Chapter 2 What Should Decision Makers Know in Order to Make Good Decisions about an Organization?

Financial Statements: The Portrait of an Organization

Question: In Chapter 1 "What Is Financial Accounting, and Why Is It Important?", mention was made that financial accounting is somewhat analogous to the painting of a giant, complex portrait. How could financial accounting possibly be compared to an artistic endeavor such as the creation of a painted portrait?

Answer: The purpose of a portrait—as might have been created by Rembrandt, van Gogh, or even Picasso—is to capture a likeness of the artist’s model. In a somewhat parallel fashion, financial accounting attempts to present a portrait of an organization that can be used by interested parties to assess its financial health and future prospects. If well painted, this picture should enable individuals to estimate future stock prices, dividend payments, and cash flows. Accounting even has specific terms (such as representational faithfulnessA reasonable agreement between reported information and the event or balance it purports to represent; this term refers to the communication of an appropriate picture of an organization, which can serve as the basis for appropriate decisions. and presents fairlyFinancial information that contains no material misstatements in accordance with an accepted standard for financial reporting.) that are used to indicate that financial information successfully provides a reasonable likeness of the reporting organization.

In accounting, this portrait is most often presented in the form of financial statementsQuantitative reports and related verbal disclosures that convey monetary information describing the operations, financial position, and cash flows of an organization as a basis for representing its financial health and future prospects.. The accountant takes all appropriate monetary information and constructs a set of financial statements to be distributed to decision makers. Financial statements are a representation of an organization’s operations, financial position, and cash flows. These statements provide the form and structure for the conveyance of financial information that will create a likeness of the reporting organization. This textbook is about the preparation of those financial statements and the meaning of their contents.

A Likeness Does Not Have to Be Exact

Question: Financial accounting deals with numbers that are exact. A 3 is a 3 and nothing else. In describing the production of financial statements, why are the results not compared to a photograph rather than a painted portrait? After all, a photograph is a much more precise likeness than a painting.

Answer: A human portrait, even by a master such as Rembrandt, will not be completely accurate. The shape of the person’s chin or the turn of the neck may be off slightly. The color of the eyes and hair cannot possibly be a perfect replica of life. It is a painted portrait, not a photograph (which is much more mechanically accurate). Fortunately, absolute exactness is not necessary for capturing the essence of a model. A likeness is achieved when a viewer exclaims, “I know that person!” Exact precision is not required to meet that objective.

Despite public perception to the contrary, financial accounting information is rarely an exactly accurate portrait. The accountant’s goal is to create financial statements that present a likeness of an organization that can be used to make decisions. For example, the reported cost of constructing a building may be off slightly because of the sheer volume of money being spent on the many different aspects of the project. No one expects the reported cost of a $50 million manufacturing plant to be accurate to the penny. As with the painted portrait, that does not necessarily reduce the usefulness of the data. If financial information provides a fair representation, an interested party should be able to make use of it to arrive at the desired projections such as future stock prices. A potential investor or creditor does not need numbers that are absolutely accurate in order to assert, “Based on the information available in the financial statements, I understand enough about this business to make informed decisions. Even if I could obtain figures that were more accurate, I believe that I would still take the same actions.”

An artist applies oil paints, pastels, or watercolors to a canvas to present a likeness of a subject. An accountant does something quite similar in constructing financial statements with numbers and words. The goal is much the same: to produce a likeness that truly reflects the essence of the model, which, in this case, is an entire organization.

Material Misstatements

Question: This is a surprising, possibly shocking, revelation. Financial accounting information has universally been branded as exhibiting rigid exactness. In fact, accountants are often referred to as “bean counters” because of their perceived need to count every bean in the bowl to arrive at obsessively accurate numbers. Here, though, the assertion is made that accounting information is not a precise picture but merely a fair representation of an organization’s financial health and future prospects. How correct or exact is the financial information that is reported by a business or other organization?

