Measuring Business Income - Why Financial Statements are Prepared at the End of the Regular Accounting Season

Measuring Business Income - Why financial statements are prepared at the end of the regular accounting period.

Major Financial Statements:
The balance sheet provides a "snapshot" of the firm's financial condition.
The income statement reports on the "performance" of the firm.
The statement of cash flows reports the cash receipts and cash outflows classified according to operating, investment and financing activities.
The statement of stockholder's equity reports the amounts and sources of changes in equity from transactions with owners.
The footnotes of the financial statements allow uses to improve assessment of the amount, timing and uncertainty of the estimates reported in the financial statements.

The most accurate way to measure the results of enterprise activity would be to measure them at the time of the enterprise's eventual liquidation. Business, government, investors, and various other user groups, however, cannot wait indefinitely for such information. If accountants did not provide financial information periodically, someone else would.

The periodicity or time period assumption simply implies that the economic activities of an enterprise can be divided into artificial time periods. These time periods vary, but the most common are monthly, quarterly, and yearly.

The information must be reliable and relevant. This requires that information must be consistent and comparable over time and also be provided on a timely basis. The shorter the time period, the more difficult it becomes to determine the proper net income for the period. A month's results are usually less reliable than a quarter's results, and a quarter's results are likely to be less reliable than a year's results. Investors desire and demand that information be quickly processed and disseminated; yet the quicker the information is released, the more it is subject to error. This phenomenon provides an interesting example of the trade-off between relevance and reliability in preparing financial data.

In practice, financial reporting is done at the end of the accounting period. Accounting periods can be any length in time. Firms typically use the year as the primary accounting period. The 12-month accounting period is referred to as the fiscal year. Firms also report for periods less than a year (e.g. quarterly) on an interim basis. Accounting period must be of equal length. Financial statements are prepared at the end of the regular accounting period to allow comparison across time.

Explain why the accounts must be adjusted at the end of each period.

Most external transactions are recorded when they occur. The employment of an accrual system means that numerous adjustments are necessary before financial statements are prepared because certain accounts are not accurately stated.
Some external transactions might not even seem like transactions and are recognized only at the end of the accounting period. Examples include unrecorded revenues and credit purchase.

Some economic activities do not occur as the result of external transactions. Examples include depreciation and the expiration of prepaid expenses.
Timing: Often a transaction affects the revenue or expenses of two or more accounting periods. The related cash inflow or outflow does not always coincide with the period in which these revenue or expense items are recorded. Thus, the need for adjusting entries results from timing differences between the receipt or disbursement of cash and the recording of revenue or expenses. For example, if we handle transactions on a cash basis, only cash transactions during the year are recorded. Consequently, if a company's employees are paid every two weeks and the end of an accounting period occurs in the middle of these two weeks, neither liability nor expense has been recorded for the last week. To bring the accounts up to date for the preparation of financial statements, both the wage expense and the wage liability accounts need to be increased.
A necessary step in the accounting process, then, is the adjustment of all accounts to an accrual basis and their subsequent posting to the general ledger. Adjusting entries are therefore necessary to achieve a proper matching of revenues and expenses in the determination of net income for the current period and to achieve an accurate statement of the assets and equities existing at the end of the period.

Adjustment principles:
The revenue recognition principle
The matching principle

What to adjust?

Each adjusting entry affects both a real account (assets, liability, or owner's equity) and a nominal or income statement account (revenue or expense). The four basic types of adjusting entries are:

1. Deferred expenses that benefits more than one period: for example, prepaid expenses (e.g. prepaid insurance, rent) are expenses paid in advance and recorded as assets before they are used or consumed. When these assets are consumed, expenses should be recognized: a debit to an expense account and a credit to an asset account. Another example is depreciation. The cost of a long-term asset is allocated as an expense over its useful life. At the end of each period depreciation expense is recorded through an adjusting entry: a debit to a depreciation expense account and a credit to an accumulated depreciation account (a contra account used to total the past depreciation expenses on specific long-term assets).

2. Accrued expenses that incurred but not yet paid or recorded: examples are employee salaries and interest on borrowed money. At the end of the accounting period, the accrued expense is recorded through an adjusting entry: a debit to an expense account (i.e. Salaries Expense) and a credit to a liability account (i.e. Salaries Payable).

