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Financial Accounting Concepts

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The Financial Statements are reports containing financial information about an organization and this includes the Profit & Loss Statement, Balance Sheet, and Cashflow Statements. The Profit & Loss Statement also variously called earnings statement, income statement, and the statement of operations, summarizes business activities for a given period and reports the net income or loss resulting from operations and from certain other defined activities. The Balance Sheet also known as statement of financial position, and statement of condition, reports as of a given point of time the resources of a business (assets), its obligations (liabilities), and the residual ownership claims against an entity’s resources (owners equity).

The Cash flow Statements is a financial report that shows incoming and outgoing money during a particular period. The statement shows how changes in balance sheet and income accounts affected cash and cash equivalents and breaks the analysis down according to operating, investing, and financing activities. As an analytical tool the statement of cash flows is useful in determining the short-term viability of a company, particularly its ability to pay bills.

To illustrate, financial reports of IBM Corp were shown below :
International Business Machine Corp.
Comparative Income Statement
For the year ended December 31, 2003-2005
(In thousand dollars)

PERIOD ENDING 31-Dec-05 31-Dec-04 31-Dec-03
Total Revenue 91,134,000 96,293,000 89,131,000
Cost of Revenue 54,602,000 60,261,000 56,113,000
Gross Profit 36,532,000 36,032,000 33,018,000
Operating Expenses
Research Development 5,842,000 5,673,000 5,077,000
Selling General and Administrative 21,314,000 19,384,000 17,852,000
Non Recurring – (1,169,000) –
Others – – –
Total Operating Expenses – – –

Operating Income or Loss 9,376,000 12,144,000 10,089,000

Income from Continuing Operations
Total Other Income/Expenses Net 3,070,000 23,000 930,000
Earnings Before Interest And Taxes 12,446,000 12,167,000 11,019,000
Interest Expense 220,000 139,000 145,000
Income Before Tax 12,226,000 12,028,000 10,874,000
Income Tax Expense 4,232,000 3,580,000 3,261,000
Minority Interest – – –

Net Income From Continuing Ops 7,994,000 8,448,000 7,613,000

Non-recurring Events
Discontinued Operations (24,000) (18,000) (30,000)
Extraordinary Items – – –
Effect Of Accounting Changes (36,000) – –
Other Items – – –

Net Income 7,934,000 8,430,000 7,583,000
Preferred Stock And Other Adjustments – – –
Net Income Applicable To Common Shares $7,934,000 $8,430,000 $7,583,000

International Business Machine Corp.
Comparative Balance Sheet
December 31, 2003-2005
(In thousand dollars)

PERIOD ENDING 31-Dec-05 31-Dec-04 31-Dec-03
Current Assets
Cash And Cash Equivalents 12,568,000 10,053,000 7,290,000
Short Term Investments 1,118,000 517,000 357,000
Net Receivables 26,193,000 30,365,000 31,465,000
Inventory 2,841,000 3,316,000 2,942,000
Other Current Assets 2,941,000 2,719,000 2,944,000
Total Current Assets 45,661,000 46,970,000 44,998,000
Long Term Investments 14,602,000 16,418,000 12,647,000
Property Plant and Equipment 13,756,000 15,175,000 14,689,000
Goodwill 9,441,000 8,437,000 6,921,000
Intangible Assets 1,663,000 1,789,000 1,388,000
Accumulated Amortization – – –
Other Assets 20,625,000 20,394,000 19,526,000
Deferred Long Term Asset Charges – – 4,288,000
Total Assets 105,748,000 109,183,000 104,457,000

Current Liabilities
Accounts Payable 17,292,000 24,524,000 21,091,000
Short/Current Long Term Debt 7,216,000 8,099,000 6,646,000
Other Current Liabilities 10,644,000 7,175,000 10,163,000
Total Current Liabilities 35,152,000 39,798,000 37,900,000
Long Term Debt 15,425,000 14,828,000 16,986,000
Other Liabilities 22,073,000 24,810,000 18,031,000
Deferred Long Term Liability Charges – – 3,676,000
Minority Interest – – –
Negative Goodwill – – –
Total Liabilities 72,650,000 79,436,000 76,593,000