Answer: In financial accounting, the data presented to decision makers by an organization should never contain any misstatementsErrors or frauds that cause reported financial information to differ from the approach required by an official standard for reporting such as the U.S. Generally Accepted Accounting Principles (U.S. GAAP) or International Financial Reporting Standards (IFRS). that are deemed to be materialThe magnitude of an omission or misstatement of accounting information that makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by that omission or misstatement.. This basic standard has long served as the required level for accuracy in financial reporting. Decision makers want financial statements—such as those prepared by Starbucks or Intel—that they can trust and use. That requires the statements to be free of any material misstatements. In that condition, reported financial information will be viewed as a likeness of the organization that is presented fairly. Thus, financial statements do not need exact accuracy. However, they must be free of material misstatements in order to be of use to decision makers.

A misstatement is an errorAn unintentional misstatement of financial information. (made accidentally) or fraudAn intentional misstatement of financial information; it can result from misappropriation of assets (theft) or fraudulent financial reporting. (done intentionally) where reported figures or words actually differ from the underlying reality. In simple terms, the information is wrong.

For example, a corporate official could erroneously record a $100,000 expenditure that was made in connection with the construction of a new building as if it pertained to the purchase of land. Consequently, the building’s cost might be reported as only $2.3 million when it was actually $2.4 million. This reported number is misstated; it is wrong. The balance presented for the building contains a $100,000 error, as does the figure shown for land. This misstatement, though, might not be viewed as material.

A misstatement is deemed to be material if it is so significant that its presence would impact a decision made by an interested party. Using the previous illustration, assume the accidental $100,000 reduction in the reported cost of this building leads an outside decision maker to alter a choice being made (such as whether to buy or sell the business’s capital stock or whether to grant a loan). Because of the change in the decision, the misstatement is judged to be material by definition. If no decision is affected, a misstatement is not material, and its existence does not prevent the reported information from still being fairly presented. The reported information is usable for decision making.

Financial information can (and almost always does) contain misstatements. However, the reporting entity must take adequate precautions to ensure that reported information holds no material misstatements for the simple reason that it is no longer fairly presented. If any material misstatements exist within the information, the portrait of the organization is not a proper likeness of the model. The decision maker is being misled.

The concept of materiality can seem rather nebulous. For the financial statements of a small convenience store, a $10 misstatement is not material whereas a $10 million one certainly is. For a business with real estate holdings of $30 billion, even a $10 million misstatement is probably not material. The problem for the accountant is determining where to draw the line for a particular organization. That is one of the most difficult decisions for any financial accountant. An exact dollar amount for materiality is virtually impossible to identify because it is a measure of the effect of a misstatement on an external party’s judgment.

Other than sheer magnitude, the cause of the problem must also be taken into consideration. An accidental mistake of $100,000 is less likely to be judged material than one of $100,000 that resulted from a fraudulent act. Fraud occurs when someone wants to misrepresent reported numbers to make the organization look differently than it is or to cover theft. Fraud includes the intent to deceive and is more troublesome to decision makers than a mere error. Thus, both size and cause should be weighed in considering whether the presence of a misstatement has the ability to impact the actions of any decision makers.

Consequently, a financial accountant never claims that reported information is correct, accurate, or exact. Such precision is rarely possible and not needed when decision makers are analyzing the financial health and future prospects of an organization. However, the accountant must take all precautions necessary to ensure that reported data contain no material misstatements. Financial figures are never released without reasonable assurance being obtained that no errors or other mistakes are included that could be material, or in other words, that could impact the decisions that are made. All parties need to believe that reported information can be used with confidence because it presents a fair likeness of the organization as a whole.

When a company reports that a building was constructed at a cost of $2.3 million, the real message is that the actual cost was not materially different from $2.3 million. This figure is a fair representation of the amount spent, one that can be used in making decisions about the organization such as whether to invest in its capital stock or provide it with a loan.

Uncertainty, the True Challenge for Reporting

Question: Financial accounting figures can certainly be exact. If a cash register is bought for $836.54, the reported cost is $836.54. However, decision makers do not need financial figures with such absolute accuracy. If reported information is presented fairly, in other words if it contains no material misstatements, it can be used to estimate a corporation’s future stock prices, cash dividend payments, and cash flows. Even if not necessary for decision makers, what prevents reported financial information from being correct in an absolute sense? Why are all reported figures not as precise as the reporting of the cash register?

