What's ahead for this company?
Q u a l i t a t i v e C h a r a c t e r i s t i c s o f
A c c o u n t i n g Information
Your Turn 2-2
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Reliability:
Information that is neutral and verffiable Is the information independent ofthe specifc person who prepared it?
Comparability:
Different companies use the same set of accounting rules.
Does the information allow meaningful comparisons of two different companies?
Consistency:
A company uses the same rules from year to year. Does the information allow meaningful comparisons of a company's performance at different points in time?
The separate-entity assumption means that the firm's financial records ano financial statements are completely separate from those of the f irm's owners The monetary-unit assumption means that the items on the f inancial statements are measured in monetary units (dollar in the U.5.).
first items sold. As a requirement of GAAP, Sears and Wal-Man will disclose these choices in the notes to their financial statements so that investors can compare the inventory infor- mation of the companies.
Consistent. To be useful, accounting information must be consistent. Consistency is the char- acteristic that makes it possible to track a company's performance or financial condition from one year to the next. Only if a company uses the same accounting methods from period to pe- riod are we able to make meaningful comparisons. For example, total revenues for Thrget were
$51.3 billion for the fiscal year ended January 28,2006, and $46.7 billion for the fiscal year ended January 29,2005. Only when these two numbers are based on the same set of account- ing methods can investors determine why sales increased. If the increase was caused partly or solely by the change in the way the company measured sales, then investors would be misled about the company's actual performance. Financial statement users want to rely on the firm's consistent application of accounting standards. Exhibit 2.2 summaizes the desired qualitative characteristics accounting information must have to be considered useful by the FASB.
1. What is the purpose of financial statements?
2. What four characteristics explain what the FASB means by "useful,, information?
Assumptions and Principles Underlying Financial Reporting
Financial information pertains to only the firm, not to any other parties such as the firm's owners. This distinction between the financial information of the firm and the hnancial in- formation of other hrms or people is called the separate-entity assumption. It means that the financial statements of a business do not include any information about the finances of individual owners or other companies. Look at the income statement in Exhibit 2.1, which summarizes the company's revenues and expenses. You will notice that the items on the fi- nancial statements are expressed in amounts of money. This is called the monetary-unit assumption. When you observe that Tom's Wear had expenses of $415 during January 2006, you know that the amount includes only company expenses. Suppose Tom took a va- cation to Hawaii at a cost of $3,000. No part of that transaction would be part of Tom's Wear's hnancial reports because of the separate-entity assumption.
C H A P T E R 2 . E L E M E N T S O F T H E At a minimum, firms prepare new financial statements every year. For internal use, finan- cial statements are prepared more frequently. The SEC requires publicly traded frms to prepare a new set of financial statements each quarler, which enables users to compare the company's performance from one quarter (every three months) to the next. Accountants divide the life of a business into time periods so they can prepare reports about the company's performance dur- ing those time periods. This creation of time periods is called the time-period assumption.
Although most companies report financial information every three months, only the annual fi- nancial information is audited. Most companies use the calendar year as their fiscal year.
Assets are recorded at their original cost to the company. This is known as the historical-cost principle. Accountants use cost because the cost of an asset is a reliable amount-it is unbiased and verifiable. Accountants assume a company will continue to re- main in business for the foreseeable future, unless they have clear evidence it will either close or go bankrupt. This is called the going-concern assumption. With this assumption, finan- cial statement values are meaningful. Would the bank lend money to a frrm if the frm were not going to continue operating in the foreseeable future? Ifthe firm expects to liquidate, the values on the financial statements lose their meaning. If a company is not a going concern, the values on the flnancial statements would need to be liquidation values to be useful.
As you have read about the four financial statements and the notes to the statements, you have learned about the qualities of financial information and the assumptions and principles that provide the foundation of financial reporting. Without these assumptions and principles, managers, investors, and analysts could not rely on the information to make decisions.
To complete the foundation for financial reporting and to enable you to gain a full un- derstanding of the information contained in the financial statements, you will need to know about two constraints that apply to the preparation of the statements. A constraint in finan- cial accounting is a limit or control imposed by GAAP. There are two constraints: materi- ality and conservatism.