3. Accrued revenues that earned but not yet received or recorded: also called unrecorded revenues. Examples include interest revenues, rent revenues, etc. Such revenues accumulate with the passing of time, but the firm may have not received the payment or billed the client. An adjusting entry should be: a debit to an asset account (i.e. Accounts Receivable) and a credit to a revenue account (i.e. Interest Revenue).

4. Unearned revenues that are revenues received in cash before delivery of goods/services: examples are magazine subscription fees, customer deposits for services. These "revenues" are not earned yet and thus should be recorded as liabilities. An adjusting entry should be: a debit to a liability account (i.e. Unearned Revenue) and a credit to a revenue account (i.e. Revenue).

Explain why the accrual basis of accounting produces more useful income statements and balance sheets than the cash basis.
Revenue is something earned through the sale of goods or services. Not all cash receipts are revenues; for example, cash received through a loan is not revenue. Expenses are the cost of goods or services used to generate revenues. Not all cash payments are expenses; for example, cash dividends paid to stockholders are not expenses. Net income is the difference between revenues and expenses. It is reported on the income statement, and is the focus in evaluating a firm's profitability.

Most companies use the accrual basis accounting, recognizing revenue when it is earned (the goods are sold or the services performed) and recognizing expenses in the period incurred, without regard to the time of receipt or payment of cash. Net income is revenue earned minus expenses incurred.

Under the strict cash basis accounting, revenue is recorded only when the cash is received and expenses are recorded only when the cash is paid. Net income is cash revenue minus cash expenses. The matching principle is ignored here, resulting inconformity with generally accepted accounting principles.

Today's economy is considerably more lubricated by credit than by cash. And the accrual basis, not the cash basis, recognizes all aspects of the credit phenomenon. Investors, creditors, and other decision makers seek timely information about an enterprise's future cash flows. Accrual basis accounting provides this information by reporting the cash inflows and outflows associated with earnings activities as soon as these cash flows can be estimated with an acceptable degree of certainty. Receivables and payables are forecasters of future cash inflows and outflows. In other words, accrual basis accounting aids in predicting future cash flows by reporting transactions and other events with cash consequences at the time the transactions and events occur, rather than when the cash is received and paid. Accrual accounting generally provides a better indication of performance than cash basis of accounting since it increases the comparability of income statements and balance sheets across periods.

Financial Reporting and Analysis

Define each asset and liability category on the balance sheet and prepare a classified balance sheet.
Think of the balance sheet as a photo of the business at a specific point in time. It presents the assets, liabilities, and the equity ownership of a business entity as of a specific date.
Assets are the economic resources controlled by the firm.
Liabilities are the financial obligations that the firm must fulfill in the future. Liabilities are typically fulfilled by payment of cash. They represent the source of financing provided to the firm by the creditors.
Equity Ownership is the owner's investments and the total earnings retained from the commencement of the firm. Equity represents the source of financing provided to the firm by the owners.
Balance sheet accounts are classified so that similar items are grouped together to arrive at significant subtotals. Furthermore, the material is arranged so that important relationships are shown.

The table below indicates the general format of balance sheet presentation:

Balance Sheet Classifications
Assets
Liabilities and Owner's Equity
Current Assets
Current liabilities
Long-term investments
Long-term debt
Property, plan and equipment
Owner's equity
Intangible assets
Capital stock
Other assets
Additional paid-in capital
Retained earnings

Current Assets are cash and other assets expected to be converted into cash, sold, or consumed either in one year or in the operating cycle, whichever is longer. The operating cycle is the average time between the acquisition of materials and supplies and the realization of cash through sales of the product for which the materials and supplies were acquired. The cycle operates from cash through inventory, production, and receivables back to cash. Where there are several operating cycles within one year, the one-year period is used. If the operating cycle is more than one year, the longer period is used.

Current assets are presented in the balance sheet in order of liquidity. The five major items found in the current asset section are:
Cash: valued at its stated value. Cash restricted for purpose other than payment of current obligations or for use in current operations should be excluded from the current asset section.
Marketable securities: Also referred to as marketable securities. Valued at cost or lower of cost and market.
Accounts receivables: amounts owed to the firm by its customers for goods and services delivered. Valued at the estimated amount collectible.
Inventories: Products that will be sold in the normal course of business.
Prepaid expenses: they are expenditures already made for benefits (usually services) to be received within one year or the operating cycle, whichever is longer. Typical examples are prepaid rent, advertising, taxes, insurance policy, and office or operating supplies. They are reported at the amount of un-expired or unconsumed cost.
Long-Term Investments:
Often referred to simply as investments, they are to be held for many years, and are not acquired with the intention of disposing of them in the near future.
Investments in securities such as bonds, common stock, or long-term notes that management does not intend to sell within one year.
Investments in tangible fixed assets not currently used in operations, such as land held for speculation.
Investments set aside in special funds such as a sinking fund, pension fund, or plant expansion fund. The cash surrender value of life insurance is included here.
Investments in non-consolidated subsidiaries or affiliated companies.
Property, Plant, and Equipment:
They are properties of a durable nature used in the regular operations of the business. With the exception of land, most assets are either depreciable (such as building) or consumable.

