Understanding Financial Statements and Accounting Principles

Posted on Sep 5, 2024 in Economy

Balance Sheet

Current Assets

  • Liquidity
  • Cash
  • Marketable Securities
  • Prepaid Expenses

Current Liabilities (Due Within One Year)

  • Accounts Payable
  • Salaries Payable
  • Accrued Expenses

Long-Term Liabilities

  • Notes Payable
  • Leases
  • Bonds Payable

Income Statement

Revenue: Recognized when earnings are substantially complete.

Expenditures (Historical Costs): All assets/liabilities are recorded at cost.

Conservatism

  1. Accountants strive to avoid overly optimistic financial statements.
  2. Conservatism guides accountants to choose the approach least likely to overstate assets and income.
  3. This convention applies only when uncertainty or doubt exists. It aims to avoid overly optimistic financial statements by anticipating and recording possible losses (a pessimistic approach) to offset natural optimism. This approach is least likely to overstate assets and income.

Revenue Recognition Principle

Revenue is recognized when:

  • An exchange transaction has occurred.
  • The entity has completed or virtually completed the earnings process.

Matching Principle

Accuracy: Offset expenses against the resulting revenues in the same accounting period wherever feasible. If the revenue recognition principle prevents an entity from recognizing certain revenue, the income statement should not subtract the expenses necessary to produce that revenue.

Consistency Principle

Economic events should receive the same accounting treatment from one accounting period to the next.

Allowance for Doubtful Accounts

The decision to establish an allowance is based on available information and must be justifiable. If a company has a reasonable basis to determine payment is probable, no allowance is needed. However, if a customer has a poor payment history, an allowance may be necessary, especially at the end of the reporting period. The nature of the business is significant. Unlike companies generating revenue from goods sales, charities rely heavily on incoming funds to settle debts. Therefore, repayment terms should be considered alongside the customer’s payment history. A pattern of late payments might justify an allowance, even without a missed due date. Personal relationships or feelings are not valid reasons to record or not record an allowance. Information received after the fiscal year-end requires determining if it was previously known. A proper inquiry during and near the year-end should have revealed any discrepancies. Analyzing payment patterns and comparing them to other customers is crucial. Arguably, the accounting decision not to record an allowance should be based on available information at the time. A full allowance against accounts receivable is essentially a write-off and might be overly conservative. When determining the journal entry, consider if the information was received before the financial statements were issued, even if after the fiscal year-end.

Factors to Consider

  • Concentration Risk: If a single customer represents a significant portion of revenues or accounts receivable, a payment default would be material and requires special consideration.
  • Payment History: A good payment history makes an allowance less likely.
  • Nature of Business: Some industries, like school districts, have a higher likelihood of receiving payments.
  • Bank Loans: While borrowing to pay off accounts receivable could indicate payment issues, banks conduct thorough due diligence before granting loans.
  • Payment Lags: Consistent delays in payments might warrant an allowance.
  • Aggressive Revenue Recognition: Seeking additional revenue through questionable sales raises concerns about earnings management and requires scrutiny.
  • New Customers: Lack of payment history and credit review (a violation of internal controls) makes it difficult to assess creditworthiness.

Revenue Recognition (GAAP)

Recognize revenue when:

  1. A bona fide exchange transaction with an external party has occurred.
  2. The enterprise has received cash or the right to receive cash, or can readily convert any other consideration received into cash or cash equivalents.
  3. The earnings process is substantially completed.

Revenue Recognition (SEC)

  1. Presumptively demonstrate the existence of an arrangement.
  2. The enterprise must have delivered the product or performed the services.
  3. The arrangement must contain a fixed or determinable sales price.
  4. There must be reasonable assurance of collectibility.

Sham Transactions

Transactions where the form satisfies the exchange transaction requirement but the substance or economic realities do not. A transfer of risk must occur to qualify as a genuine exchange.

Deferred Revenue

A liability representing cash received for goods or services to be delivered in a future accounting period. As the income is earned, the related revenue is recognized, and deferred revenue is reduced.

Buyback Agreements

If a company sells a product with an agreement to buy it back later, and the buyback price covers all inventory costs and related expenses, the inventory remains on the seller’s books. This is not considered a sale.

Returns

Companies unable to reasonably estimate future returns or with extremely high return rates should recognize revenue when the return right expires. Companies that can estimate returns and have relatively low return rates can recognize revenue at the point of sale but must deduct estimated future returns. If there’s a high degree of uncertainty about collectibility, revenue recognition should be deferred.

Installment Sales

This method allows recognizing income proportionally to the cash collected, based on the gross profit percentage. Unearned income is deferred and recognized as cash is collected. For example, if 45% of the total price is collected, 45% of the total profit can be recognized.

Cost Recovery Method

: when  these ir an extremely high probabiooity of uncollectable payments. no profit is recognized until cashh colletiosn exceed the sellers cost-ex. sold asset for 10k for 15 k.  can star twhen buyer pays more than 10k.  Deposit0can’t record until transfer of title.

 Depreciation:  The transfer of a potition fo the asset’s cost from the balance sheet ot the income statment during each eyar of the asset’s life.  Cost of asset = 10.5k less SV – 500 Depreciable basae 0f 10k years of useful life = 5.  depreciation expense per year = 2000.