Materialie refers to the size or significance of an item or transaction in relation to the com- pany's overall financial performance or financial position. An item is material if it is large enough to influence investors' decisions. For example, the cost of fueL the amounts paid to em- ployees, and the cost of buying or leasing airplanes are all material items for JetBlue or South- west Airlines. In contrast, an item is considered immaterial if it is too small to influence investors. GAAP does not have to be strictly applied to immaterial items (measured in total).
For example, suppose JetBlue Airlines made an isolated error and failed to record the revenue from your $350 ticket purchased and used in 2005. Because JetBlue's total revenue was over
$1.6 billion for its fiscal year ended December 31,2005, the company would not need to cor- rect this single enor. The item is considered immaterial. (However, if there were lots of these errors, the total amount could be material.)
Conservatism refers to the choices accountants make when preparing the financial statements. When there is any question about how to account for a transaction, the accoun- tant should select the treatment that will be least likely to overstate income or overstate as- sets. Accountants believe it is better to understate income or assets than it is to overstate either. For example, JetBlue's December 3I,2005, balance sheet shows total property and equipment of over $2.9 billion. GAAP requires JetBlue to evaluate these assets to make sure they are not overstated with respect to their future revenue-generating potential.
Elements of the Financial Statements
As you learned in Chapter 1, a complete set of financial statements includes the:
1. Income statement
2. Balance sheet (sometimes called the statement of ftnancial position)
3. Statement of changes in shareholders' equity (also called the statement of changes in owners'equity)
4. Statement of cash flows
5. Notes to the financial statements
GAAP describe the individual items that are included in the financial statements. To learn what is shown on each financial statement. we will look at the second month of business for
F I N A N C I A L S T A T E M E N T S 5 3
The time-period assumption means that the life of a business can be divided into meaningful time periods for financial reporting.
The historical-cost principle means that transactions are recorded at actual cost.
The going-concern assumption means that, unless there is obvious evidence to the contrary, a firm is expected to continue operating in the foreseeable future.
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ldentify the elements of the f i n a n c i a l s t a t e m e n t s a n d d e s c r i b e t h e i r
cha racteristics.
54 C H A P T E R I o eUALtTtEs o F A c c o U N T t N G t N F o R M A T t o N
Tom's Wear. We will take the second month's transactions and see how they affect the ac- counting equation and the financial statements. Then, we will relate the statements to the qual- itative characteristics described by GAAP.
At the beginning of the second month, on February l,2006, Tom's Wear has a balance sheet that is identical to the balance sheet dated January 3 1, 2006. Recall that the company's assets, liabilities, and shareholder's equity balances roll forward when the new period starts.
Transactions for the Second Month of Business
The transactions for Tom's Wear's second month of business are shown in Exhibit 2.3.The first transaction in February is the purchase of 200 T-shirts, costing $4 each. Last month, Tom's Wear paid cash for the purchase of the T-shirts. This month, the company buys them on credit, also known as on account. This means Tom's Wear will pay for them later. The purchase increases the company's assets-$8O0 worth of T:shirts-and the $800 claim be- longs to the vendor. When a company owes a vendoq accounts payable are the amounts the company owes. This is the first traasaction shown in Exhibit 2.4,where the transactions are presented in the accounting equation worksheet.
Next, Tom hires a company to advertise his business immediately. This cost is $150 for a service. Tom's Wear pays $100 when the service is provided, so the company still owes
$50. Like the first transaction, this one also postpones payment. However, in this transaction, Tom's Wear has incurred an expense. In the first transaction-when the inventory was pur- chased-Tom's Wear gained an asset. The cost of the shirts will become an expense when the shirts are sold. In contrast, the work done related to the advertising is complete, and that signals an expense. (The timing of recognizing expenses can be tricky; the next chapter will discuss timing in detail.) The $150 expense, like all expenses, reduces the owner's claims to the assets of the firm. Assets decrease by $100, the cash paid for the advertising; and the remaining $50 increases creditors' claims-liabilities-because it will be paid later. It is shown as other payables because accounts payable is generally reserved for amounts a firm owes its vendors. This is the second transaction shown in Exhibit 2.4. Notice that the ex- pense is recorded even though all of the cash has not yet been paid.