Intangible Assets:
They lack physical substance and usually have a high degree of uncertainty concerning their future benefits. They include patents, copyrights, franchises, goodwill, trademarks, trade names, secret processes, and organization costs. Generally, all of these intangibles are written off (amortized) to expense over 5 to 40 years.

Other Assets:
They vary widely in practice. Examples include deferred charges (long-term prepaid expenses), non-current receivables, intangible assets, assets in special funds, and advances to subsidiaries.

Current Liabilities:
They are obligations that are reasonably expected to be liquidated either through the use of current assets or the creation of other current liabilities within one year or within the operating cycle, whichever is longer. They are not reported in any consistent order. A typical order is: Notes payable, accounts payable, accrued items (e.g. accrued warranty costs, compensation and benefits) income taxes payable, current maturities of long-term debt, etc.
The excess of total current assets over total current liabilities is referred to as working capital. It represents the net amount of a company's relatively liquid resources; that is, it is the liquid buffer, or margin of safety, available to meet the financial demands of the operating cycle.

Long-Term Liabilities
They are obligations that are not reasonably expected to be liquidated within the normal operating cycle but, instead, at some date beyond that time. Bonds payable, notes payable, deferred income taxes, lease obligations, and pension obligations are the most common long-term liabilities. Generally they are of three types:
Obligations arising from specific financing situations, such as issuance of bonds, long-term lease obligations, and long-term notes payable.
Obligations arising from the ordinary operations of the enterprise such as pension obligations and deferred income tax liabilities.
Obligations that are dependent upon the occurrence or non-occurrence of one or more future events to confirm the amount payable, or the payee, or the date payable, such as service or product warranties and other contingencies.
Owner's Equity:
The complexity of capital stock agreements and the various restrictions on residual equity imposed by state corporation laws, liability agreements, and boards of directors make the owner's equity section one of the most difficult sections to prepare and understand. The section is usually divided into three parts:
Capital stock: the par or stated value of the shares issued.
Additional paid-in capital: the excess of amounts paid in over the par or stated value.
Retained earnings: the corporation's undistributed earnings.

Define each component of a multi-step income statement and prepare a multi-step income statement.
The income statement measures the success of business operations for a given period of time. A single-step income statement groups revenues together and expenses together, without further classifying each of the groups. A multi-step income statement makes further classifications to provide additional important revenue and expense data. These classifications make the income statement more informative and useful. It is recommended because:
It recognizes a separation of operating transactions from non-operating transactions;
It matches costs and expenses with related revenues;
It highlights certain intermediate components of income that are used for the computation of ratios used to assess the performance of the enterprise.

Components:
Operating section: a report of the revenues and expenses of the company's principal operations.
Sales or revenue section: a subsection presenting sales, discounts, allowances, returns, and other related information, and to arrive at the net amount of sales revenue.
Cost of goods sold section: a subsection that shows the cost of goods that were sold to product the sales.
Selling expense: a subsection that lists expenses resulting from the company's efforts to make sales.
Administrative or general expenses: a subsection reporting expenses of general administration.

Non-operating section: a report of revenues and expenses resulting from secondary or auxiliary activities of the company. In addition, special gains and losses that are infrequent or unusual, but not both, are normally reported in this section. Generally these items break down into two main subsections:
Other revenues and gains: A list of the revenues earned or gains incurred, generally net of related expenses, from non-operating transactions.
Other expenses and losses: A list of the expenses or losses incurred, generally net of any related incomes, from non-operating transactions.

Income taxes: A short section reporting federal and state taxes levied on income from continuing operations.
Discontinued operations: material gains or losses resulting from the disposition of a segment of the business.
Extraordinary items: Unusual AND infrequent material gains and losses.
Cumulative effect of a change in accounting principle.
Earnings per share.

