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Brandon Zweifel
Foundations of Writing 1
Dr. Riley
May 10, 2013
Financial Reporting
Accounting plays an important role in society in the business world. Accountants are
needed to help interpret financial information to upper management of a business and to
investors. Upper management needs this financial information in order to make the right
decisions for a business. Investors need this financial information in order to know what
company would be beneficial to invest in. Accountants interpret the financial information of a
business in the form of financial statements and these financial statements are usually produced
at the end of each year. “Because poor decisions can lead to financial stress and failure, the role
of financial statements is central to maintaining firm’s competitiveness and solvency” (Van
Auken & Carraher, 2011, p. 1). The three main financial statements are the income statement,
balance sheet, and the cash flow statement.
The income statement is usually the first financial statement made. The income statement
contains the revenue and expense
accounts. Expenses are subtracted
from revenue to get the total
amount of net income earned.
Fitzpaterick, Raju, and Tocco
(2010) of Rockhurst University
Principles of Accounting. (2011). Income Statement
say that income statements
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report three alternative measures of accounting income: net income, comprehensive income and
continuing income (p. 22). One example of a revenue account is sales revenue and an example of
an expense account is utilities expense. One problem that companies have with revenue is that
revenue can only be recognized at a certain period. “Revenues are recognized when services are
rendered, goods are delivered or work is completed” (TNT, 2009, p. 65). First sales returns and
allowances are subtracted from sales to get the net sales. Then cost of goods sold is subtracted
from net sales to get the gross profit. Finally, regular expense accounts are deducted from the
gross profit to get the net income. An income statement is used to evaluate past performance and
to predict future performance. The objective of a firm involving the income statement is to get
the highest net income possible. Firms want to achieve a higher net income than Wall Street
expectations so that the market price of their stock increases. If the firm’s net income ends up
being lower than Wall Street expectations, the market price of their stock will decrease.
Unfortunately, there is upper level management who decide to purposely misinterpret the income
statement in order to make the net income higher. Management can do this by understating the
expense accounts or overstating the revenue accounts. Income statements are audited to make
sure that the income statement is interpreted correctly.
The balance sheet is made after the income statement and the balance sheet contains
asset, liability, and owner’s equity accounts. It helps in predicting future amounts, timing, and
uncertainty of future cash flows. In order for the balance sheet to be efficient, assets must equal
liabilities plus owner’s equity. If assets do not equal liabilities plus owner’s equity, then an
account amount was put into the balance sheet incorrectly. Assets are what the company owns
that has value. An example of an asset accounts is cash. Liabilities are debt or a financial
obligation. An example of liabilities is accounts payable. Owner’s equity is an owner’s
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ownership in the business.
Examples of owner’s equity are
capital and drawing. Assets and
liabilities are usually broken
down into current and long-term.
The balance sheet can be
misinterpreted by overvaluing the
assets or understating the
Principles of Accounting. (2011). Balance Sheet
liabilities. There are many other
ways of misstating the balance sheet and the balance sheet gets audited just like the income
statement.
The final major financial statement is the statement of cash flows. The statement of cash
flows helps show where the cash came from, what it was used for, and the change in cash
balance. The statement of cash flows shows the cash inflows and cash outflows of the company.
The statement of cash flows shows a comparison of different types of accounts from one period
to another. These accounts are grouped into different activities which are called operating
activities, investing activities, and financing activities. The most important activity is operating
because it shows how the company spends cash and gains cash through the operation part of the
business. Operating activities involves accounts payable, accounts receivable, or cash paid for
salaries. Investing activities involves purchasing land or buildings. Financing involves paying
dividends or issuing stock. Accounts that increase from one period to another could increase cash
or decrease cash and the same goes to a decrease of an account from one period to another. An
example is if accounts receivable increased from one period to another, then it would lead to a
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decrease in cash because accounts receivable is cash that you are receiving later rather than now.
All of the cash gained from each activity is added up to get net cash. A company would like to
have a high amount of cash in the statement of cash flows so it looks good to investors.
Companies can develop two kinds of cash flow statements which are the direct method and the
indirect method. Bradbury (2011, p. 128) had this to say about the two methods:
The direct cash flow reporting format, relative to the indirect method, leads to better
prediction of future firm performance and has a stronger association with share prices.
The direct method of cash flow reporting lowers information asymmetry.
Fraud does not occur in the statement of cash flows as much as it does on the income statement
and balance sheet, but the statement of cash flows still gets audited.
So each year, companies generate financial statements to interpret the performance of the
company. Three major statements developed are the income statement, balance sheet, and the
cash flow statement. The income statement shows how much income the company earns in a
given time period. The balance sheet shows the value of assets, liabilities, and owner’s equity in
a given time period and the cash flow statement shows the cash inflows and outflows in a given
period. These financial statements can be fraudulently misstated which is why auditors have to
audit the financial statements. These three statements may contain different concepts, but they all
interpret the timing of cash which is important for investors.
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References
Bradbury, M. (2011). Direct or indirect cash flow statements? Australian Accounting Review.
Retrieved from
http://onlinelibrary.wiley.com/doi/10.1111/j.1835-2561.2011.00130.x/pdf
Fitzpaterick, B., Raju, S., & Tocco, A. (2010). Comprehensive income options: A detriment to
transparency. International Business & Economics Research Journal. Retrieved from
http://www.journals.cluteonline.com/index.php/IBER/article/view/609/595
Principles of Accounting. (2011). Income statement and balance sheet picture. Retrieved from
http://www.principlesofaccounting.com/chapter5/chapter5.html
TNT. (2009). Report of the board of management. Retrieved from
http://group.tnt.com/Images/TNT_annual_report_2009_chapter06_tcm177-491416.pdf
Van Auken, H., Carraher, S. (2011). How do small firms use financial statements?
Allied Academies International Conference. Retrieved from
http://alliedacademies.org/Public/Proceedings/Proceedings28/AAFS%20Proceedings%20
Spring%202011.pdf#page=39
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