Answer: In truth, a reasonable percentage of numbers reported in a set of financial statements are exact. Materiality is not an issue in such cases. The cash register mentioned here has a reported cost of $836.54—a precise measure of the amount paid. Likewise, a cash balance shown as $2,785.16 is exact to the penny. However, many of the other figures reported by an organization do not lend themselves to such accuracy.

The primary reason that exactness is not a goal—often not even a possibility in financial accounting—can be summed up in a single word: uncertainty. Many of the events encountered every day by an organization contain some degree of uncertainty. Unfortunately, no technique exists to report uncertain events in precise terms.

When first introduced to financial accounting, many students assume that it is little more than the listing of cash receipts and disbursements in much the same way that elementary school children report how they spent their weekly allowances. That is a misconception. Financial accounting is a structured attempt to paint a fairly presented portrait of an organization’s overall operations, financial condition, and cash flows. This requires the reporting of many events where a final resolution might not occur for months or even years. Here are just a few examples of the kinds of uncertainty that virtually every business (and financial accountant) faces in creating financial statements.

• A business is the subject of a lawsuit. Perhaps a customer has filed this legal action claiming damage as a result of one of the company’s products. Such legal proceedings are exceedingly common and can drag on in the courts for an extended period of time before a settlement is reached. The actual amount won or lost (if either ever occurs) might not be known for years. What should the business report now?
• A sale of merchandise is made today for $300 with the money to be collected from the customer in several months. Until the cash is received, no one can be sure of the exact amount that will be collected. What should the business report now?
• An employee is promised a cash bonus next year that will be calculated based on any rise in the market price of the corporation’s capital stock. Until the time passes and the actual increase (if any) is determined, the amount of this bonus remains a mystery. What should the business report now?
• A retail store sells a microwave oven today with a warranty. If the appliance breaks at any time during the next three years, the store has to pay for the repairs. No one knows whether the microwave will need to be fixed during this period. What should the business report now?

Any comprehensive list of the uncertainties faced regularly by most organizations would require pages to enumerate. Many of the most important accounting rules have been created to establish requirements for the reporting of uncertain situations. Because of the quantity and variety of such unknowns, exactness simply cannot be an objective of financial reporting.

For many accountants, dealing with so much uncertainty is the most interesting aspect of their job. Whenever an organization encounters a situation of this type, the accountant must first come to understand what has happened and then determine a logical method to communicate a fair representation of that information within the framework provided by financial accounting rules. Thus, reporting events in the face of uncertainty is surely one of the major challenges of being a financial accountant.

Accounting as the Language of Business

Question: Accounting is sometimes referred to as the “language of business.” However, in this book, financial accounting has already been compared to the painting of a fairly presented portrait of an organization. Given the references throughout this chapter to painting, is accounting really a type of language? Is it possible for accounting to paint portraits and also be a language?

Answer: The simple answer to this question is that accounting is a language, one that enables an organization to communicate a portrait of its financial health and future prospects to interested parties by using words and numbers rather than oils or watercolors. The formal structure of that language becomes especially helpful when an organization faces the task of reporting complex uncertainties.

Any language, whether it is English, Spanish, Japanese, or the like, has been developed through much use to allow for the effective transfer of information between two or more parties. If a sentence such as “I drive a red car” is spoken, communication is successful but only if both the speaker and the listener have an adequate understanding of the English language. Based solely on the arrangement of these five words, information can be passed from one person to the another.

This process succeeds because English (as well as other languages) relies on relatively standardized terminology. Words such as “red,” “car,” and “drive” have defined meanings that the speaker and the listener both know with a degree of certainty. In addition, grammar rules such as syntax and punctuation are utilized to provide a framework for the communication. Thus, effective communication is possible in a language when

1. Set terminology exists
2. Structural rules and principles are applied

As will be gradually introduced throughout this textbook, financial accounting has its own terminology. Many words and terms (such as “LIFO” and “accumulated depreciation”) have very specific meanings. In addition, a comprehensive set of rules and principles has been established over the decades to provide structure and standardization. They guide the reporting process so that the resulting information will be fairly presented and can be readily understood by all interested parties, both inside and outside of the organization.

