In this chapter, we are going to provide an overview of the financial reporting landscape, and talk about what is required in financial reporting, who makes the rules, what is the basic set of financial statements.
let's begin with the obvious question:
What is Accounting?
Accounting is a system for tracking business transactions to provide users who need this information with detailed statements of a company's financial position.
We first start with recording transactions. This part is essential, as not everything a business does gets recorded in the financial statements, so we will need to record a transaction. The second part is about providing summary statements. Big companies have billions of transactions every year. If they make them available to you in a giant folder, your first question would be, how can I summarize all this in one or two summary statements? The third part focuses on users because different user groups would want different numbers. So most companies have to keep three sets of books. Our focus in this chapter will be the first set of books or financial accounting.
Financial accounting is directed toward external users, such as shareholders, creditors, customers, and any other individual who has an interest in the company.
However, such financial statements are not be used to calculate taxes. There is a different set of books based on tax rules that are used to determine how much tax a company has to pay. Then, there is managerial accounting.
Managerial accounting provides customized reports and information needs for internal decision-makers, such as officers, managers, etc.
What are the financial reporting requirements?
The Securities and Exchange Commission (SEC) requires periodic financial statement filings. Companies must file an annual report or 10-K once a year, which includes a full set of financial statements. The other three-quarters of the year, firms must file a quarterly report, or 10-Q, which has a full set of financial statements but less required disclosure than the annual report. If material information changes happen between quarter ends, companies must file an 8K or current report. By material information we mean anything important enough to move the stock price, which means companies file these quite often. They do not require the financial statements, just an update of any significant corporate event. All of these filings have to be prepared under generally accepted accounting principles, or GAAP.
As we mentioned before, Financial accounting is governed by concepts and rules known as generally accepted accounting principles (GAAP). GAAP are established by the US Congress, but they usually delegate to the Securities and Exchange Commission. Nevertheless, they are often too busy to make the rules. So they delegate to the Financial Accounting Standards Board, or FASB, which has the authority to make the accounting rules in the US.
Internationally, there are international financial reporting standards, or IFRS that are established by the International Accounting Standards Board, or IASB, based in London, and is now required in more than 115 countries. However, as of now, US GAAP is still required for US firms.
Who is responsible for financial reporting?
Management is responsible for preparing financial statements. Managers put together their financial statements because they have the most information about what happened in the company. However, it is fundamental to recall that they may utilize this prudence to attempt to control the discernments. We, therefore, put various checks and balances in order to restrict the opportunistic actions of managers.
First, the Audit Committee of the Board of Directors provides oversight of management's accounting process. However, this is not a foolproof check on managers' behavior. So then the auditors are hired by the board to express an opinion about whether the statements are prepared in accordance with GAAP. This also is not enough because an auditor can sign off on some certain activities to approve the company's accounting activities. The next line of defense is the SEC and different regulators who will take movement against the company if any violations of GAAP or different rules are found.
What are the required financial statements?
First, there is an income statement, which describes a company's revenues and expenses with resulting net income or loss over a period of time using accrual accounting. Over a period of time, we mean between two balance sheets, so either a quarter or a year.
Next is the statement of stockholder's equity, or Statement of Retained Earnings, which shows the change in equity over a period of time.
Then, there is the balance sheet, which is a snapshot in time of a company's financial position and includes a listing of all its resources and obligations on a specific date.
And finally, there is the statement for cash flows, which will give us all the sources and uses of cash over a period of time.
Chapter Summary:
Accounting is how business transactions are recorded.
There are three sets of books:
Financial accounting
– Provides external users (shareholders, lenders, etc.) with financial statements.
Tax Accounting
– IRS rules for computing taxes payable
Managerial Accounting
– Provides information needs for internal decision makers (officers, managers, etc.).
The time period assumptions allow accountants to break up business periods into a year, semi-annual, quarterly, or monthly periods.
The most common periods that are used include:
1) The annual periods or 12 months
2) Quarterly periods or three months
3) Semi-annual or six months
4) Single month periods
Who makes the rules?
There are two big sets of accounting standards in the world.
Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS).
Financial accounting is governed by concepts and rules known as generally accepted accounting principles (GAAP). In the United States, the Securities and Exchange Commission has the legal authority to establish reporting requirements and set GAAP for companies that issue stock to the public.
The International Accounting Standards Board (IASB) establishes the International Financial Reporting Standards (IFRS) that identify accounting practices in other countries.
What are the required financial statements?
Balance Sheet
A snapshot in time of a company's financial position and includes a listing of all its resources and obligations on a specific date.
Income Statement
Describes a company's revenues and expenses with resulting net income or loss over a period of time using accrual accounting.
Statement of Cash Flows
Sources and uses of cash over a period of time.
Statement of Retained Earnings
Changes in stockholders' equity over a period of time.
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