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- Herausgeber: John Wiley & Sons
- Kategorie: Fachliteratur
- Sprache: Englisch
Learn to speak fluent finance--and ace your exams! Warren Buffett said that "accounting is the language of business." And for many accounting and business students, the obscure terminology of accounting makes fluency hard to achieve. Financial Accounting For Dummies can help to demystify abstract concepts in a straightforward, friendly way. With step-by-step examples and real-world scenarios practice, it helps you grasp the fundamentals of accounting until you're ready to interpret, analyze, and evaluate corporate financial statements like you've been doing it all your life. Packed with easy-to-understand examples, this book takes you from the big three financial statements all the way through to income taxes. Or join the anti-fraud squad by discovering how to spot the ten most common accounting shenanigans. * Grasp introductory financial accounting course material * Explore common concepts financial professionals use to compile reports * Understand leases, free cash flow, and statement analysis * Learn accounting for small businesses Whether you're studying for your bachelor's, MBA, or MAcc, you'll find everything you need to speak the language of finance like a native--and use it to get to wherever you want to go!
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Seitenzahl: 594
Veröffentlichungsjahr: 2020
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Financial Accounting For Dummies®, 2nd Edition
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Library of Congress Control Number: 2020949692
ISBN 978-1-119-75812-9 (pbk); ISBN 978-1-119-75813-6 (ePDF); ISBN 978-1-119-75814-3 (epub)
Financial Accounting For Dummies®
To view this book's Cheat Sheet, simply go to www.dummies.com and search for “Financial Accounting For Dummies Cheat Sheet” in the Search box.
Table of Contents
Cover
Title Page
Copyright
Introduction
About This Book
Foolish Assumptions
Icons Used in This Book
Beyond the Book
Where to Go from Here
Part 1: Getting a Financial Accounting Initiation
Chapter 1: Seeing the Big Picture of Financial Accounting
Knowing the Purposes of Financial Accounting
Getting to Know Financial Accounting Users
Respecting the Key Characteristics of Financial Accounting Information
Accepting Financial Accounting Constraints
Considering Your Ethical Responsibilities
Introducing the Conceptual Framework of Financial Accounting
Chapter 2: Introducing the Big Three Financial Statements
Gauging the Health of a Business through Its Financials
Reporting Assets and Claims: The Balance Sheet
Posting Profit or Loss: The Income Statement
Showing the Money: The Statement of Cash Flows
Chapter 3: Running the Numbers for Success
Identifying Accounting Issues and Solutions
Selecting a Business Entity
Reporting for Small Businesses
Managing Cash
Chapter 4: Acronym Alert! Setting the Standards for Financial Accounting
Walking through the Origins of Number Crunching
Knowing the Role of the American Institute of Certified Public Accountants (AICPA)
Following Regulatory Issues
Getting to Know the Financial Accounting Standards Board (FASB)
Part 2: Reviewing Some Accounting Basics
Chapter 5: Booking It: The Process Behind Financial Accounting
Shedding Some Light on Bookkeeping
Analyzing the Effect of Business Transactions
Defining Journals
Bringing It All Together in the Ledger
Chapter 6: Focusing on Accounting Methods and Concepts
Distinguishing between Key Accounting Methods
Sorting through Standards for Other Types of Accounting
Considering the Conceptual Framework of Financial Accounting
Part 3: Spending Quality Time with the Balance Sheet
Chapter 7: Assessing the Balance Sheet’s Asset Section
Homing in on Historic Cost
Learning What Makes an Asset Current
Keeping Track of Noncurrent (Long-Term) Assets
Studying the Asset Section of the Balance Sheet
Chapter 8: Digging for Debt in the Liabilities Section
