The Effect of Accounting Principles on Financial Statements

Now that you have been introduced to many of the underlying accounting principles and concepts, let’s examine what they mean for a company’s financial reporting.

Distributing a complete set of financial statements

The accounting profession believes that a single financial statement is not sufficient for someone to understand a company’s financial affairs. Therefore, if a company releases its financial statement(s) to someone outside of the company, it should distribute a set of financial statements containing the following:

  • Income statement
  • Statement of comprehensive income
  • Balance sheet
  • Statement of stockholders’ (or owner’s) equity
  • Statement of cash flows
  • Notes to the financial statements

The balance sheet reports the assets, liabilities, and stockholders’ equity as of the final moment of the accounting period (December 31, June 30, etc.).

The other financial statements report the amounts that occurred throughout the accounting period shown in the heading (year ended December 31, three months ended June 30, etc.).

The notes to the financial statements are referenced on each financial statement to inform the user that the notes are an integral part of each financial statement. The notes are necessary because a company’s business activity cannot be communicated completely by the amounts appearing on the face of the financial statements.

In addition to complying with US GAAP, corporations with capital stock that is traded on a stock exchange must also comply with some additional rules and communication required by the U.S. Securities and Exchange Commission (SEC). Regular U.S. corporations must also comply with federal and state income tax reporting regulations.

Accrual Method of Accounting

To properly (report) revenues and expenses on the income statement, and assets and liabilities on the balance sheet, companies must use the accrual method of accounting (or accrual accounting). The following examples illustrate accrual accounting:

  • Revenues are reported on the income statement when they have been earned. Generally, this means there will also be a related asset reported on the company’s balance sheet, such as cash or accounts receivable. In accounting terminology, the revenues and the related asset are recognized (reported on the financial statements) when the revenues and asset have been earned.

    A simple example of revenue recognition occurs when a company completes a service for $5,000 on December 28. On the same day, the company bills the customer $5,000 with credit terms of net 30 days. A month later (on January 29) the company receives the $5,000.

  • On December 28, the company records a $5,000 increase in its current asset account Accounts Receivable and a $5,000 increase in its income statement account Revenues Earned. On January 29, when the company receives the $5,000, it will increase its cash by $5,000 and will reduce its accounts receivable by $5,000.

  • Expenses are reported (recognized) on the income statement when an expense occurs. The date of the company’s payment to the vendor is not relevant.

    To illustrate, assume that a company incurs a $3,000 repair expense on December 26. On December 28, the company receives the vendor’s invoice stating that the bill is to be paid within 15 days. On January 8, the company pays $3,000 to the vendor.

    The company must record the $3,000 increase in its expenses and liabilities as of December 26 or 28. When the company pays the vendor $3,000 on January 8, the company will decrease its cash balance and will decrease its liabilities.

In short, the company’s financial statements are more complete when the accrual method is used.

To comply with the accrual method, companies record adjusting entries as of the final day of the accounting period. Adjusting entries make certain that the proper amount of expenses and liabilities, and the proper amount of revenues and assets, are reported on the appropriate period’s financial statements.

Revenues Reported on the Income Statement

Under the accrual method, revenues are reported or recognized on the company’s income statement for the period in which the revenues were earned.

Depending on the transactions, revenues may be earned and reported on a company’s income statements at any of the following times:

  • Before receiving the money from customers (sales and services were provided on credit)
  • At the time customers pay (cash sales)
  • After money is received from customers (some future services were required)

To achieve the accrual method, companies will make the following revenue-related adjusting entries at the end of the accounting period to:

  • Accrue revenues (and the related receivables) that were earned, but the company had not yet billed the customer
  • Defer revenues (and the related liabilities) for money received from customers, but not yet earned by the company

In 2014, the FASB issued an Accounting Standards Update (ASU) entitled Revenue from Contracts with Customers (Topic 606) which provides extensive guidance for reporting revenues on the income statement.

Expenses Reported on the Income Statement

Under the accrual method, expenses are to be reported (recognized) on the company’s income statement during the accounting period in which the expenses:

  • Were caused by revenues (e.g., matching the cost of goods sold and sales commissions with the related revenues)

  • Expired or were used up (e.g., matching prepaid insurance to the accounting periods in which the prepaid amount had expired; systematically allocating the cost of equipment used in the business to the accounting periods in the equipment’s useful life)

  • Had no future economic benefit that could be measured (e.g., advertising expense, office salaries, research expenses)

To achieve the accrual method, companies will make accrual, deferral, depreciation, and other adjusting entries for expenses at the end of each accounting period.

To learn more, visit our Explanation of Income Statement.

Assets Reported on the Balance Sheet

The cost principle (or historical cost principles) means that a company’s assets are recorded at their cost at the time of the transaction. Once recorded, the cost of most assets (some marketable investment securities are an exception) will not be increased because of inflation or increases in market value.

To illustrate, assume that 18 years ago a company purchased a parcel of land for its future use at a cost of $50,000. Today, the market value of the land is $300,000. The company’s current balance sheet will report the land at its cost of $50,000.

A company that sells goods will report its inventory at its cost, not at the sales value.

The cost principle prevents a company from recording and reporting its talented employees as assets. Similarly, a company’s brands and logos that were developed internally and enhanced through advertising expenses cannot be reported as assets.

If an asset’s fair value drops below its book or carrying value, the asset’s book value may have to be decreased and an impairment loss reported on the income statement.

Liabilities Reported on the Balance Sheet

Liabilities are a company’s obligations resulting from a past transaction. Typical liabilities include accounts payable, notes or loans payable, wages payable, interest payable, taxes payable, customer deposits, deferred revenue, and more.

At the end of each accounting period, there will be amounts owed by a company, but the company has not yet been billed or has not yet processed the transaction. A few examples include:

  • Interest on loans payable
  • Electricity and gas charges
  • Wages for hourly paid employees that have been earned but not yet processed
  • Repair work that was recently done by a contractor

These obligations and the related expense must be recorded for the financial statements to be complete and to comply with the accrual method of accounting. This is done with accrual-type adjusting entries.

Stockholders’ Equity Reported on the Balance Sheet

Stockholders’ equity or shareholders’ equity is the difference between the amount of a corporation’s assets and liabilities that are reported on the balance sheet. (Owner’s equity is the difference between a sole proprietorship’s assets and liabilities.)

Since most of a company’s assets are reported at cost (or lower), the amount reported as stockholders’ equity is not an indicator of the corporation’s market value. Picture a service business that has developed amazing software that generates huge fees with little expenses and the owners draw out most of the profits. As a result, this service business is extremely valuable but has only a small amount reported on its balance sheet for assets and stockholders’ equity.

To learn more, visit our Explanation of Balance Sheet.

Notes to the Financial Statements

The full disclosure principle requires that sufficient financial information be presented so that an intelligent person can make an informed decision. As a result of this principle, it is common to find many pages of notes to the financial statements.

A few examples of the many items disclosed in the notes to the financial statements include:

  • Summary of significant accounting policies
  • Leases
  • Income taxes
  • Employee benefit plans
  • Stock options
  • Commitments and contingencies