Financial statements are written records of business finances, including balance sheets and profit and loss statements. They stand as one of the most essential components of business information, and as the principal method of communicating financial information about an entity to outside parties. In a technical sense, financial statements are a summation of the financial position of an entity at a given point in time. General purpose financial statements are designed to meet the needs of many diverse users, particularly present and potential owners and creditors. Financial statements result from simplifying, condensing, and aggregating masses of data obtained primarily from a company's (or individual's) accounting system.
According to the Financial Accounting Standards Board, financial reporting includes not only financial statements but also other means of communicating financial information about an enterprise to its external users. Financial statements provide information useful in investment and credit decisions and in assessing cash flow prospects. They provide information about an enterprise's resources, claims to those resources, and changes in the resources.
Financial reporting is a broad concept encompassing financial statements, notes to financial statements and parenthetical disclosures, supplementary information (such as changing prices), and other means of financial reporting (such as management discussions and analysis, and letters to stockholders). Financial reporting is but one source of information needed by those who make economic decisions about business enterprises.
The primary focus of financial reporting is information about earnings and its components. Information about earnings based on accrual accounting usually provides a better indication of an enterprise's present and continuing ability to generate positive cash flows than that provided by cash receipts and payments.
MAJOR FINANCIAL STATEMENTS
The basic financial statements of an enterprise include the 1) balance sheet (or statement of financial position), 2) income statement, 3) cash flow statement, and 4) statement of changes in owners' equity or stockholders' equity. The balance sheet lists all the assets, liabilities, and stockholders' equity (for a corporation) of an entity as of a specific date. The balance sheet is essentially a financial snapshot of the entity. The income statement presents a summary of the revenues, gains, expenses, losses, and net income or net loss of an entity for a specific period. This statement is similar to a moving picture of the entity's operations during this period of time. The cash flow statement summarizes an entity's cash receipts and cash payments relating to its operating, investing, and financing activities during a particular period. A statement of changes in owners' equity or stockholders' equity reconciles the beginning of the period equity of an enterprise with its ending balance.
For an item to be recognized in the financial statements, it should meet several fundamental recognition criteria: 1) Meet the definition of an element of financial statements; 2) Subject to reliable standards of measurement; 3) Potentially pertinent in user decisions; 4) Verifiable; and 5) Representative of the subject's true standing.
Items currently reported in financial statements are measured by different attributes (for example, historical cost, current cost, current market value, net reliable value, and present value of future cash flows). While historical cost has traditionally been the major attribute assigned to assets and liabilities, the Financial Accounting Standards Board expects to continue to use different attributes.
Notes to financial statements are informative disclosures appended to financial statements. They provide information concerning such matters as depreciation and inventory methods used, details of long-term debt, pensions, leases, income taxes, contingent liabilities, method of consolidation, and other matters. Notes are considered an integral part of the financial statements. Schedules and parenthetical disclosures are also used to present information not provided elsewhere in the financial statements.
Each financial statement has a heading, which gives the name of the entity, the name of the statement, and the date or time covered by the statement. The information provided in financial statements is primarily financial in nature and expressed in units of money. The information relates to an individual business enterprise. The information often is the product of approximations and estimates, rather than exact measurements. The financial statements typically reflect the financial effects of transactions and events that have already happened (i.e., historical).
Financial statements presenting financial data for two or more periods are called comparative statements. Comparative financial statements usually give similar reports for the current period and for one or more preceding periods. They provide analysts with significant information about trends and relationships over two or more years. Comparative statements are considerably more significant than are single-year statements. Comparative statements emphasize the fact that financial statements for a single accounting period are only one part of the continuous history of the company.
Interim financial statements are reports for periods of less than a year. The purpose of interim financial statements is to improve the timeliness of accounting information. Some companies issue comprehensive financial statements while others issue summary statements. Each interim period should be viewed primarily as an integral part of an annual period and should generally continue to use the generally accepted accounting principles (GAAP) that were used in the preparation of the company's latest annual report. Financial statements are often audited by independent accountants for the purpose of increasing user confidence in their reliability.