Seeing How Businesses Account for Liabilities
Keeping Current Liabilities under Control
Planning for Long-Term Obligations
Accounting for Bond Issuances
Chapter 9: Letting Owners Know Where They Stand: The Equity Section
Distinguishing Different Types of Business Entities
Defining Paid-in Capital
Recording Retained Earnings
Spotting Reductions to Stockholders’ Equity
Learning about Stock Splits
Accounting for Accumulated Other Comprehensive Income
Seeing a Sample Equity Section of the Balance Sheet
Part 4: Investigating Income and Cash Flow
Chapter 10: Searching for Profit or Loss on the Income Statement
Presenting the Income Statement in One of Two Ways
Defining Different Types of Businesses
Examining Income Statement Sections
Watching Out for Unusual Income Statement Items
Arriving at the Final Product
Chapter 11: Following the Money by Studying Cash Flow
Understanding the Difference between Cash and Profit
Realizing the Purpose of the Statement of Cash Flows
Walking through the Cash Flow Sections
Recognizing Methods for Preparing the Statement of Cash Flows
Interpreting the Statement of Cash Flows
Looking at Two Sample Statements of Cash Flows
Chapter 12: Examining Depreciation Cost Flow Assumptions
Discovering How Depreciation Affects All Financial Statements
Mastering Costs
Distinguishing among Depreciation Methods
Preparing a Depreciation Schedule
Chapter 13: Learning about Inventory Cost Flow Assumptions
Discovering How Inventory Valuation Affects the Financial Statements
Do Service Companies Have Inventory?
Classifying Inventory Types
Getting to Know Inventory Valuation Methods
Preparing an Inventory Worksheet
Part 5: Analyzing the Financial Statements
Chapter 14: Using Ratios and Other Tools
Learning about Liquidity Measurements
Measuring Profitability
Exploring Activity Measures
Analyzing Financial Statements
Using Common Size Financial Statements
Chapter 15: Got Your Dictionary Ready? Reading Explanatory Notes and Disclosures
Realizing How Corporations Should Govern Themselves
Identifying Corporate Characteristics
Reviewing Common Explanatory Notes
Putting the Onus on the Preparer
Chapter 16: Studying the Report to the Shareholders
Why Private and Public Companies Treat Annual Reports Differently
Fulfilling Three Purposes
Reading the Annual Report to Shareholders
Walking through the Form 10-K
Part 6: Feeling Brave? Tackling More Advanced Financial Accounting Topics
Chapter 17: Accounting for Emerging Issues
Reviewing Different Technological Effects on Financial Accounting
Introducing the Pharmaceutical Industry
Crediting Research and Development Costs
Recognizing Losses
Chapter 18: Accounting for Income Taxes
Identifying Financial Income versus Taxable Income
Taking Advantage of Net Operating Losses
Presenting a Side-by-Side Comparison of Book and Tax Calculations
Taking Deferred Tax Liabilities or Assets to the Balance Sheet
Chapter 19: Accounting for Leases
Reviewing Lease Basics
Accounting for the Lessee
Accounting for the Lessor
Chapter 20: Reporting Changes in Methods and the Correction of Errors
Coping with Accounting Changes
Dealing with Errors
Part 7: The Part of Tens
Chapter 21: Ten Financial Accounting Shenanigans
Reporting Revenue in the Wrong Period
Reporting Fictitious Income
Increasing Income with Misleading Events
Shifting Expenses Between Periods
Misclassifying Cash
Failing to Record Liabilities
Reporting Liabilities in the Wrong Period
Not Disclosing Related-Party Transactions
Capitalizing Normal Operating Expenses
Deleting Transactions
Chapter 22: Ten Accounting Career Opportunities
Certified Public Accountant
Consultant
Corporate Accountant
Forensic Accountant
Government Accountant
Information Technology Auditor
Income Tax Accountant
International Accountant
Non-Accounting Accountant
Not-for-Profit Accountant
Index
About the Author
Connect with Dummies
End User License Agreement
List of Tables
Chapter 17
TABLE 17-1 Allocating Costs to Expense or Asset
List of Illustrations
Chapter 2
FIGURE 2-1: An abbreviated classified balance sheet.
