on trade-off analysis as a larger amount of information costs more to prepare and use. Information disclosed should be enough to make a judgment while keeping costs reasonable. Information is presented in the main body of financial statements, in the notes or as supplementary information.

Note that the historical cost and the matching principle are slowly disappearing, having been replaced by FASB No. 157, which requires companies to classify assets based on fair value.

Five Basic Constraints

The five basic constraints surrounding GAAP reporting are as follows:

1. objectivity principle—The company financial statements provided by the accountants should be based on objective evidence.

2. materiality principle—The significance of an item should be considered when it is reported.

3. consistency principle—The company uses the same accounting principles and methods from year to year.

4. conservatism principle—When choosing between two solutions, the one that will be least likely to overstate assets and income should be picked.

5. cost-benefit relationship—The company considers the costs necessary to prepare the information and what benefit users will get from it.

International Financial Reporting Standards (IFRS)

The International Financial Reporting Standards (IFRS) is a common global financial language for business affairs that is understandable and comparable across international boundaries.

Many countries use or are moving toward using the IFRS, which were established and maintained by the IASB. In some countries, local accounting principles are applied for regular companies, but listed or larger companies must conform to the IFRS, so statutory reporting is comparable internationally, across jurisdictions.

The IFRS: History and Purpose

The IFRS is designed as a common global language for business affairs so that company accounts are understandable and comparable across international boundaries. They are a consequence of growing international shareholding and trade. The IFRS is particularly important for companies that have dealings in several countries. They are progressively replacing the many different national accounting standards.

The IFRS began as an attempt to harmonize accounting across the European Union, but the value of harmonization quickly made the concept attractive around the world. They are occasionally called by the original name International Accounting Standards (IAS). The IAS were issued between 1973 and 2001 by the Board of the International Accounting Standards Committee (IASC). On April 1, 2001, the new IASB took over the responsibility for setting International Accounting Standards from the IASC. During its first meeting the new board adopted existing IAS and Standing Interpretations Committee standards (SICs). The IASB has continued to develop standards, calling the new standards the IFRS.

Framework

The Conceptual Framework for Financial Reporting states the basic principles for IFRS. The IASB and FASB frameworks are in the process of being updated and converged. The Joint Conceptual Framework project intends to update and refine the existing concepts to reflect the changes in markets and business practices. The project also intends to consider the changes in the economic environment that have occurred in the two or more decades since the concepts were first developed.

A financial statement should reflect a true and fair view of the business affairs of the organization. As these statements are used by various constituents of the society and regulators, they need to reflect an accurate view of the financial position of the organization. It is very helpful to check the financial position of the business for a specific period.

Accounting Models and Assumptions

The IFRS are based on three basic accounting models as well as three underlying assumptions. The accounting models are as follows:

1. Current cost accounting, under physical capital maintenance at all levels of inflation and deflation under the historical cost paradigm as well as the capital maintenance in units of constant purchasing power paradigm

2. Financial capital maintenance in nominal monetary units (i.e., globally implemented historical cost accounting during low inflation and deflation only under the traditional historical cost paradigm)

3. Financial capital maintenance in units of constant purchasing power (i.e., constant item purchasing power accounting [CIPPA] in terms of a daily consumer price index or daily rate at all levels of inflation and deflation under the capital maintenance in units of constant purchasing power paradigm and constant purchasing power accounting (CIPPA) during hyperinflation under the historical cost paradigm.

The three basic assumptions are detailed below:

1. going concern—For the foreseeable future, an entity will continue under the historical cost paradigm as well as under the capital maintenance in units of constant purchasing power paradigm

2. stable measuring unit assumption—financial capital maintenance in nominal monetary units or traditional historical cost accounting only under the traditional historical cost paradigm

3. units of constant purchasing power—capital maintenance in units of constant purchasing power at all levels of inflation and deflation in terms of a daily consumer price index or daily rate only under the capital maintenance in units of constant purchasing power paradigm

Differences Between GAAP and IFRS and Implications of Potential Convergence

A major difference between GAAP and IFRS is that GAAP is rule based, whereas IFRS is principle based.

Principles Based vs. Rules Based

With a principle-based framework, there is the potential for different interpretations of similar transactions, which could lead to extensive disclosures in the financial statements. Although, the standards-setting board in a principle-based system can clarify areas that are unclear. This could lead to fewer exceptions than a rules-based system.

Another difference between IFRS and GAAP is the methodology used to assess an accounting treatment. Under GAAP, the research is more focused on the literature, whereas under IFRS, the review of the fact pattern is more thorough.