As his business grows, Tom decides his company needs some insurance. Tom's Wear pays $150 for 3 months' worth of coverage, beginning February 14. When a company pays for something in advance, the item purchased is something of future value to the company. Because such an item provides future value, it is classified as an asset. Items purchased in advance may seem like unusual assets, and often have the word prepaid with them to provide information about what sort of assets they are. Common prepaid items are insurance, rent, and supplies. In this case, Tom's Wear has purchased an asset called prepaid insurance. Cash is decreased by $150, and the new asset-prepaid insurance- is increased by $150. Notice that insurance expense has not been recorded. Until some of the insurance is used up-and it can be used up only from one point in time to a subse- quent point in time-there is no expense. This is another case of the cash flow being dif- ferent than the expense.
On account means on credlt.
The expression applies to e i t h e r b u y i n g o r s e l l i n g o n cred it.
Accounts payable are amounts that a company owes its vendors. They are l i a b i l i t i e s a n d a r e s h o w n o n the balance sheet.
Prepaid insurance is the name for insurance a business has purchased but not yet used. lt is an asset.
E X H I B I T 2 . 3 Date Tlansaction
Transactions for Tom's Wear for February
February I
Febmary 5
February 14
February 23
February 28
Tom's Wear purchases 200 Ashirts at $4 each.
They are purchased on credit.
Tom's Wear buys advertising for $150, paying $100 in cash and the remainder on account. The ad runs immediately.
Tom's Wear purchases 3 months' worth of insurance for $150 cash, with the policy begiruring on the date of purchase.
Tom's Wear sells 185 Tshirts for $10 each. 170 of these are sold for cash and the remainder on account.
Tom's Wear declares and pays a dividend of $100.
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Accounts receivable are amounts customers owe a company for goods or services purchased on credit.
Adjusting the books means to make changes in the
accounting records, at the end of the period, just before the financial statements are prepared, to make sure the amounts ref lect the financial condition of the company at that date.
55 C H A P T E R 2 o QUALITIES O F A C C O U N T I N G I N F O R M A T I O N
The company's success continues with the sale of 185 more T-shirts at $10 each. Al- though Transaction 4 shows these sales as a single transaction, they could have been individ- ual sales. They are grouped together here to make the presentation simple. Of the 185 shirts s o l d , l T 0 w e r e s o l d f o r c a s h o f $ 1 , 7 0 0 ( 1 7 0 s h i r t s a t $ 1 0 e a c h ) a n d 1 5 w e r e s o l d o n c r e d i t f o r
$150 (15 shirts at $10 each). When a sale is made on credit, accounts receivable are the amounts owed to the firm by customers. Accounts receivable are assets-things of value to a business. This is the fourth transaction shown in Exhibit 2.4. Notice that the rest of this transaction includes the decrease in inventory of $740 (185 shirts at $4 each) with a corre- sponding expense-cost of goods sold of $740-which decreases retained earnings by $740.
At the end of the second month of business, Tom's Wear pays a dividend of $100 to its only stockholder, Tom. This transaction reduces assets-cash-by $100, and it reduces re- tained earnings by $100. This is the fifth transaction shown in Exh1bit2.4.
The financial statements for February can be prepared with the information from these transactions. However, there is still one more step before accurate financial statements can be prepared. This step is called adjusting the books. You need to review the amount that has been recorded for each asset and each claim to make sure every amount correctly reflects the financial situation of the company on the specific date of the balance sheet-the last day of the fiscal period (month, quarter, or year). After reviewing the transactions for Tom's Wear during the month, can you identify any amount that seems incorrect to you? Start at the be- ginning of the accounting equation worksheet in Exhibit 2.4 and look at each item that has been recorded. The assets are cash, $6,695; accounts receivable, $150; inventory, $100; and prepaid insurance, $150. Are these amounts accurate at February 28,2006, the end of the second month of Tom's Wear? Is any asset likely to communicate incorrect information?
Yes-prepaid insurance, as it currently appears in the company's records, will not ex- press what it should. Because the balance sheet will have the date February 28, 2006, Tom's Wear wants the amount of prepaid insurance to be accurate at that date. What is the amount of the asset-insurance that is still unused-at the date of the balance sheet? The $ 150, paid on February 14, applied to 3 months. On February 28,half amonth's worth has passed. So, approximately one-sixth (half a month's worth) of the prepaid insurance has been used. An adjustment must be made to make sure the correct amount of prepaid insurance is shown on the balance sheet. Like routine transactions, adjustments must keep the accounting equa- tion in balance. To record this adjustment in the accounting equation, subtract $25 (l/6 x
$150) from the prepaid insurance column, reducing the amount of prepaid insurance, and then reduce owner's claims by the same $25 amount. This reduction in the owner's claims is an expense-insurance expense-so it will be shown in the red-boxed area in the ac- counting equation worksheet. This adjustment is shown as Al on the worksheet in Exhibit 2.4. The correct amount of the asset-the unused portion-will be shown on the balance sheet at February 28,2006, as $125.