Some students who read this textbook will eventually become accountants. Those individuals must learn specific terminology, rules, and principles in order to communicate financial information about an organization that is presented fairly. Others (probably most readers) will become external decision makers. They will make financial decisions. They will evaluate loan applications, buy capital stock, grant credit, make employment decisions, provide investment advice, and the like. They will not present financial information with all of its uncertainties but rather they will need to make use of it. The more such individuals know about financial accounting terminology, rules, and principles, the more likely it is that they will arrive at appropriate decisions.

To communicate a portrait properly in any language, both the speaker and the listener must understand the terminology as well as the structural rules and principles. That holds true even if the language is financial accounting.

The Existence of Formal Accounting Standards

Question: Rules and principles exist within financial accounting that must be followed. They provide the structural guidance that is essential for achieving effective communication. For example, assume that a reporting organization encounters an uncertainty (such as a lawsuit) and is now preparing financial information to portray the reality of that event. When faced with such complexity, how does the financial accountant know which method of reporting is appropriate? How does a decision maker who analyzes that reported information know what guidelines were used in its preparation?

Answer: The existence of financial accounting standards is essential to ensure that all communicated information is understood properly. Both the accountants within the reporting organization and the decision makers analyzing the resulting financial statements must understand those rules. The question that has haunted the accounting profession in recent times is, who should have the authority to create those standards?

For decades, a wide variety of formal accounting principles were developed in the United States as well as throughout the rest of the world. Japanese accounting rules evolved differently from those in Australia while Australian standards were not consistent with those in the United States. In earlier times, such country-by-country rules caused few problems because most businesses operated solely within their country’s boundaries. During the past ten years or so, as a truly global economy became a reality, two primary systems of accounting rules emerged. U.S. Generally Accepted Accounting Principles (U.S. GAAP)A recognized set of accounting rules used and followed in the United States; it is created and updated by the Financial Accounting Standards Board (FASB). are applied to most financial information presented within the United States. International Financial Reporting Standards (IFRS) are now used almost exclusively in the rest of the world. In accounting at the present time, two languages exist rather than one.

Having two bodies of rules causes problems for decision makers. For example, on its Web site, BP presents a 2010 set of financial statements prepared according to IFRS. One of its biggest competitors, Exxon Mobil, posted its own 2010 financial statements, but those amounts and explanations were created by following U.S. GAAP. Clarity and understanding are not enhanced when different communication standards are applied by such similar businesses.

Not surprisingly, many corporate officials and decision makers would prefer to see one universal set of accounting standards. If that were to happen, a corporation in Michigan and a corporation in Germany would produce comparable financial information that could be utilized for all reporting purposes around the world.

Over the past few years, extensive progress has been made in bringing these two sets of standards into alignment. However, a number of significant differences continue to exist. Many interested parties want to see IFRS adopted exclusively in the United States. According to this group, it is unlikely that the rest of the world will choose to follow U.S. GAAP so harmony can only be achieved by a general acceptance of IFRS. Others believe that U.S. GAAP is a superior system and should not be abandoned.

The debate has been intense and promises to continue to be so until some type of official resolution occurs.

At the time of this writing, U.S. GAAP continues to be the required system for most of the financial reporting found in the United States although a mandated switch to IFRS (in some form) during the next few years is quite possible. Because of the current situation and the uncertainty as to how legal requirements will eventually change, this textbook is primarily a presentation of U.S. GAAP. For the most part, U.S. GAAP and IFRS are based on the same accounting principles. However, varying interpretations of those principles have resulted in differences between U.S. GAAP and IFRS standards. In areas where IFRS disagrees with U.S. GAAP in significant ways, both methods of reporting will be described in this textbook.