FIGURE 2-2: A simple income statement.
FIGURE 2-3: A very basic statement of cash flows.
Chapter 3
FIGURE 3-1: Service business income statement.
FIGURE 3-2: Merchandising business income statement.
FIGURE 3-3: Cash budget.
FIGURE 3-4: Bank statement reconciliation.
FIGURE 3-5: Cash to accrual cheat sheet
Chapter 5
FIGURE 5-1: Horizontal analysis.
FIGURE 5-2: A partial cash receipts journal.
FIGURE 5-3: A partial cash disbursements journal.
FIGURE 5-4: A partial sales journal.
FIGURE 5-5: A partial purchases journal.
FIGURE 5-6: The standard journal entry format.
FIGURE 5-7: Recording service income.
FIGURE 5-8: Journalizing a loan transaction.
FIGURE 5-9: Journalizing common business transactions.
FIGURE 5-10: A partial general ledger.
FIGURE 5-11: A partial trial balance.
Chapter 7
FIGURE 7-1: The asset section of a balance sheet.
Chapter 8
FIGURE 8-1: The liability section of a balance sheet.
FIGURE 8-2: Inventory purchase on account and payment within discount period.
FIGURE 8-3: Journal entry to record accrued payroll and taxes.
FIGURE 8-4: Recording accrued and actual warranty expense.
Chapter 9
FIGURE 9-1: A statement of owner’s equity for a sole proprietorship.
FIGURE 9-2: A statement of partners’ equity.
FIGURE 9-3: The equity section of a balance sheet.
Chapter 10
FIGURE 10-1: A single step format income statement.
FIGURE 10-2: A multiple step format income statement.
FIGURE 10-3: Net sales.
FIGURE 10-4: Computing COGS for a manufacturing company.
FIGURE 10-5: The step-by-step preparation of cost of goods manufactured during ...
FIGURE 10-6: Reporting unusual income statement items.
FIGURE 10-7: An income statement for a manufacturing business.
Chapter 11
FIGURE 11-1: A direct method statement of cash flows.
FIGURE 11-2: An indirect method statement of cash flows.
Chapter 12
FIGURE 12-1: Recording land purchases and related costs.
FIGURE 12-2: A double declining balance depreciation calculation.
FIGURE 12-3: Comparison of depreciation expense among methods.
FIGURE 12-4: Example of a depreciation schedule.
Chapter 13
FIGURE 13-1: Effect of changes in price levels on inventory.
FIGURE 13-2: Kool Kicks inventory analysis.
FIGURE 13-3: FIFO cost-flow assumption.
FIGURE 13-4: LIFO cost-flow assumption.
FIGURE 13-5: Partial inventory worksheet.
Chapter 14
FIGURE 14-1: Income statement horizontal analysis for 2020 and 2021.
FIGURE 14-2: Income statement vertical analysis for 2020 and 2021.
Chapter 16
FIGURE 16-1: Select financial information.
FIGURE 16-2: An unqualified independent auditor’s report for Village Shipping, ...
Chapter 17
FIGURE 17-1: Summary of the credit for increasing research activities.
Chapter 18
FIGURE 18-1: Financial income provision for income taxes.
FIGURE 18-2: Tax calculation using the General Business Credit and the Foreign ...
FIGURE 18-3: Calculating income tax refund receivable for an NOL carryback.
FIGURE 18-4: Calculating income tax refund receivable for an NOL carryforward.
FIGURE 18-5: Comparing figures calculated for an income statement to those used...
Chapter 19
FIGURE 19-1: Recording a finance lease transaction.
Chapter 20
FIGURE 20-1: Change in method of accounting for inventory.
Guide
Cover
Title Page
Copyright
Table of Contents
Begin Reading
Index
About the Author
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Introduction
Accounting is known as the language of business because it communicates financial and economic facts about a business to all sorts of interested parties — both internal (employees of the company) and external (people not employed by the company in question). External users include investors, creditors, banks, and regulatory agencies such as the Internal Revenue Service and the U.S. Securities and Exchange Commission.