Stockholders’ Equity
Misc Stocks Options Warrants – – –
Redeemable Preferred Stock – – –
Preferred Stock – – –
Common Stock 28,926,000 18,355,000 16,269,000
Retained Earnings 44,734,000 42,464,000 37,525,000
Treasury Stock (38,546,000) (31,072,000) (24,034,000)
Capital Surplus – – –
Other Stockholder Equity (2,016,000) – (1,896,000)
Total Stockholder Equity 33,098,000 29,747,000 27,864,000
Net Tangible Assets $21,994,000 $19,521,000 $19,555,000

International Business Machine Corp.
Comparative Cash Flow Statement
December 31, 2003-2005
(In thousand dollars)

PERIOD ENDING 31-Dec-05 31-Dec-04 31-Dec-03
Net Income 7,934,000 8,430,000 7,583,000

Operating Activities, Cash Flows Provided By or Used In
Depreciation 5,188,000 4,915,000 4,701,000
Adjustments To Net Income 1,736,000 1,681,000 901,000
Changes In Accounts Receivables 2,219,000 2,613,000 2,024,000
Changes In Liabilities (219,000) (476,000) 798,000
Changes In Inventories 202,000 (291,000) 293,000
Changes In Other Operating Activities (2,186,000) (1,567,000) (1,923,000)
Total Cash Flow From Operating Activities 14,874,000 15,323,000 14,407,000

Investing Activities, Cash Flows Provided By or Used In
Capital Expenditures (3,842,000) (4,368,000) (4,393,000)
Investments (346,000) 112,000 552,000
Other Cashflows from Investing Activities (235,000) (1,090,000) (1,281,000)
Total Cash Flows From Investing Activities (4,423,000) (5,346,000) (5,122,000)

Financing Activities, Cash Flows Provided By or Used In
Dividends Paid (1,250,000) (1,174,000) (1,085,000)
Sale Purchase of Stock (6,506,000) (5,418,000) (3,232,000)
Net Borrowings 609,000 (1,027,000) (3,481,000)
Other Cash Flows from Financing Activities – – –
Total Cash Flows From Financing Activities (7,147,000) (7,619,000) (7,798,000)
Effect Of Exchange Rate Changes (789,000) 405,000 421,000
Change In Cash and Cash Equivalents $2,515,000 $2,763,000 $1,908,000

Accountants have the responsibility for preparing the financial statements of an entity in accordance with generally accepted accounting principles. Auditors review the work done by accountants and, acting independently from management, issue opinions as to fairness of the financial statements and their adherence to the generally accepted principles of accounting.

Independent auditing as performed by an auditor is the objective examination of financial statements prepared by the business entity. The major purpose of an independent audit is to investigate and determine if the financial statements submitted for audit have been prepared in accordance with financial reporting practices that are appropriate for the auditee. In most cases, generally accepted accounting principles constitute the proper audit criteria for judging an auditee’s financial reporting practices.

The independent audit process normally terminates in an attestation regarding the fairness and dependability of the financial statements. This audit attestation is communicated to the officials of the audited entity ( and other external recipients of the financial statements in the form of a written audit report which accompanies the financial statements.

An auditor’s opinion on the financial statements is recognized as a label of credibility. In order to preserve the credibility, the profession has found it necessary to establish regulations for members within the profession, and to establish standards and principles to govern the work done by the professional people. The major organizations involved include the American Institute of Certified Public Accountants (AICPA), state boards and state societies of accountants, the Financial Accounting Standards Board (FASB), the Securities and Exchange Commission (SEC), and the American Accounting Association (AAA).