Every financial statement is prepared on the basis of several accounting assumptions: that all transactions can be expressed or measured in dollars; that the enterprise will continue in business indefinitely; and that statements will be prepared at regular intervals. These assumptions provide the foundation for the structure of financial accounting theory and practice, and explain why financial information is presented in a given manner. Financial statements also must be prepared in accordance with generally accepted accounting principles, and must include an explanation of the company's accounting procedures and policies. Pervasive accounting principles include the recording of assets and liabilities at cost, the recognition of revenue when it is realized and when a transaction has taken place (generally at the point of sale), and the recognition of expenses according to the matching principle (costs to revenues). The convention of conservatism requires that uncertainties and risks related to a company be reflected in its accounting reports. The convention of materiality requires that anything that would be of interest to an informed investor should be fully disclosed in the financial statements.
Accounting procedures are those rules and practices that are associated with the operations of an accounting system and that lead to the development of financial statements. Accounting procedures include the methods, practices, and techniques used to carry out accounting objectives and to implement accounting principles. Accounting policies are those accounting principles followed by a specific entity. Information about the accounting policies adopted by a reporting enterprise is essential for financial statement users and should be disclosed in the financial statements. Accounting principles and their method of application in the following areas are considered particularly important: 1) a selection from existing alternatives; 2) areas that are peculiar to a particular industry in which the company operates; and 3) unusual and innovative applications of GAAP. Significant accounting policies are usually disclosed as the initial note or as a summary preceding the notes to the financial statements.
ELEMENTS OF FINANCIAL STATEMENTS
The Financial Accounting Standards Board (FASB) has defined the following elements of financial statements of business enterprises: assets, liabilities, equity, revenues, expenses, gains, losses, investment by owners, distribution to owners, and comprehensive income. According to FASB, the elements of financial statements are the building blocks with which financial statements are constructed—the broad classes of items that financial statements comprise. These FASB definitions, articulated in its "Elements of Financial Statements of Business Enterprises," are as follows:
* Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.
* Comprehensive income is the change in equity (net assets) of an entity during a period from transactions and other events and circumstances from nonowner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners.
* Distributions to owners are decreases in net assets of a particular enterprise resulting from transferring assets, rendering services, or incurring liabilities to owners. Distributions to owners decrease ownership interest or equity in an enterprise.
* Equity is the residual interest in the assets of an entity that remains after deducting its liabilities. In a business entity, equity is the ownership interest.
* Expenses are outflows or other uses of assets or incurring of liabilities during a period from delivering or producing goods or rendering services, or carrying out other activities that constitute the entity's ongoing major or central operation.
* Gains are increases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity during a period except those that result from revenues or investments by owner.
* Investments by owners are increases in net assets of a particular enterprise resulting from transfers to it from other entities of something of value to obtain or increase ownership interest (or equity) in it.
* Liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.
* Losses are decreases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity during a period except those that result from expenses or distributions to owners.
* Revenues are inflows or other enhancements of assets of an entity or settlement of its liabilities (or a combination of both) during a period from delivering or producing goods, rendering services, or other activities that constitute the entity's ongoing major or central operations.
A subsequent event is an important event that occurs between the balance sheet date and the date of issuance of the annual report. Subsequent events must have a material effect on the financial statements. A subsequent event does not include the recurring economic fluctuations associated with the economy and with free enterprise, such as a strike or management change. A subsequent event is considered to be important enough that without such information the statement would be misleading if the event were not disclosed. The recognition and recording of these events requires the professional judgment of an accountant or external auditor.
Events that effect the financial statements at the date of the balance sheet might reveal an unknown condition or provide additional information regarding estimates or judgments. These events must be reported by adjusting the financial statements to recognize the new evidence. Events that relate to conditions that did not exist on the balance sheet date but arose subsequent to that date do not require an adjustment to the financial statements. The effect of the event on the future period, however, may be of such importance that it should be disclosed in a footnote or elsewhere.
PERSONAL FINANCIAL STATEMENTS
The reporting entity of personal financial statements is an individual, a husband and wife, or a group of related individuals. Personal financial statements are often prepared to deal with obtaining bank loans, income tax planning, retirement planning, gift and estate planning, and the public disclosure of financial affairs.