Zeroing in on the external users of accounting information, this book is about financial accounting. Financial accounting serves the needs of external users by providing them with understandable, materially correct financial statements. There are three financial statements: the income statement, balance sheet, and statement of cash flows. This book is a step-by-step guide on how to prepare all three.
You also find out the purposes of the financial statements:
To report on the financial position of the company — what types of assets the company owns and what types of liabilities it owes.
To show how well the company performs over a period of time, which is referred to as an
accounting period.
You measure performance by seeing whether the company made or lost money during the accounting period.
A lot of first-time accounting students tell me that they are afraid they won’t do well in their financial accounting class because they haven’t done well in math classes they’ve taken in the past. Forgot about the math — that’s why you have a computer and a calculator! Financial accounting is less about adding and subtracting than using logic-based skills. Added to the mix is the importance of gaining a working understanding of the standards set in place by authoritative accounting bodies.
After years spent in the classroom as both a professor and student, I realize that many accounting textbooks are, well, boring. My purpose in writing this book is to breathe some life into the subject of financial accounting and make it more understandable.
About This Book
This book, like all For Dummies books, is written so that each chapter stands on its own. I always assume that whatever chapter you’re reading is the first one you’ve tackled in the book. Therefore, you can understand the concepts I explain in each chapter regardless of whether it’s your first chapter or your last.
However, certain terms and concepts pertain to more than one subject in this book. To avoid writing the same explanations over and over, whenever I reference a financial accounting term, method, or other type of fact that I fully explain in another chapter, I give you a brief overview and direct you to the spot where you can get more information. For example, I may suggest that you “see Chapter 11” (which, by the way, discusses the statement of cash flows).
Also, in this book I break financial accounting down to its lowest common denominator. I avoid using jargon that only accounting majors with several accounting classes already under their belts will understand. Please keep in mind that the list of financial accounting topics and methods I present in this book isn’t all-inclusive. I simply can’t cover every possible nuance and twist related to preparing financial accounting data and statements. This book is meant to illuminate the rather dry presentation of topics given in all the financial accounting textbooks from which I’ve taught, providing a perfect companion to the financial accounting textbook your professor is using.
Furthermore, I briefly discuss the Sarbanes-Oxley Act of 2002 (SOX) and the watchdog over the audits of publicly traded companies, the Public Company Accounting Oversight Board (PCAOB). If you have the time, I recommend reading Sarbanes-Oxley For Dummies by Jill Gilbert Welytok, JD, CPA (published by Wiley). This handbook walks you through the new and revised SOX laws.
Foolish Assumptions
I assume you don’t have more than a rudimentary knowledge of accounting, and I’m guessing you’re one of the following people:
A college financial accounting student who just isn’t getting it by reading (and rereading) the assigned textbook. (I’ve seen that deer-in-the-headlights look many times in my classroom.)
A non-accounting student currently enrolled in either business or liberal arts who’s considering changing his major to accounting.
A business owner (particularly someone operating a small business with gross receipts of under $1 million) who wants to attempt preparing her own financial statements or just wants to have a better understanding about the financial statements prepared by the in-house or external accountant.
A brand-new accountant working in financial accounting who needs a plain-talk refresher of accounting concepts.
Icons Used in This Book
Throughout the book, you see the following icons in the left margin:
Text accompanied by this icon contains useful hints that you can apply during your class (or on the job) to make your studies (or work) a bit easier and more successful.
When you see this icon, warm up your brain cells, because it sits next to information you want to commit to memory.
Looking for what not to do in the world of financial accounting? Check out paragraphs next to this icon because they alert you to what can trip you up while taking your class or working in the field.
This icon includes information that enhances the topic under discussion but isn’t necessary to understand the topic.
Beyond the Book
In addition to what you’re reading right now, this product also comes with a free access-anywhere Cheat Sheet that talks about the three key financial statements and covers important terms and definitions. To get this Cheat Sheet, simply go to www.dummies.com and search for Financial Accounting For Dummies Cheat Sheet in the Search box.