The following list shows a few examples of the differences between IFRS and US GAAP:

· consolidation—IFRS favors a control model whereas GAAP prefers a risks-and-rewards model. Some entities consolidated in accordance with FIN 46(R) may have to be shown separately under IFRS.

· statement of income—Under IFRS, extraordinary items are not segregated in the income statement. With GAAP, they are shown below the net income.

· inventory—Under IFRS, last in, first out (LIFO) cannot be used, but GAAP, companies have the choice between LIFO and first in, first out (FIFO).

· earning per share—Under IFRS, the earning-per-share calculation does not average the individual interim period calculations, whereas under GAAP the computation averages the individual interim period incremental shares.

· development costs—These costs can be capitalized under IFRS if certain criteria are met, while it is considered as expenses under US GAAP.

Convergence

The convergence of accounting standards refers to the goal of establishing a single set of accounting standards that will be used internationally, and in particular the effort to reduce the differences between the US GAAP and the IFRS. Convergence in some form has been taking place for several decades, and efforts today include projects that aim to reduce the differences between accounting standards.

The goal of and various proposed steps to achieve convergence of accounting standards has been criticized by various individuals and organizations. For example, in 2006, senior partners at PricewaterhouseCoopers (PwC) called for convergence to be “shelved indefinitely” in a draft paper, calling for the IASB to focus instead on improving its own set of standards.

Convergence is also taking place in other countries, with all major economies planning to either adopt the IFRS or converge towards it. For example, Canada required all listed entities to use the IFRS from January 1, 2012, and Japan permitted the use of IFRS for certain multinational companies from 2010, and is expected to make a decision on mandatory adoption. 

Implications of Potential Convergence

The growing acceptance of International Financial Reporting Standards (IFRS) as a basis for US financial reporting represents a fundamental change for the US accounting profession. Today, approximately 113 countries require or allow the use of IFRS for the preparation of financial statements by publicly held companies. In the United States, SEC has been taking steps to set a date to allow US public companies to use IFRS and perhaps make its adoption mandatory.

Full-Disclosure Principle

The full disclosure principle states information important enough to influence decisions of an informed user should be disclosed.

Principle of Full Disclosure

The full disclosure principle states that information important enough to influence the decisions of an informed user of the financial statements should be disclosed. Depending on its nature, companies should disclose this information either in the financial statements, in notes to the financial statements, or in supplemental statements. In judging whether or not to disclose information, it is better to err on the side of too much disclosure rather than too little. Many lawsuits against CPAs and their clients have resulted from inadequate or misleading disclosure of the underlying facts. 

A good rule to follow is, if in doubt, disclose. Another good rule is, if you are not consistent, disclose all the facts and the effect on income.

To be free from bias, information must be sufficiently complete to ensure that it validly represents underlying events and conditions. Completeness means disclosing all significant information in a way that aids understanding and does not mislead. Firms can reduce the relevance of information by omitting information that would make a difference to users. Required disclosures may be made in (1) the body of the financial statements, (2) the notes to such statements, (3) special communications, or (4) the president’s letter or other management reports in the annual report. Another aspect of completeness is fully disclosing all changes in accounting principles and their effects.

Importance of Full Disclosure Principle: Subject to Audit

As an accountant, the full disclosure principle is important because the notes to the financial statements and other financial documents are subject to audit. To obtain an unqualified (or clean) opinion, one must have an intrinsic understanding of the full disclosure principle to insure sufficient information for an unqualified opinion on the financial audit.

An opinion is said to be unqualified when the auditor concludes that the financial statements give a true and fair view in accordance with the financial reporting framework used for the preparation and presentation of the financial statements. An auditor gives a clean opinion or unqualified opinion when he or she does not have any significant reservation in respect to matters contained in the financial statements.

An unqualified opinion is given under the following circumstances:

1. The financial statements have been prepared using the generally accepted accounting principles which have been consistently applied.

2. There is adequate disclosure of all material matters relevant to the proper presentation of the financial information subject to statutory requirements, where applicable.

3. Any changes in the accounting principles or in the method of their application and the effects thereof have been properly determined and disclosed in the financial statements.

The Disclosure Process

The process of disclosing financial statements is carried out through what is known as a Form 10-K. This is an annual report required by the SEC that gives a comprehensive summary of a company’s performance. Although similarly named, the annual report on Form 10-K is distinct from the often glossy annual report to shareholders, which a company must send to its shareholders when it holds an annual meeting to elect directors (though some companies combine the annual report and the 10-K into one document). The 10-K includes information such as company history, organizational structure, executive compensation, equity, subsidiaries, and audited financial statements, among other information.