A review ofthe other items on the balance sheet does not reveal any other needed ad- justments on this particular balance sheet date. In the next chapter, you will learn about other situations requiring adjustments before the financial statements can be prepared. For now, this adjustment makes the accounting records ready for the preparation of the finan- cial statements at the end of February.
The income statement, prepared first, lists the revenues and expenses for the period;
you can find those in the red-boxed area in Exhibit 2.4. Allrevenues increase retained earn- ings; all expenses decrease retained earnings. The only item that we regularly find under re- tained earnings that is nor included on the income statement is a distribution to the owners, dividends in a corporation. GAAP says that distributions are not expenses.
All of the items for the income statement are in the red-boxed area of the worksheet.
We can simply take the amounts in the red box in the retained earnings columns and group the transactions into revenues and expenses to form an income statement. The sales rev- enue, often simply called sales, is $1,850.
There are three types of expenses listed. One is the cost of goods sold-also known as cost of sales. Recall, this is the expense associated with selling something purchased from someone else. Tom's Wear has cost of goods sold of $740. The other two expenses are $150 for the advertising and $25 for insurance. Be sure you see and understand that the insurance expense is not the amount Tom's Wear actually paid to the insurance company. Instead, it
C H A P T E R 2 . E L E M E N T S O F T H E
Tom's Wear, Inc.
Income Statement
For the Month Ended February 28,2006
F I N A N C I A L S T A T E M E N T S
E X H I B I T 2 . 5 l n c o m e S t a t e m e n t for Tom's Wear
This is the income statement for the second month of business for Tom's Wear.
57
Revenue
S a l e s . . . $ 1 ' 8 5 0
Expenses
Cost of goods sold Advertising expense Insurance expense
740
lbu
25
T o t a l e x p e n s e s .. . . . vt-D
Net income $ 935
is the cost of the insurance that was used during the period. The amount that has not been used as of February 28 remains on the balance sheet as an asset.
The net income for the period is $935-revenues of $1,850 minus expenses of $915.
Check it out in Exhibit 2.5,the income statement forTom's Wear for the month of February.
The statement of changes in shareholder's equity is prepared next (shown in Exhibit 2.6).
This statement provides the details of the changes in shareholder's equity during the year.
The information for this statement is found in the shareholder's equity columns of the worksheet in Exhibit 2.4, shown in the yellow-boxed area. Tom's Wear began the month with $5,000 in contributed capital. No new stock was issued during the month. That means no new contributions were made during the month. Retained earnings began the month with a balance of $385. Net income of $935 increases retained earnings, and the dividend of $100 decreases retained earnings. Because we have already prepared the in- come statement to summarize what happened in the red-boxed area in the retained earn- ings column, we do not need to list all of the individual items again. We just need to add net income as a single amount. The amount of retained earnings at the end of the period i s $1,220 ( $ 3 8 5 + 935 - 100).
Next, Tom's Wear prepares the balance sheet. The balance sheet was really prepared as the transactions were put in the accounting equation worksheet-but not in a way to communicate the information most effectively. The transactions need to be summarized and organized to communicate the information clearly and effectively. Each asset owned at Feb- ruary 28 is listed, along with the claims to those assets. Notice the similarity between the list of transactions on the worksheet in Exhibit 2.4 and the balance sheet in Exhlbit2.T .
Tom's Wear, Inc.
Statement of Changes in Shareholder's Equity For the Month Ended February 28,2006
Beginning common stock $ 5,000
Common stock issued during the month . 0
Ending common stock $ 5,ooo
Beginningretainedearnings ... $ 385
Net income for the month 935
Dividends declared .. .. (100)
E X H I B I T 2 . 6
Statement of Changes in Shareholder's Equity for Tom's Wear
for February
The Statement of Changes in Shareholder's Equity shows how all of the equity accounts have changed during the month.
Ending retained earnings Total shareholder's equity
r,220
$ 6,220
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