One of the major function of the AICPA is to assist the states in the regulation of those entering the profession by administering and grading the uniform CPA examination. Other responsibilities include establishing and enforcing rules of professional conduct (professional ethics), establishing standards of auditing practice, representing and speaking for the members of the profession to government, education, and the business community, and, in the past, establishing generally accepted accounting principles. This latter responsibility has now been largely assumed by the Financial Accounting Standards Board (FASB), an entity organized separately from the AICPA.

All financial statements must conform with the Generally Accepted Accounting Principles (GAAP) which is the common set of accounting principles, standards and procedures that companies must use. GAAP are a combination of authoritative standards and simply the commonly accepted ways of recording and reporting accounting information.

GAAP are imposed on companies so that investors have a minimum level of consistency in the financial statements they use when analyzing companies for investment purposes. GAAP cover such things as revenue recognition, balance sheet item classification and outstanding share measurements. Companies are expected to follow GAAP rules when reporting their financial data via financial statements. If a financial statement is not prepared using GAAP principles, then users of the financial statements will be mislead.

Since 1973, the Financial Accounting Standards Board, or FASB, has been the designated organization in the private sector for establishing standards of financial accounting and reporting in the United States. Those standards govern the preparation of financial reports. They are officially recognized as authoritative by the Securities and Exchange Commission (Financial Reporting Release No. 1, Section 101) and the American Institute of Certified Public Accountants (Rule 203, Rules of Conduct, as amended May 1973 and May 1979).

The Securities and Exchange Commission has statutory authority to establish financial accounting and reporting standards for publicly held companies under the Securities Exchange Act of 1934. Throughout its history, however, the Commission’s policy has been to rely on the private sector for this function to the extent that the private sector demonstrates ability to fulfill the responsibility in the public interest.

The mission of the Financial Accounting Standards Board is to establish and improve standards of financial accounting and reporting for the guidance and education of the public, including issuers, auditors, and users of financial information.

The effectiveness of the regulations lies on the reliability of financial statements. But most of the FASB’s opinions represent conservative accounting principles. This means the standards tend to peg revenues, earnings, and assets at a lower value compared to the alternative practices they are designed to eliminate; and conversely, costs and liabilities tend to be reported at a higher value. Indeed, in implementing FASB standards, companies collectively have “lost” literally hundreds of billions of dollars of profit in accounting terms, all because transactions and assets affecting their income statements were reclassified. The board likewise tends to frown on ambiguous accounting practices, such as not including one-time gains or losses in the income statement or recording acquisition financing entirely as a stock swap (although neither practice is forbidden). In the interests of full and accurate disclosure, the FASB standards would have businesses overstate their weaknesses and understate their strengths, rather than the reverse.

With this reason, the FASB’s approach often elicits criticism from top management, particularly those without an accounting background, who want to see their bottom lines growing instead of shrinking. Certain standards have provoked such controversy that members of Congress have tried to intervene on the side of business and legislatively subvert the FASB’s independence. However, most chief financial officers and other executives report wanting an independent, private standards organization over direct government control, even if they disagree with specific standards.

For companies like IBM who wants to attract investors and customer, may want to show a bigger asset but under the principle of conservatism, fixed assets acquired must be carried in the balance sheet at historical or acquisition cost which is much lower than fair market value, in this case the regulation seems to be ineffective. However, the regulation is effective in requiring the disclosure of changes in accounting policies, practices, or the methods of applying them, together with the financial effect, and the justification for the change, for the reason that management and other financial users will not be mislead and can come up with a right decision.

1. Stice, Earl..et al. Intermediate Accounting. Thomson/ South Western, 2004.
2. Spiceland, David. Intermediate Accounting. Boston,MA, Mcgraw-hill, 1998.
3. Holmes, Arthur & Burns, David. Auditing. Richard D. Irwin, Inc, 1981.
4. Boynton, William. Modern Auditing. Wiley, 2001
5. Financial Standards Accounting Board. “FASB Welcome Page.” Norwalk, CT, 1999. Available from www.fasb.org.

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