In addition to the 10-K, which is filed annually, a company is also required to file quarterly reports on Form 10-Q. Information for the final quarter of a firm’s fiscal year is included in the annual 10-K, so only three 10-Q filings are made each year. In the period between these filings, and in case of a significant event (such as a CEO departing or bankruptcy) a Form 8-K must be filed in order to provide up-to-date information.

Filing Deadlines

Historically, a Form 10-K had to be filed with the SEC within 90 days after the end of the company’s fiscal year. However, in September 2002, the SEC approved a rule that changed the deadline to 75 days for accelerated filers. Accelerated filers are issuers that have a public float of at least $75 million, that have been subject to the Exchange Act’s reporting requirements for at least 12 calendar months, that previously have filed at least one annual report, and that are not eligible to file their quarterly and annual reports on Forms 10-QSB and 10-KSB. These shortened deadlines were to be phased in over a three-year period; however, in 2004 the SEC postponed the three-year phase-in by one year.

In December 2005, the SEC created a third category of large accelerated filers, which are accelerated filers with a public float of over $700 million. As of December 27, 2005, the deadline for filing for large accelerated filers was still 75 days; however, beginning with the fiscal year ending on or after December 15, 2006, the deadline is 60 days. For other accelerated filers, the deadline remains at 75 days, and for nonaccelerated filers the deadline remains at 90 days.

Structure of a Form 10-K

Every annual report contains four parts and 15 schedules:

Part I

· Item 1. Description of business—This describes the business of the company, who and what the company does, what subsidiaries it owns, and what markets it operates in. It may also include recent events, competition, regulations, and labor issues. Other topics in this section may include special operating costs, seasonal factors, or insurance matters.

· Item 1A. Risk factor—Here, the company lays out anything that could go wrong, likely external effects, possible future failures to meet obligations, and other risks in order to adequately warn investors and potential investors.

· Item 1B. Unresolved staff comments

· Item 2. Description of properties—This section lays out the significant properties, or physical assets, of the company. This only includes physical types of property, not intellectual or intangible property.

· Item 3. Legal proceedings—Here, the company discloses any significant pending lawsuit or other legal proceeding. References to these proceedings could also be disclosed in the Risks section or other parts of the report.

· Item 4. Mine safety disclosures—This section requires some companies to provide information about mine safety violations or other regulatory matters.

Part II

· Item 5. Market for registrant’s common equity, related stockholder matters and issuer purchases of equity securities—Gives highs and lows of stock in a simple statement.

· Item 6. Selected financial data—This section contains financial data showing consolidated records for the legal entity as well as subsidiary companies.

· Item 7. Management’s discussion and analysis of financial condition and results of operations—Here, management discusses the operations of the company in detail by usually comparing the current period versus prior period. These comparisons provide a reader an overview of the operational issues of what causes such increases or decreases in the business.

· Item 7A. Quantitative and qualitative disclosures about market risk

· Item 8. Financial statements and supplementary data

· Item 9. Changes in and disagreements With accountants on accounting and financial disclosure

· Item 9A(T). Controls and procedures

· Item 9B. Other information

Part III

· Item 10. Directors, executive officers and corporate governance

· Item 11. Executive compensation

· Item 12. Security ownership of certain beneficial owners and management and related stockholder matters

· Item 13. Certain relationships and related transactions, and director independence

· Item 14. Principal accounting fees and services

Part IV

· Item 15. Exhibits, financial statement schedules, and signatures

Events Triggering Disclosure

Events that trigger disclosure should be based on an accountant’s assessment of materiality.

Consistency generally requires that a company use the same accounting principles and reporting practices through time. This concept prohibits indiscriminate switching of accounting principles or methods, such as changing inventory methods every year. However, consistency does not prohibit a change in accounting principles if the information needs of financial statement users are better served by the change. When a company makes a change in accounting principles, it must make the following disclosures in the financial statements (in the Notes to the Financial Statements):

· nature of the change

· reasons for the change

· effect of the change on current net income, if significant

· cumulative effect of the change on past income

Another event that can trigger a disclosure is prior period adjustments. Events that trigger disclosure should be based on an accountant’s assessment of materiality, especially when facing decisions related to the full disclosure principle. Disclosures will normally include details to materiality decisions in the notes to financial statements.

Voluntary Disclosure

Voluntary disclosure in accounting is the provision of information by a company’s management beyond requirements such as generally accepted accounting principles and SEC rules, where the information is believed to be relevant to the decision-making of users of the company’s annual reports.

Voluntary disclosures can include strategic information such as company characteristics and strategy, nonfinancial information such socially responsible practices, and financial information such as stock price information.