The Development of Accounting Standards

Question: Whether in the form of U.S. GAAP or IFRS, financial accounting standards must be created in some logical fashion. Who is in charge of the production of formal accounting standards? How often do these official standards come into existence?

Answer: The Financial Accounting Standards Board (FASB) has held the authority to develop U.S. GAAP since 1973. An abundance of information can be found about this board and its activities by going to http://www.fasb.org/ and clicking on “About FASB.”

IFRS are produced by the London-based International Accounting Standards Board (IASB). This group took over responsibility for international standards from a predecessor group in 2001. Information about the resulting official pronouncements and the standard setting process is available at http://www.iasb.org/ by clicking on “About us.”

Although some basic elements of accounting standards have been in use almost throughout history, many reporting rules are relatively new—often developed within the last few decades. Whether U.S. GAAP or IFRS, accounting standards evolve quite quickly as the nature of business changes and new reporting issues, problems, and resolutions arise. The growth of advanced technology speeds this process even more quickly. Fairly important changes in the formal structure of accounting rules occur virtually every year.

In the United States, the existence of U.S. GAAP means that a business in Seattle, Washington, and a business in Atlanta, Georgia, must account for financial information in much the same manner. As will be discussed later in this textbook, a few allowed alternatives do exist in connection with specific reporting challenges.

Because standardization exists in most areas of the reporting process, any decision maker with an adequate knowledge of financial accounting—whether located in Phoenix, Arizona, or in Portland, Maine—should be able to understand the fairly presented financial information conveyed by a wide variety of organizations. They all speak the same language. Put simply, the existence of accounting standards enables organizations and other interested parties to communicate successfully.

The Importance of Accounting Standards

Question: Several years ago, a front page article in the Wall Street Journal contained a controversial assessment of U.S. GAAP: “When the intellectual achievements of the 20th century are tallied, GAAP should be on everyone’s Top 10 list. The idea of GAAP—so simple yet so radical—is that there should be a standard way of accounting for profit and loss in public businesses, allowing investors to see how a public company manages its money. This transparency is what allows investors to compare businesses as different as McDonald’s, IBM and Tupperware, and it makes U.S. markets the envy of the world.”Clay Shirky, “How Priceline Became a Real Business,” Wall Street Journal, August 13, 2001, A-12.

Could formal accounting standards be so very important? Can the development of U.S. GAAP possibly be one of the ten most important intellectual achievements of the entire twentieth century? A list of other accomplishments during this period includes air travel, creation of computers, birth of the Internet, landing on the moon, and the development of penicillin. With that level of competition, U.S. GAAP does not seem an obvious choice to be in the top ten. How can it be so important?

Answer: The United States has a capitalistic economy, which means that businesses are (for the most part) owned by private citizens and groups rather than by the government. To operate and grow, these companies must convince investors and creditors to contribute huge amounts of their own money voluntarily. Not surprisingly, such financing is only forthcoming if the possible risks and rewards can be assessed and then evaluated with sufficient reliability. Before handing over thousands or even millions of dollars, decision makers must believe that they are using reliable data to make reasonable estimations of future stock prices, cash dividends, and cash flows. Otherwise, buying stocks and granting credit is no more than gambling. As this quote asserts, U.S. GAAP enables these outside parties to obtain the financial information they need to reduce their perceived risk to acceptable levels. Thus, money can be raised, and businesses can grow and prosper.

Without U.S. GAAP, investors and creditors would encounter significant difficulties in evaluating the financial health and future prospects of an organization.The wide-scale financial meltdown in the world economy that began to be evident in 2008 put a serious strain on the traditional capitalist model. The United States and other governments had to spend billions of dollars to bail out (and, in some cases, take over) major enterprises. Whether U.S. GAAP could have done a better job to help avoid this calamity will probably not be fully known for years. Because of that uncertainty, they would be more likely to hold on to their money or invest only in other, safer options. Consequently, if accounting standards did not exist, the development and expansion of thousands of the businesses that have become a central part of today’s society might be limited or impossible simply because of the lack of available resources. An expanding economy requires capital investment. That funding is more likely to be available when financial information can be understood because it is stated in a common language: U.S. GAAP.