Where to Go from Here
Each chapter stands on its own, so no matter where you start, you won’t feel like you’re coming in on a movie halfway through. Your motivation for purchasing this book will likely dictate which chapters you want to read first and which you’ll read only if you have some spare time in the future.
If you’re a financial accounting student, flip to the chapter explaining a topic you’re a little fuzzy on after reading your textbook. Business owners can get a good overview of the financial accounting process by starting with Chapters 1 and 3; these two chapters explain the nuts and bolts of financial accounting and its concepts. Otherwise, check out the table of contents or index for a topic that interests you, or jump in anywhere in the book that covers the financial accounting information you’re wondering about.
Part 1
Getting a Financial Accounting Initiation
IN THIS PART …
Discover why financial accounting is so important to many different individuals and businesses.
Get a brief overview of the three financial statements: the balance sheet, income statement, and statement of cash flows.
Learn information relevant to small business owners.
Meet the various financial accounting standard-setting and regulatory organizations, such as the Financial Accounting Standards Board (FASB) and the U.S. Securities and Exchange Commission (SEC).
Chapter 1
Seeing the Big Picture of Financial Accounting
IN THIS CHAPTER
Figuring out why financial accounting matters
Meeting the financial accounting stakeholders
Introducing key financial accounting characteristics
Accepting ethical responsibilities
I assume that you have a very good reason for purchasing this book; most people don’t buy a title like Financial Accounting For Dummies on a whim in the bookstore. Most likely, you’re taking your first financial accounting class and want to be sure you pass it, but perhaps you’re a business owner wanting to get a better handle on financial statement preparation. Whatever your motivation, this chapter is your jumping board into the pool of financial accounting.
I explain what financial accounting is and why it’s so important to many different individuals and businesses. I spell out the various users of financial accounting data and explain why they need that data. Finally, I briefly introduce four all-important characteristics of financial accounting: relevance, reliability, comparability, and consistency. Whether you’re a financial accounting student or a business owner, you need to understand these crucial financial accounting terms from the very beginning.
Knowing the Purposes of Financial Accounting
Broadly speaking, accounting is the process of organizing facts and figures and relaying the result of that organization to any interested customers of the information. This process doesn’t just relate to numbers spit out by a computer software program; it pertains to any type of reconciliation.
Here’s an example from my own life of accounting that doesn’t involve numbers or money: A teenager slinks in after curfew, and his parent asks for a complete accounting of why he is late. When the teenager tells the facts, you have information (his car broke down in an area with no cell coverage), the individual producing the information (the mischievous teen), and the interested customer, also known as the user of the information (the worried parent).
The subject of this book, financial accounting, is a subset of accounting. Financial accounting involves the process of preparing financial statements for a business. (Not sure what financial statements are? No worries — you can find an overview of them in the next section.) Here are the key pieces of the financial accounting process:
Information:
Any accounting transactions taking place within the business during the accounting period. This includes generating revenue from the sales of company goods or services, paying business-related expenses, buying company assets, and incurring debt to run the company.
Business entity:
The company incurring the accounting transactions.
Users:
The persons or businesses that need to see the accounting transactions organized into financial statements to make educated decisions of their own. (More about these users in the “
Getting to Know Financial Accounting Users
” section of this chapter.)
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 statement, 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:
Income statement: This financial statement shows the results of business operations consisting of revenue, expenses, gains, and losses. The end product is net income or net loss. I talk about the income statement in Chapter 2, and then I cover it from soup to nuts in Chapter 10. 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.
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.
Balance sheet: This statement has three sections: assets, liabilities, and equity. Standing on their own, these sections contain valuable information about a company. However, a user has to see all three interacting together on the balance sheet to form an opinion approaching reliability about the company.