FASB classified voluntary disclosures into six categories below:

1. business data—breakdown of market share growth and information on new products

2. analysis of business data—trend analysis and comparisons with competitors

3. forward-looking information—sales forecast breakdown and plans for expansion

4. information about management and shareholders—information on stockholders and creditors and shareholding breakdown

5. company background—product description and long-term objectives

6. information about intangible assets—research and development and customer relations

Meek, Roberts, and Gray (1995) classified voluntary disclosures into three major groups: strategic, nonfinancial, and financial information.

The determinants of the extent and type of voluntary disclosures of firms have been explored in the financial reporting literature. Meek, Roberts, and Gray found that the extent and type of voluntary disclosure differs by geographic region, industry, and company size, and other research has found that the extent of voluntary disclosure is affected by the firm’s corporate governance structure and ownership structure.

Current Issues in Reporting and Disclosure

Accountants must stay up to date with current issues in reporting and disclosures related to standards set by regulatory agencies.

Mark-to-Market or Fair Value Accounting

Mark-to-market or fair-value accounting refers to accounting for the fair value of an asset or liability based on the current market price, for similar assets and liabilities, or based on another objectively assessed fair value. Fair value accounting has been a part of GAAP in the United States since the early 1990s and used increasingly since then.

Mark-to-market accounting can change values on the balance sheet as market conditions change. In contrast, historical cost accounting, based on the past transactions, is simpler, more stable, and easier to perform, but does not reflect current fair value. Instead, it summarizes past transactions. Mark-to-market accounting can become inaccurate if market prices change unpredictably. Buyers and sellers may claim a number of specific instances when this is the case, including inability to both accurately and collectively value the future income and expenses, often due to unreliable information and over optimistic and over pessimistic expectations.

SFAS No. 157

In September 2006, the US Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards 157: Fair Value Measurement, which “defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements.” This statement is effective for financial reporting fiscal periods commencing after November 15, 2007, and the interim periods applicable.

Fair Value GAAP vs. IFRS

Under GAAP, there is only one measurement model for fair value (with limited exceptions). GAAP defines fair value as the price that would be received to sell an asset or paid to transfer a liability (at the measurement date). Note that fair value is an exit price, which may differ from the transaction (entry) price.

Various IFRS standards use slightly varying wording to define fair value. Under IAS 39, fair value is defined as the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction. At inception, transaction (entry) price generally is considered fair value.

Sarbanes-Oxley Act

Following the Enron scandal, changes were made to mark to market via the Sarbanes-Oxley Act in 2002. Sarbanes-Oxley affected mark to market by forcing companies to implement stricter accounting standards. These included more transparency in financial reporting and stronger internal controls to prevent and identify fraud and auditor independence. Also, the Public Company Accounting Oversight Board (PCAOB) was created by the SEC for the purpose of overseeing audits. This act also implemented harsher penalties for fraud, such as enhanced prison sentences and fines for committing fraud. Although the law was created to restore investor confidence, the cost of implementing the regulations caused many companies to avoid registering on US stock exchanges.

Internal Revenue Code Section 475 contains the mark-to-market accounting method rule for taxation. It provides that qualified security dealers who elect mark to market treatment shall recognize gain or loss as if the property were sold for its fair market value on the last business day of the year, and any gain or loss shall be taken into account in that year. The section also provides that commodities dealers can elect mark to market treatment for any commodity (or their derivatives) which is actively traded (i.e., for which there is an established financial market providing a reasonable basis to determine fair market value by disseminating price quotes from brokers/dealers or actual prices from recent transactions).

Stock Option Expensing

Stock option expensing is a method of accounting for the value of share options, distributed as incentives to employees, within the profit and loss reporting of a listed business. On the income statement, balance sheet, and cash flow statement it should say that the loss from the exercise is accounted for by noting the difference between the market price (if one exists) of the shares and the cash received, the exercise price, for issuing those shares through the option.

Opponents of considering options as an expense say that the real loss—due to the difference between the exercise price and the market price of the shares—is already stated on the cash flow statement. They would also point out that a separate loss in earnings per share (due to the existence of more shares outstanding) is also recorded on the balance sheet by noting the dilution of shares outstanding. Simply, accounting for this on the income statement is believed to be redundant.

Currently, the future appreciation of all shares issued are not accounted for on the income statement but can be noted upon examination of the balance sheet and cash flow statement.

The two methods to calculate the expense associated with stock options are the intrinsic value method and the fair-value method. Only the fair-value method is currently US GAAP. The intrinsic value method, associated with Accounting Principles Board Opinion 25, calculates the intrinsic value as the difference between the market value of the stock and the exercise price of the option at the date the option is issued (the grant date). Since companies generally issue stock options with exercise prices which are equal to the market price, the expense under this method is generally zero.