By any method of measurement, the explosive development of the U.S. economy during the twentieth century (especially following World War II) has been spectacular, close to unbelievable. This growth has been fueled by massive amounts of money flowing from inside and outside the United States into the country’s businesses. Much of the vitality of the U.S. economy results from the willingness of people to risk their money by buying capital stock or making loans or extending credit to such companies as McDonald’s, IBM, and Tupperware. Without those resources, most businesses would be small or nonexistent, and the United States would surely be a radically different country.

The Evolution of Accounting Standards

Question: Accounting standards are important to businesses and decision makers alike. FASB is in charge of the creation of U.S. GAAP. As stated, all accounting standards tend to evolve over time. Official rules are modified, deleted, or added every year. How do new accounting standards come into existence?

Answer: As indicated earlier, since 1973, FASB has served as the primary authoritative body in charge of producing U.S. GAAP for nongovernmental entities such as businesses and private not-for-profit organizations. FASB is an independent group supported by the U.S. government, various accounting organizations, and many private businesses.

Typically, accounting problems arise over time within the various areas of financial reporting. New types of financial events can be created, for example, that are not covered by U.S. GAAP or, perhaps, weaknesses in earlier rules start to become evident. If such concerns grow to be serious, FASB steps in to study the issues and alternatives. After a period of study, the board might pass new rules or make amendments to previous ones. FASB is methodical in its deliberations, and the entire process can take years. Changes to U.S. GAAP are never made without proper consideration.

Several other official bodies also play important roles in the creation of U.S. GAAP. They are normally discussed in detail in upper-level accounting textbooks. However, the major authority for the ongoing evolution of U.S. GAAP lies with FASB and its seven-member board. It has released scores of official statements during its first four decades of existence. The impact that those rulings have had on U.S. GAAP and the financial reporting process in this country is almost impossible to overemphasize.

As just one example, FASB recently made a number of changes in the required reporting of receivables because of the chance that some (perhaps many) of these balances would not be collected. Possibly as a result of the current economic difficulties around the world, the members of FASB felt that more information was needed from organizations to inform decision makers about the risk involved with the collection of these receivables. This type of evolution takes place frequently in the language known as financial accounting. Whether U.S. GAAP or IFRS, financial accounting rules must be updated as needed to meet current informational needs.

In 2009, FASB combined all authoritative accounting literature into a single source for U.S. GAAP, which is known as the Accounting Standards Codification. By bringing together hundreds of authoritative documents, FASB has made U.S. GAAP both more understandable and easier to access. A multitude of pronouncements has been woven together in a logical fashion so that all rules on each topic are now gathered in one location.

Assets, Liabilities, Revenues, and Expenses

Question: Attaining a thorough understanding of financial accounting and its underlying standards is a worthwhile endeavor especially if a person hopes to become successful at making decisions about businesses or other organizations. Where should the journey to gain knowledge of financial accounting and its principles begin?

Answer: The study of a language usually starts with basic terminology. That is also an appropriate point of entry for an exploration into financial accounting. Consequently, four fundamental terms are introduced here in this section. Knowledge of these words is essential in gaining an understanding of accounting because they serve as the foundation for a significant portion of the financial information provided by any organization.

To illustrate, when examining the financial statements presented by Sears (formally known as Sears Holdings Corporation) for January 29, 2011, and the year then ended, four monetary balances immediately stand out because of their enormous size. On this date, the corporation reported $24.3 billion in assetsProbable future economic benefits owned or controlled by an organization. along with $15.6 billion in liabilitiesProbable future sacrifices of economic benefits arising from present obligations; the debts of an organization.. During that year, Sears generated revenuesMeasures of the increases in or inflows of net assets (assets minus liabilities) resulting from the sale of goods and services. of $43.3 billion and incurred expensesMeasures of decreases in or outflows of net assets (assets minus liabilities) incurred in connection with the generation of revenues. of $43.2 billion.