Part 3 of this book is all about the balance sheet, but for now here are the basics about each balance sheet component:
Assets:
Resources owned by a company, such as cash, equipment, and buildings.
Liabilities:
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
Once you understand who uses financial accounting information, I can 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 decision-making 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 2021, and your analysis indicates that the company’s sales should increase two-fold in the subsequent year. When you later check out the 2022 income statement, the company’s gross receipts have, indeed, doubled. Woohoo! With the relevant information in hand, you see that your prediction came true.
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.)
Reliable information must be verifiable and have representational faithfulness. Here’s what I mean:
A hallmark of verifiability is that an independent evaluation of the same information leads to the same conclusion as presented by the company. An accounting application of this concept could be an independent third party, such as an auditor, checking that the dollar amount shown on the balance sheet as accounts receivable (money owed to the company by customers) is indeed correct.
Representational faithfulness
means that if the company says it has gross receipts of $200,000 in the first quarter of 2021, it actually has receipts of $200,000 — not any other amount.
Comparability
Comparability means the quality of the information is such that users can identify differences and similarities among companies they are evaluating — or among different financial periods for the same company. For example, users need to know what particular GAAP the different companies they are examining are using to depreciate their assets. Without this knowledge, the users cannot accurately evaluate the relative worth of one company over the other.
INDEPENDENT VERIFICATION OF ACCOUNTS RECEIVABLE
Many companies sell goods or services to customers on account, which means the customer promises to pay in the future. When this happens, the amount of unpaid customer invoices goes into an account called accounts receivable. (See Chapters 7 and 10 for detailed info about accounts receivable.) For a business carrying a sizable amount of accounts receivable, an error in this account can have a material effect on the reliability of the income statement and balance sheet.
Independent confirmation of the accounts receivable balance is done by sending requests for confirmation. Confirmations are form letters sent to customers listed in the accounts receivable subsidiary ledger (a listing showing all customers with a balance owed). The letters seek to verify the facts and figures contained in the company’s books. The confirmation form letter is usually brief, listing the total amount the company shows the customer owes at a certain date.
Some confirmation letters ask for a response; others ask the customer to respond only if the information on the confirmation form is incorrect. An independent party, such as the company’s external certified public accountant (CPA), tallies the results of the confirmations and either verifies or refutes the amount the company asserts that its customers owe.
Consider a personal example: Think about the last time you purchased a laptop. To the novice computer buyer, the shiny black cases and colored displays all look pretty much the same. But the price of each model varies — sometimes substantially. Therefore, you have to ferret out the facts about each model to be able to compare models and decide on the best one for your needs. What do you do? You check out the manufacturer’s specs for each laptop in your price range, comparing such important facts as the size of the hard drive, processing speed, and (if you want to be truly mobile) the laptop’s size and weight. By doing so, you are able to look beyond outward appearance and make a purchasing decision based on comparative worth among your options.
Though the United States is developing a global marketplace, as of this writing, U.S. GAAP may differ significantly from accounting principles used by businesses in other countries. Therefore, comparing financial statements of a foreign-based company and a U.S.-based company is difficult.
Consistency
Consistency means the company uses the same accounting treatment for the same type of accounting transactions — both within a certain financial period and among various financial periods. Doing so allows the user to know that the financial accountant is not doing the accounting equivalent of comparing a dog to a cat. Both are animals, both are furry, but as any pet owner knows, you have a basic lack of consistency between the two.
Keep in mind that a company is allowed to switch accounting methods if it has a valid business purpose for the switch; the company isn’t stuck using only one method throughout its existence. An example of a good reason for a switch in methods is if using a different accounting method presents a more accurate financial picture. But a change in methods can’t be done willy-nilly whenever the business feels like it. I provide the whole scoop on changes in accounting treatment in Chapter 20. Also, the company has to disclose this change in its footnotes to the financial statements; see Chapter 15.
