Essay Questions:
§ What information do financial accounting statements provide to the management of an organisation?
§ What are the limitations of this information for the purpose of management decision making?
Discussion:
Financial accounting's primary objective is to present the financial condition of a business organization. Guidelines for the preparation of financial statements are provided by the GAAP, or the generally accepted accounting principles. However, GAAP applies only to financial accounting and not to any other major fields of accounting, such as tax, managerial and cost accounting. These financial statements are audited by certified public accountants (CPAs), which render opinions as to whether or not the conditions of a firm are fairly presented in the statements. (Droms, 1997)
Further, financial accounting provide information useful in: making investment and credit decisions; assessing the amount, timing, and uncertainty of future cash flows; and learning about the enterprise's economic resources, claims to resources, and changes in claims to resources. Financial accounting information can be described as "a means to an end", "historical in nature", information resulting from inexact and approximate measures of business activity, and information that is based on a general-purpose assumption. (Williams, Haka, Bettner and Meigs, 2002)
Published financial statements, in order to comply with GAAP, must comprise the three basic purpose financial statements: the balance sheet or the statement of financial position; the income statement (the statement of profit and loss or the statement of operations); and the cash flow statement. These three basic financial statements are said to be general purpose statements because they are designed to satisfy the needs of a wide range of user groups, which include the investors, creditors, financial and credit analysts, insurance companies, labour unions, employees and government agencies. (Sannella, 1991)
Accordingly, the balance sheet is a statement that details the company's assets, liabilities and owner's equity on a particular date. (Bizzer Professional Training, 1998) It provides a "snapshot" of the financial condition of the firm. (Droms, 1997) From an economic standpoint, the balance sheet presents the stock of wealth of the firm. (Sannella, 1991, p. 12)
Assets can be defined as the economic resources owned or controlled by the firm that have future economic benefit to the firm. It may not necessarily be owned by the firm; as long as the economic resources are controlled and may provide future economic benefit, these resources can be considered assets of the company. On the other hand, liabilities are debts of the firm owed to outsiders (e.g., creditors). It is also known as the "creditor's equity", or claim against the asset of the firm. Finally, the owner's equity is the capital of the firm that represents the owner's wealth or outstanding claim on the assets of the firm. It is also called net worth or net assets due to the fact that the creditor's claims must be satisfied first before the owner's. (Sannella, 1991)
Further, Sannella (1991) said: "The classification of assets and liabilities is useful for the analyst in "matching maturities" of assets and liabilities. The excess of current assets over current liabilities, or working capital, is an important concept in the assessment of a firm's liquidity in the analysis of financial statements." (p. 14)
Items on balance sheet are listed in order of liquidity. Liquidity takes on different meanings on the context of assets and liabilities. For assets, liquidity means nearness to cash, while for liabilities, liquidity refers to how quickly claims against the company matures.
Balance sheets are called as such because entries in it must tally. Specifically, the assets must equal the claims on assets. The concept of balancing depends on the accounting equation: assets= liabilities + owner's equity. (Williams, Haka, Bettner and Meigs, 2002)
Otherwise, the income statement, also called statement of profit and loss or statement of operations, is a listing of revenues, expenses, and net income or net loss over a period of time. The income statement presents the change in owners' wealth or the flow of wealth for the accounting period (e.g., one month, one quarter or one year). The model for the income statement is: Net Income (Loss) = Revenues - Expenses. The income statement is the flow of wealth or the change in capital resulting from the operations of the firm over a particular period of time. Therefore, the balance sheet is a permanent statement while the income statement is only a temporary statement. As a result, at the end of each accounting period, the change in owners' wealth from the income statement must be transferred to capital (specifically retained earnings) on the balance sheet. (Sannella, 1991, p. 14)
Sannella further explains: "Due to the fact that net income or loss is transferred or closed out to capital (i.e., retained earnings) at the end of each accounting period, all revenue and expense accounts begin each period with a zero balance. It is for this reason that income statement accounts are sometimes known as temporary accounts, and the income statement is said to reflect "completed accounting cycles". On the other hand, the balance sheet is said to consist of permanent accounts because their balances are cumulative and are carried forward period to period. Because of the cumulative nature of the balance sheet accounts, the balance sheet is said to reflect "incomplete accounting cycles". The balance sheet cycles will be completed when the economic resources of the firm generate revenues which are matched on the income statement with the expenses incurred to produce those revenues." (p. 15)
A basic overview of income statement items shows how a manufacturing company might present an income statement. Income statements for other companies may appear to be slightly different, but in general the construction would be the same. An important concept in understanding the income statement is Earnings Per Share (EPS). The EPS for a company is net income divided by the number of shares of common stock outstanding. It represents the bottom line for a company. Companies continually make decisions on how their bottom line will be impacted since shareholders in the company are concerned with how management decisions affect individual shareholder position. (Williams, Haka, Bettner and Meigs, 2002)
Finally, the statement of cash flows. The statement of cash flows primary are designed to provide information about the firm's cash receipts and cash payments from operating activities, and also to provide information about the firm's financing and investing activities over a period of time. In addition, an analysis of the cash flow statement, along with the income statement and footnote disclosures, enables the analyst to explain or reconcile the change in cash as well as other elements of the balance sheet. (Sannella, 1991, p. 15)
Sannella (1991) shows an "interrelationship" or "articulation" between the three basic general purpose financial statements: "the income statement and the statement of cash flows, with adequate footnote disclosure, can be used to explain or reconcile changes from one balance sheet to another. The ability to link or relate financial information contained on different financial statements is known as "articulation". Specifically, articulation refers to the interaction between assets, liabilities and equity elements with revenues and expenses. In other words, the elements of the three basic general purpose financial statements are intrinsically interrelated so that the elements of the balance sheet are dependent on the elements of the income statement and the elements of the income statement are dependent on the elements of the balance sheet. (p. 17)
References:
Droms, William G. (1997). Finance and Accounting for Nonfinancial Managers: All the Basics You Need to Know. Reading , MA
____. (1998). An Introduction to Understanding Financial Statements. In Bizzer Professional Training. Available at: [http://www.bizzer.com/images/Financial/index.html]. Accessed: [14/01/04].
Needles, Belverd E. Jr. and Powers, Marian.Financial Accounting. In [http://college.hmco.com/accounting/needles/fa/instr/pp t/ch01/index.htm]. Accessed: [14/01/04].
Sannella, John. (1991). The Impact of GAAP on Financial Analysis: Interpretations and Applications for Commercial and Investment Banking. New York
Williams, Jan R., Haka, Susan F., Bettner, Mark S., and Meigs, Robert F. (2002). Financial and Managerial Accounting: The Basis for Business Decisions. In McGraw-Hill Higher Education. Available in: [www.mhhe.com]. Accessed: [14/01/04].
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