For each reporting entity, a statement of financial position is required. The statement presents assets at estimated current values, liabilities at the lesser of the discounted amount of cash to be paid or the current cash settlement amount, and net worth. A provision should also be made for estimated income taxes on the differences between the estimated current value of assets. Comparative statements for one or more periods should be presented. A statement of changes in net worth is optional.
Personal financial statements should be presented on the accrual basis. A classified balance sheet is not used. Assets and liabilities are presented in the order of their liquidity and maturity, respectively (not on a current/noncurrent basis). A business interest that constitutes a large part of an individual's total assets should be shown separate from other assets. Such an interest would be presented as a net amount and not as a pro rata allocation of the business's assets and liabilities. A statement of changes in net worth would disclose the major sources of increases and decrease in net worth. Increases in personal net worth arise from income, increases in estimated current value of assets, decreases in estimated current amount of liabilities, and decreases in the provision for estimated income taxes. Decreases in personal net worth arise from expenses, decreases in estimated current value of assets, increases in estimated current amount of liabilities, and increases in the provision for income taxes.
DEVELOPMENT STAGE COMPANIES
An enterprise is a development stage company if substantially all of its efforts are devoted to establishing a new business and either of the following is present: 1) principal operations have not begun, or 2) principal operations have begun but revenue is insignificant. Activities of a development state enterprise frequently include financial planning, raising capital, research and development, personnel recruiting and training, and market development.
A development stage company must follow generally accepted accounting principles applicable to operating enterprises in the preparation of financial statements. In its balance sheet, the company must report cumulative net losses separately in the equity section. In its income statement it must report cumulative revenues and expenses from the inception of the enterprise. Likewise, in its cash flow statement, it must report cumulative cash flows from the inception of the enterprise. Its statement of stockholders' equity should include the number of shares issued and the date of their issuance as well as the dollar amounts received. The statement should identify the entity as a development stage enterprise and describe the nature of development stage activities. During the first period of normal operations, the enterprise must disclose its former developmental stage status in the notes section of its financial statements.
FRAUDULENT FINANCIAL REPORTING
Fraudulent financial reporting is defined as intentional or reckless reporting, whether by act or by omission, that results in materially misleading financial statements. Fraudulent financial reporting can usually be traced to the existence of conditions in either the internal environment of the firm (e.g., inadequate internal control), or in the external environment(e.g., poor industry or overall business conditions). Excessive pressure on management, such as unrealistic profit or other performance goods, can also lead to fraudulent financial reporting.
The accounting profession generally is of the opinion that it is not the responsibility of the auditor to detect fraud, beyond what can be determined with the diligent application of generally accepted auditing standards. Because of the nature of irregularities, particularly those involving forgery and collusion, a properly designed and executed audit may not detect a material irregularity. The auditor is not an insurer and the auditor's report does not constitute a guarantee that material misstatements do not exist in the financial statement.
The preparation and presentation of a company's financial statements are the responsibility of the management of the company. Published financial statements are audited by an independent certified public accountant. During an audit, the auditor conducts an examination of the accounting system, records, internal controls, and financial statements in accordance with generally accepted auditing standards. The auditor then expresses an opinion concerning the fairness of the financial statements in conformity with generally accepted accounting principles. The auditor's standard opinion typically includes the following statements: the auditor is independent; the audit was performed on specified financial statements; the financial statements are the responsibility of the company's management; the opinion of the auditor is the auditor's responsibility; the audit was conducted according to generally accepted auditing standards; the audit was planned and performed to obtain reasonable assurance about whether the financial statements are free of material misstatements; the audit included examination, assessment, and evaluation stages; the audit provided a reasonable basis for an expression of an opinion concerning the fair presentation of the audit; and the signature and date by the auditing firm.
An unqualified opinion contains three paragraphs: an introductory paragraph, a scope paragraph, and the opinion paragraph. In addition to the unqualified opinion, an auditor may issue a qualified opinion, an adverse opinion, or a disclaimer of opinion.