SEEING HOW DEPRECIATION AFFECTS THE BOTTOM LINE
Depreciation is the process of systematically reclassifying the cost of an asset from the balance sheet to the income statement over its useful life — a topic I discuss at length in Chapter 12. A few different methods of depreciation are allowed by GAAP, so unless you know which method the company is using, you can’t effectively compare one company to another.
Consider an example. For the same asset, here is the amount of depreciation a company can take for the asset’s first year of use depending on which commonly used depreciation method it employs:
Straight-line depreciation: $54,000Double-declining balance depreciation: $120,000The difference between the two methods is a whopping $66,000 ($120,000 – $54,000)! Now imagine depreciating equipment that costs in the millions of dollars; the effect on the company’s bottom line net income of choosing one depreciation method versus another would be even more astonishing.
Luckily for the financial statement users, to aid in comparability, the depreciation method in use by a company must be disclosed in the notes to the financial statements. For much more info about depreciation, jump to Chapter 12. For the scoop on what financial statement notes are, head to Chapter 15.
Consistency is crucial when it comes to depreciation. If the company lacks consistency —for example, it uses different depreciation methods when accounting for the same asset in different years — you cannot create truly useful financial statements.
Accepting Financial Accounting Constraints
While preparing financial statements, accountants realize that time is money and there is a limit to the amount of cost that should be incurred for any reporting benefit. The agencies that set the standards for accounting practices (which I introduce in Chapter 4) always perform a cost/benefit analysis before finalizing any reporting requirements. Associated with this financial accounting constraint is the concept of materiality.
Materiality is the importance you place on an area of financial reporting based upon its overall significance. What is material for one business may not be material for another. You have to consider the size of the company, the size of the financial statement transaction, the particular circumstances in which the transaction occurred, and any other factors that can help you judge whether the issue is truly significant to the financial statement users.
COST/BENEFIT LOST IN THE WOODS
Years ago, the bookkeeper at one of my client companies spent five hours tracking down the reason why the company bank reconciliation was off by $2 to make sure the bank hadn’t made a mistake. (Preparing a bank reconciliation means you take the balance in the bank account per the bank as of a certain date, add in any deposits that got to the bank too late to hit the statement, and subtract any checks the company has written that have not yet cleared.) Yikes!
Now, was this an effective and efficient use of that bookkeeper’s time and salary expense? No, of course not. Say she was paid $10 per hour. It cost the company $50 for her to confirm that the operating account bank balance was indeed off by $2, and it wasn’t just an inadvertent mistake on the part of the bank.
For example, an expense totaling $10,000 would be material if the total expense amount is $50,000 but would likely be immaterial if the total expense was $500,000. But the nature of the transaction may make the difference material even if the comparative size is immaterial. For example, $10,000 that is deliberately — not accidentally — excluded from income may be material even if the amount is a small percentage of overall income. That’s because the deliberate exclusion may be an attempt by the owner of the company to avoid paying taxes on the income.
Conservatism is very important in financial accounting. It means that when in doubt, the financial accountant should choose the financial accounting treatment that will cause the least favorable effect on revenue or expenses.
Considering Your Ethical Responsibilities
Every professional — and, frankly, every individual — should operate using a code of conduct. This means you should always attempt to act in an ethical manner and do the right thing, regardless of whether doing the right thing is the best choice for you personally.
In this section, I give you the nuts and bolts of the code of conduct that financial accountants must follow. Plus, you find out about the goals toward which financial accountants strive: integrity, objectivity, and independence.
Following the accountant’s code of conduct
In a financial accounting class, you learn about different employment and licensing options available to financial accountants — a topic I discuss in Chapter 22. Financial accountants who are serious about their profession normally become certified public accountants (CPAs), which means they have to take a certain number of accounting and auditing classes, pass a four-part exam, and comply with any other requirements of their state’s licensing board.
Working as a financial accountant doesn’t require any special licensing, but a lack of licensing may limit your career options. Thinking that after graduation taking another test is a big no-no? As Chapter 22 points out, many interesting and exciting accounting careers do not require licensure.
