Financial Accounting For Dummies. Maire Loughran

Debt the business incurs for operating and expansion purposes.Equity: The amount of ownership left in the business after deducting total liabilities from total assets.

       Statement of cash flows: This statement contains certain components of both the income statement and the balance sheet. The purpose of the statement of cash flows is to show cash sources and uses during a specific period of time — in other words, how a company brings in cash and for what costs the cash goes back out the door.

      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:

       The income statement is finite in what it reflects. For example, it may report net income for the 12-month period ending December 31, 2021. This means any accounting transactions taking place prior to or after this 12-month window do not show up on the report.

       The statement of cash flows is also finite in nature, showing cash ins and outs only for the reporting period.

      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.

      

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 refer to 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:

       Existing or potential investors in the company’s stocks or bonds.

       Individuals or businesses thinking about extending credit terms to the company. Examples of creditors include banks, automobile financing companies, and the vendors from which a company purchases its inventory or office supplies.

       Governmental agencies, such as the U.S. Securities and Exchange Commission (SEC), which want to make sure the company is fairly presenting its financial position. (I discuss the history and role of the SEC in Chapter 4.)

      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 (IRS), of course, because financial statements are the starting point for reporting taxable income.

      Recognizing their needs

      

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

      

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:

       Those looking for growth: These investors want the value of a stock to increase over time. Here’s an example of growth at work: You do some research about a little-known company that is poised to introduce a hot new computer product into the market. You have $1,000 sitting in a checking account that bears no interest. You believe, based on your research, that if you purchase some stock in this company now, you’ll be able to sell the stock for $2,000 shortly after the company releases the computer product.

       Those looking for income: These investors are satisfied with a steady stock that weathers ebbs and flows in the market. The stock neither increases nor decreases in value per share by an enormous amount, but it pays a consistent, reasonable dividend. (Keep in mind that reasonableness varies for each person and his or her investment income goals.)

      

You can make money in two ways: 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