• Assets
• Liabilities
• Revenues
• Expenses

There are thousands of words and concepts found in accounting. No terms are more crucial to a comprehensive understanding of the reporting process than these four. Almost all discussions concerning financial information, whether practical or theoretical, come back to one or more of these words.

Definition of the Term “Asset”

Question: The first essential term presented here is “asset.” Is an asset a complicated accounting concept? What general information is conveyed to a decision maker by the term “asset”?

Answer: Simply put, an asset is a probable future economic benefit that an organization either owns or controls.This is one of the opening chapters in an introductory financial accounting textbook. Definitions are somewhat simplified here so that they will be more understandable to students who are just beginning their exploration of accounting. Many terms and definitions will be expanded in later chapters of this textbook or in upper-level financial accounting courses. On January 29, 2011, Sears reported holding over $24.3 billion of these economic benefits. If a customer walks into one of the company’s retail stores, many of these assets are easy to spot. The building itself may well be owned by Sears and certainly provides a probable future economic benefit by allowing the company to display merchandise and make sales. Other visible assets are likely to include cash registers, the cash held in those machines, available merchandise from jewelry to car tires to children’s clothing (usually referred to as inventoryA current asset bought or manufactured for the purpose of selling in order to generate revenue. in financial accounting), shopping carts, delivery trucks, and the shelves and display cases. Each of those assets is acquired with the hope that it will help Sears prosper in the future.

Examples of Typical Assets

Question: All decision makers who evaluate the financial health and future prospects of an organization should be interested in learning about its assets because those balances reflect the economic resources held at the present time. This is valuable information. What are some of the largest asset balances that a business like Sears is likely to report?

Answer: Every business has its own particular mix of assets. Virtually all have cash and accounts receivable (money due from customers). Many also have inventory (merchandise held for resale). The size and type of other assets will vary significantly based on the company and the industry in which it operates.

However, as a result of financial reporting and the existence of the Internet, such information is readily available to anyone wanting to learn about virtually any business. The assets are reported in the financial statements. As of January 29, 2011, the following four assets were reported by Sears as having the highest dollar amounts. Each of these asset categories will be discussed in detail later in this textbook.

Definition of the Term “Liability”

Question: As of January 29, 2011, Sears also reports owing more than $15.6 billion in liabilities. Does this figure reflect the total amount that the reporting company will eventually have to pay to outside parties? What does the balance reported as liabilities represent?

Answer: A more formal definition of a liability is that it is a probable future sacrifice of economic benefits arising from present obligations, but, for coverage here at the introductory level, liabilities can be viewed as the debts of the organization.

The $15.6 billion liability total disclosed by Sears most likely includes (1) amounts owed to the vendors who supply merchandise to the company’s stores, (2) notes due to banks as a result of loans, (3) income tax obligations, and (4) balances to be paid to employees, utility companies, advertising agencies, and the like. The amount of such liabilities owed by many businesses can be staggering. Walmart, for example, disclosed approximately $109 billion in liabilities as of January 31, 2011. Even that amount pales in comparison to the $627 billion liability total reported by General Electric at the end of 2010. To ensure that a fairly presented portrait is shown to decision makers, businesses such as Sears, Walmart, and General Electric must make certain that the reported data contain no material misstatements. Thus, all the information that is provided about liabilities should be based on the rules and principles to be found in U.S. GAAP.

Another term that is often encountered in financial reporting is “net assets.” The net asset total for an organization is simply its assets (future benefits) less its liabilities (debts). This balance is also known as “equity” in reference to the owners’ rights to all assets in excess of the amount owed on liabilities. A business’s net assets will increase if assets go up or if liabilities decrease. Changes in net assets show growth (or shrinkage) in the size of the organization over time. For example, IBM reported net assets of $22.7 billion at the end of 2009 (assets of $109.0 billion and liabilities of $86.3 billion). That number had risen to $23.2 billion by the end of 2010 (assets of $113.5 billion and liabilities of $90.3 billion). The ability of this business to increase its net assets by $500 million ($33.2 billion less $32.7 billion) during 2010 is certainly of interest to every decision maker analyzing the financial health and future prospects of IBM.