CPAs have to abide by their state’s code of conduct and also follow the code of conduct established by the American Institute of Certified Public Accountants (AICPA) — the national professional organization for all CPAs. The AICPA is responsible for establishing accounting, auditing, and attestation standards for private companies in the United States, as well as for enforcing a code of professional conduct for its members. (Attestation involves generating reports on subjects that are the responsibility of another person or business.) In Chapter 4, I outline that code of conduct in detail.
But what if you’re a financial accountant who isn’t a CPA or a member of the AICPA? Do you still have to worry about abiding by a code of conduct? Of course, you do! Any profession lacking ethical behavior descends into chaos. Financial accountants must have high professional standards, a strict code of professional ethics, and a commitment to serving the public interest. They achieve these goals through their integrity, objectivity, and independence.
Having integrity
In the world of financial accounting, integrity means you act according to a code or standard of values. You demonstrate integrity when you do the right thing, regardless of whether doing so is best for you personally.
Specifically, having integrity means that you serve, to the best of your ability, your employer and/or the client for whom you are preparing financial statements, keeping in mind that doing so may not be the same thing as completely agreeing with the way the employer or client wants you to prepare the financial statements. You can’t be worried that your employer or client is going to be mad at you or fire you if you disagree with him.
Maintaining objectivity
Whether you work in public accounting (you have multiple clients) or private accounting (you provide accounting services only for your employer), you must be objective, meaning impartial and intellectually honest:
Being impartial means you’re neutral and unbiased in all decision-making processes. You base your opinion and reporting only on the facts, not on any preconceived notions or prejudices.
Being intellectually honest means you interpret rules and policies in a truthful and sincere manner, staying true to both their form and spirit.
If you’re objective, you keep an open mind until all facts are revealed, despite what you hear from your client’s managers, employees, or anyone else privy to the work you’re doing.
Financial accountants must be objective, and the users of the financial statements must perceive that the accountants are objective. You never want to compromise your objectivity or else you risk creating the perception that your work — and the financial statements that result from your work — cannot be trusted.
Achieving independence
Many types of public accounting services, such as auditing, require the financial accountant to be independent in both fact and appearance. Being independent while providing services means that you have no special relationship with or financial interest in the client that would cause you to disregard evidence and facts when evaluating your client.
What does it mean to be independent in both fact and appearance? The biggie is that you avoid any real or perceived conflicts of interest: You don’t perform services for any client with whom you have either a personal or non-audit-related business relationship. For example, if you have a significant financial interest with a major competitor of your client, your client may question whose best interests you have in mind while performing the accounting services.
Financial accountants providing tax and consulting services do not have to be independent; however, they still have to be objective.
The concepts of independence and objectivity differ somewhat depending on whether you work in public accounting or private accounting. Public accounting is when a financial accountant, most likely a CPA, works for an accounting firm providing services such as auditing or financial statement preparation for clients. Private accounting is when you do accounting work for your own employer rather than for a client. Obviously, you can’t strive for independence when you’re doing accounting work for your own employer. So, in private accounting, objectivity is key.
Introducing the Conceptual Framework of Financial Accounting
Every profession needs a roadmap to help the people employed in the field provide the best possible service while doing their jobs. For example, my airline pilot clients have shown me a detailed checklist they must follow each and every time they get in the cockpit, regardless of how many years of experience they have.
For financial accountants, the Financial Accounting Standards Board (FASB) started work on providing a conceptual framework — a structure of financial accounting concepts — back in the 1970s. The Financial Accounting Standards Board (FASB), which I discuss in Chapter 4, issued eight Statements of Financial Accounting Concepts through February 2018. Six of the eight were issued between 1978 to 1985. The concepts cover the financial accounting topics of objectives, qualitative characteristics, elements, and financial statement measurement.
Not sure what each of these terms means? I discuss this topic in detail in Chapter 6. For now, just remember that this financial accounting conceptual framework exists — or jump to Chapter 6 right now to read all about it!