Short-Term Liquid Assets

Describe how to choose the appropriate accounting method for investment securities and explain how fair (market) value gains and losses on such investments are reported.

Short-term investments, also called marketable securities, ordinarily consist of short-term paper (certificates of deposit, treasury bills, and commercial paper), marketable debt securities (government and corporate bonds), and marketable equity securities (preferred and common stock) acquired with cash not immediately needed in operations.

They must be:
Readily marketable: can be sold quite easily.
Intended to be converted into cash as needed within one year or the operating cycle, whichever is longer. Securities that are intended to be held for more than one year are called long-term investments.

There are two types of gains and losses:
Realized gains and losses: the difference between the fair market value and the cost of the securities when they are sold.
Unrealized holding gains and losses: the difference between the fair market value and the cost of the securities when they are still held by the firm. The gains and losses are unrealized because securities have not been sold.
In general:
When securities are purchased, they are recorded at cost. The cost of the securities includes purchase price and any broker's fees or fees paid to acquire securities.
Interest and dividends generally are recognized as revenue when they are received.
When securities are sold, the cost is compared to the sales price, and the difference is recorded as a gain or a loss.
At the end of each accounting period, the balance of the controlling account is adjusted to reflect the current market value of the securities owned.

However, different categories of investment securities have different treatment on unrealized holding gains and losses.
Held-to-maturity securities: Debt securities that management intends to hold to their maturity date. At year end, they are reported at cost adjusted for the effect of interest (debit the securities account and credit interest income account), and unrealized holding gains and losses are not recognized.
Trading securities: Debt and equity securities bought and held mainly for sale in the near term to generate income on price changes. At year end, they are reported at their fair market value. Any unrealized holding gains or losses are recognized on the firm's income statement as part of the net income. When they are sold, the realized gains or losses will also appear on the income statement. Realized gains and losses are not affected by any unrealized gains or losses recognized before.

Example:
1. 12/1/2002, 100 shares purchased at $80 per share for trading purposes:
Entry: Trading Securities 8000(Debit) | Cash 8000 (Credit)
2. 12/31/2002, the price is $60 per share.
Entry: Unrealized Loss on Investments 2000 (Debit) | Allowance to Adjust Short-Term Investments to Market 2000 (Credit).
The allowance account is shown on the balance sheet as a contra-asset account:
Trading Securities (at cost) 8000
Allowance Account (2000)
Trading Securities (at market) 6000
The $2000 unrealized loss is reported in the income statement for 2002.
3. 06/12/2003, 100 shares sold at $120 per share.
Entry: Cash 12000 (Debit) | Trading Securities 8000 (Credit) | Realized Gain on Investment 4000 (Credit)
The $4000 realized gain is reported in the income statement of 2003.

Available-for-sale securities: Debt and equity securities not classified as held-to-maturity or trading securities. The unrealized gains and losses are reported in the balance sheet as an adjustment to the shareholders' equity (in contrast, the unrealized gains or losses of trading securities are reported in the income statement as part of the net income). Other than that, they are accounted for in the same way as trading securities.
Example:
1. 12/1/2002, 100 shares purchased at $80 per share for trading purposes:
Entry: Available-for-Sale Securities 8000(Debit) | Cash 8000 (Credit)
2. 12/31/2002, the price is $60 per share.
Entry: Unrealized Loss on Investments 2000 - Equity (Debit) | Allowance to Adjust Short-Term Investments to Market 2000 (Credit).
The allowance account is shown on the balance sheet as a contra-asset account:
Available-for-Sale Securities (at cost) 8000
Allowance Account (2000)
Available-for-Sale Securities (at market) 6000
The $2000 unrealized loss is reported in the balance sheet for 2002 as a component of stockholder's equity.
3. 06/12/2003, 100 shares sold at $120 per share.
Entry: Cash 12000 (Debit) | Trading Securities 8000 (Credit) | Realized Gain on Investment 4000 (Credit)
The $4000 realized gain is reported in the income statement of 2003.

AFS can be short or long-term. Since they are reported on the balance sheet at market value, this reporting needs to be adjusted from their last carrying amount to current market value.
The unrealized gain or loss is reported in 2 places:
(1) Income statement - under 'Other comprehensive income' (net of tax) [but not as part of net income];
(2) OE - Accum.comprehensive income - unrealized gains on investments (net of tax).