Accounting: The Language of Business - Vol 2 [Intermediate (Part 2)]

Over the years, Charlie [Munger, Berkshire Hathaway Vice Chairman] and I have observed many accounting-based frauds of staggering size. Few of the perpetrators have been punished; many have not even been censured. It has been far safer to steal large sums with pen than small sums with a gun.

Warren Buffett

The Financial Reporting Environment

(Part B)

by

Charles Lamson

Sources of Financial Information. The financial reporting process generates a significant amount of finance information that uses the four basic financial statements, as well as the footnote disclosures. In the posts that follow, we continue the theory, rational, and principles underlying the four basic financial statements: 

• The balance sheet (also referred to as the statement of financial position)

• The statement of comprehensive income 

• The statement of cash flows

• The statement of shareholders' equity

Published financial statements are called general-purpose financial statements because they provide information to a wide spectrum of user groups: investors, creditors, financial analysts, customers, employees, competitors, suppliers, unions, and government agencies. Although considered general purpose, most financial information is provided to satisfy users with limited ability or authority to obtain additional information, which includes investors and creditors. The Financial Accounting Standard Board (FASB), which is the body responsible for promulgating U.S. GAAP, identifies investors, lenders, and other creditors as the primary users of the financial statements.

Financial statements are the culmination of the financial reporting process. These financial statements, along with the accompanying footnote disclosures are the primary source of publicly available financial information for investors and creditors. None of the other sources of financial information---such as management, forecasts, press releases, and regulatory reports provide as much information as the financial statements.

The term financial information includes more information than the financial statements. The financial statements include the four basic financial statements and the related footnotes. However, financial information also includes items such as: 

• A letter to the shareholders

• A formal discussion and analysis of the firm by the management of the firm

• Management report

• Auditor's report

• Financial summary

Therefore, the general-purpose financial statements and the related footnotes are subsets of financial information. The financial statements and the footnotes are governed by U.S.

GAAP, which may not always be the case for all components of financial information.

Economic Entity

The second element in the definition of financial accounting involves the economic entity for which the financial statements and other financial information are presented. An economic entity is an organization or unit with activities that are separate from those of its owners and other entities. Financial information always relates to a particular economic entity. Economic entities can be corporations, partnerships, sole proprietorships, or governmental organizations. Also, economic entities may be privately held or publicly held. If the entity is publicly held, then its equity can be bought and sold by external parties on stock exchanges. 

Financial Statement User Groups

The third element in the financial accounting definition involves identifying the primary user groups that demand financial information. Some assets employ accounting information to make economic decisions for their own benefit while other users employ accounting information to make economic decisions for the benefit of others, or to assist others in making investment or credit decisions. Exhibit 1.2 lists the user groups. 

EXHIBIT 1.2 User Groups

Equity Investors. Equity investors are the shareholders of the company. That is, an equity investor purchases a percentage ownership of the company. Equity investors include individuals, other corporations, partnerships, mutual funds, pension plans, and other financial institutions that expect to receive a return on their investment either through dividends (i.e., distributions of cash or other assets to owners) or in the form of an increase in the price of their equity shares.

Equity investors use financial information to determine a company's ability to generate earnings and cash flow, as well as to make an assessment of the potential risks and returns of their investments. Equity investors also use financial information to assess the ability of the entity to pay dividends and to grow over time. Firm growth in earnings and cash flow are important for the investor to sell his or her investment at a gain. 

*GORDON, RAELY, & SOMNELLA, 2019, INTERMEDIATE ALGEBRA, 2ND ED., PP. 3-4*

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