In 2002, another method was suggested—expensing the options as the difference between the market price and the strike price when the options are exercised, and not expensing options which are not exercised, and reflecting the unexercised options as a liability on the balance sheet. This method, which defers the expense, also was requested by companies.

FASB has moved against Opinion 25, which left it open to businesses to monetize options according to their intrinsic value, rather than their fair value. The preference for fair value appears to be motivated by its voluntary adoption by several major listed businesses and the need for a common standard of accounting.

References

Meek, G., Roberts, B., & Gray, S. (1995). Factors influencing voluntary annual report disclosures by US, UK, and Continental European multinational corporations. Journal of International Business Studies, 26(3), 555–572.

Horizontal Analysis

Horizontal analysis, also known as trend analysis, includes comparisons made to a selected base year or period. Trend percentages are useful for comparing financial statements over several years because they disclose changes and trends occurring through time, especially compared to the previous year.

Trend percentages, also referred to as index numbers, help you to compare financial information over time to a base year or period. You can calculate trend percentages using the following formula:

· selecting a base year or period

· assigning a weight of 100 percent to the amounts appearing on the base-year financial statements

· expressing the corresponding amounts on the other years’ financial statements as a percentage of base-year or period amounts

Compute the percentages using the equation analysis year amount / base year amount and then multiplying the result by 100 to get a percentage.

The following information for a sample company illustrates the calculation of trend percentages:

(USD millions)	20Y3	20Y4	20Y5
Net sales	$9,105.50	$10,029.80	$10,498.80
Cost of goods sold	$4,696.00	$5,223.70	$5,341.30
Gross profit	$4,409.50	$4,806.10	$5,157.50
Operating expenses	$3,353.60	$4,369.90	$4,012.00
Income before income taxes	$1,055.90	$436.20	$1,145.50

 

We will calculate the trend percentages using 20Y3 as the base year, and everything in 20Y3 will be 100 percent. For net sales in 20Y4, take ($10,029.80 from 20Y4 minus $9,105.50 from 20Y3) / $9,105.50 from 20Y3 and multiply by 100 to get 10.15%. The same process continues for each account using the amount for each account in the base year 20Y3. The trend analysis would look like this (calculations added beside each column):

Trend Analysis with Calculation
	20Y3	20Y4		20Y5
Net Sales	100.0%	10.15%	($10,029 − $9,105.50) / $9,105.50	115.30%	$10,498.80 / $9,105.50
Cost of goods sold	100	111.2	$5,223.70 / $4,696.00	117.7	$5,341.30 / $4,696.00
Gross profit	100	109	$4,806.10 / $4,409.50	117	$5,157.50 / $4,409.50
Operating expenses	100	130.3	$4,369.90 / $3,353.60	119.6	$4,012.00 / $3,353.60
Income before income taxes	100	41.3	$436.20 / $1,055.90	108.5	$1,145.50 / $1,055.90

These trend percentages indicate the changes taking place in the organization and highlight the direction of these changes. In horizontal analysis, we find the percentage change from one year another one. For instance, the percentage of sales is increasing each year compared to the base year. Cost of goods sold increased at a lower rate than net sales in 20Y3 and 20Y5, causing gross profit to increase at a higher rate than net sales. Operating expenses in 20Y4 increased due to the provision for restructured operations, causing a significant decrease in income before income taxes. Percentages provide clues to an analyst about which items need further investigation or analysis. In reviewing trend percentages, a financial statement user should pay close attention to the trends in related items, such as the cost of goods sold in relation to sales. Trend analysis that shows a constantly declining gross margin (profit) rate may be a signal that future net income will decrease.

As useful as trend percentages are, they have one drawback. Expressing changes as percentages is usually straightforward as long as the amount in the base year or period is positive—that is, not zero or negative. Analysts cannot express a $30,000 increase in notes receivable as a percentage if the increase is from zero last year to $30,000 this year (remember, you cannot divide by zero). Nor can they express an increase from a loss last year of $10,000 to income this year of $20,000 in a realistic percentage term.

Proper analysis does not stop with the calculation of increases and decreases in amounts or percentages over several years. Such changes generally indicate areas worthy of further investigation and are merely clues that may lead to significant findings. Accurate predictions depend on many factors, including economic and political conditions; management’s plans regarding new products, plant expansion, and promotional outlays; and the expected activities of competitors. Considering these factors along with horizontal analysis, vertical analysis, and trend analysis should provide a reasonable basis for predicting future performance.