Definition of the Term “Revenue”

Question: In financial accounting, a business or other organization reports its assets, which are probable future economic benefits, such as buildings, equipment, and cash. Liabilities (debts) are also included in the financial information being disclosed. Both of these terms seem relatively straightforward. The third essential term to be discussed at this time—revenue—is one that initially appears to be a bit less clear. Sears reported that its stores generated revenues of $43.3 billion in 2010 alone. What does that tell a decision maker about Sears? What information is conveyed by the reporting of a revenue balance?

Answer: “Revenue” is a measure of the financial impact on an organization that results from a particular process. This process is a sale. A customer enters a Sears store at the local mall and pays $100 to purchase several items, such as hammers, shirts, socks, and scarves. Sears receives an asset—possibly $100 in cash. This asset inflow into the business results from a sale and is called revenue. Revenue is not an asset; it is a measure of the increase in net assets created by the sale of inventory and services. Thus, for The Coca-Cola Company, revenues are derived (net assets are increased) from the sale of soft drinks. For The Hershey Company, revenues come from sales of chocolate whereas The Walt Disney Company generates revenue by selling admission to its amusement parks and movies.

For timing purposes, as will be discussed in a later chapter, revenue is recognized when the earning process takes place. That is normally when the goods or services are delivered. Therefore, throughout each day of the year, Sears makes sales to customers and accepts cash, checks, or credit card payments. The reported revenue figure is merely a total of all sales made during the period, clearly relevant information to any decision maker attempting to determine the financial prospects of this company. During 2010, the multitude of Sears stores located both inside and outside the United States sold inventory and services and received $43.3 billion in assets in exchange. That is the information communicated by the reported revenue balance. To reiterate, this figure is not exact, precise, accurate, or correct. However, according to Sears, $43.3 billion is a fairly presented total determined according to the rules of U.S. GAAP so that it contains no material misstatement. Any outside party analyzing Sears should be able to rely on this number with confidence in making possible finanical decisions about this business as a whole.

Definition of the Term “Expense”

Question: That leaves “expense” as the last of the four essential accounting terms introduced at this point. Sears reported $43.2 billion in total expenses during 2010. This figure apparently is important information that helps paint a proper portrait of the company, a portrait that can be used by decision makers. What is an expense?

Answer: An expense is an outflow or reduction in net assetsAn expense often causes an immediate reduction in assets, especially if cash is paid. Frequently, though, an expense creates an increase in liabilities instead of a reduction in assets. That happens if the cost is incurred but payment is delayed until a later date. In either case—the reduction of an asset or the creation of a liability—the amount of net assets held by the organization decreases as a result of the expense. that was incurred by an organization in hopes of generating revenue. To illustrate, assume that—at the end of a week—a local business pays its employees $12,000 for the work performed during the previous few days. A $12,000 salary expense must be reported. Cash (an asset) was reduced by that amount, and this cost was incurred because the company employed those individuals to help generate revenues. That is an expense. The same general logic can be applied in recording insurance expense, rent expense, advertising expense, utility expense (such as for electricity and water), and many other similar costs. For each, net assets are reduced (assets go down or liabilities go up) to help create sales.

In some ways, expenses are the opposite of revenues that measure the inflows or increases in net assets that are created by sales. Expense figures reflect outflows or decreases in net assets incurred in hopes of generating revenues.

Four Essential Terms Encountered in Financial Accounting

Question: To reiterate, four terms are basic to an understanding of financial accounting. Almost any coverage of accounting starts with these four. What is the meaning of asset, liability, revenue, and expense?

Answer:

• Asset. A probable future economic benefit owned or controlled by the reporting company, such as inventory, land, or equipment.
• Liability. A probable future economic sacrifice or, in simple terms, a debt.
• Revenue. A measure of the inflow or increase in net assets generated by the sales made by a business. It is a reflection of the amounts brought in by the sales process during a specified period of time.
• Expense. A measure of the outflow or reduction in net assets caused by a business’s attempt to generate revenue and includes many common costs, such as rent expense, salary expense, and insurance expense.