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Explain the importance of financial accounting information for external partiesprimarily investors and creditorsin terms of the objectives and the characteristics of that information.
Financial accounting is an important subject for students who need only an introduction to the field of accounting, as well as for students who will pursue accounting as a major and take many additional accounting courses. Financial accounting provides information about the financial resources, obligations, and activities of an enterprise that is intended for use primarily by external decision makersinvestors and creditors.
EXTERNAL USERS OF ACCOUNTING INFORMATION
What do we mean by external users and who are they? External usersIndividuals and other enterprises that have a financial interest in the reporting enterprise but that are not involved in the day-to-day operations of that enterprise (e.g., owners, creditors, labor unions, suppliers, customers). of accounting information are individuals and other enterprises that have a current or potential financial interest in the reporting enterprise, but that are not involved in the day-to-day operations of that enterprise. External users of financial information may include the following:
- Potential investors
- Labor unions
- Governmental agencies
- Trade associations
- General public
Each of these groups of external decision makers requires unique information to be able to make decisions about the reporting enterprise. For example, customers who purchase from the enterprise need information to allow them to assess the quality of the products they buy and the faithfulness of the enterprise in fulfilling warranty obligations. Governmental agencies such as the Federal Trade Commission may have an interest in whether the enterprise meets certain governmental regulations that apply. The general public may be interested in the extent to which the reporting enterprise is socially responsible (for example, does not pollute the environment).
Providing information that meets the needs of such a large set of diverse users is difficult, if not impossible, in a single set of financial information. Therefore, external financial reporting is primarily used by two groupsinvestors and creditors. As you will soon see, investors are individuals and other enterprises that own the reporting enterprise. Creditors, on the other hand, are individuals and other enterprises to whom the reporting entity owes money, goods, or services. For example, a commercial bank may have loaned money to the reporting enterprise, or a supplier may have permitted the reporting enterprise to purchase goods and to pay for those goods later. Our assumption is that by meeting the financial information needs of investors and creditors, we provide information that is also useful to many other users of financial information.
For these reasons, we sometimes refer to investors and creditors as the primary external financial information users. When you see references like these, keep in mind that we are talking about both current investors and creditors and those individuals and other enterprises that may become investors and creditors in the future.
OBJECTIVES OF EXTERNAL FINANCIAL REPORTING
If you had invested in a company, or if you had loaned money to a company, what would be your primary financial interest in the company? You probably would be interested in two things, both of which make up the companys cash flow prospectsThe likelihood that an enterprise will be able to provide an investor with both a return on the investors investment and the return of that investment.. You would be interested in the return to you at some future date of the amount you had invested or loaned. We refer to this as the return of your investmentThe repayment to an investor of the amount originally invested in another enterprise.. In addition, you would expect the company to pay you something for the use of your funds, either as an owner or a creditor. We refer to this as the return on your investmentThe payment of an amount (interest, dividends) for using anothers money.. Information that is useful to you in making judgments about the companys ability to provide you with what you expect in terms of the return of your funds as well as a return on your funds while you do not have use of them is what we mean by information about cash flow prospects.
|YOUR TURN||You as a Creditor|| (K)|
You are a loan officer at a bank that makes small loans to individuals to help finance purchases such as automobiles and appliances. You are considering an application from a young woman who needs to purchase a new car. She is requesting a loan of $10,000 which, when combined with the trade-in value of her old car, will allow her to meet her needs. What are your expectations with regard to repayment of the loan, and what information would help you decide whether she is a good credit risk for your bank?
(See our comments on the Online Learning Center Web site.)
Assume that you have a friend who wants to start a business and needs some help getting the money required to rent space and acquire the needed assets to operate the business (for example, delivery truck, display fixtures) and pay employees for their work before the doors open and customers begin paying for the products the company plans to sell. You are in a financially strong position and agree to loan your friend $100,000. Your intent is not to be a long-term investor or co-owner of the business, but rather to help your friend start his company and at the same time earn a return on the funds you have loaned him. Assume further that you agree to let your friend have the use of your $100,000 for one year and, if you had not loaned this amount to him, you could have earned an 8 percent return by placing your money in another investment.
In addition to wanting to help a friend, you are interested in knowing how much risk you are taking with regard to your $100,000. You expect your friend to pay that $100,000 back, and to also pay you an additional amount of $8,000 ($100,000 × 8%) for his use of your money. The total return of your investment ($100,000) back to you one year later, added to the amount you expect to receive for his having used your money for a year ($8,000), is shown in Exhibit 13.
|Exhibit 13||INVESTMENT ANALYSIS|
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Providing information for you to assess your friends ability to meet his cash flow commitment to you is essentially what financial reporting is about. You need information to assess the risk you are taking and the prospects that your friend will be able to deliver $108,000 to you one year from the time you loan him the $100,000. While this is a relatively simple example, it sets the stage for your understanding of the kinds of information that will help you make this important investment decision.
The accounting profession has identified certain objectives of external financial reporting to guide its efforts to refine and improve the reporting of information to external decision makers. These general objectives are displayed in Exhibit 14 and are best understood if studied from the bottom upfrom general to specific.2
|Exhibit 14||OBJECTIVES OF FINANCIAL REPORTING: BUILDING FROM THE GENERAL TO THE SPECIFIC|
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The first objective is the most general and is to provide information that is useful in making investment and credit decisions. As we indicated earlier, investors and creditors are the primary focus of external financial reporting. We believe that, by meeting the information needs of investors and creditors, we provide general information that is also useful to many other important financial statement users.
The second objective, which is more specific than the first, is to provide information that is useful in assessing the amount, timing, and uncertainty of future cash flows. As we discussed earlier, investors and creditors are interested in future cash flows to them, so an important objective of financial reporting is to provide general information that permits that kind of analysis.
The most specific objective of external financial reporting is to provide information about the enterprises resources, claims to those resources, and how both the resources and claims to resources change over time. An enterprises resources are often referred to as assets, and the primary claims to those resources are the claims of creditors and owners, known as liabilities and owners equity.
One of the primary ways investors and creditors assess whether an enterprise will be able to make future cash payments is to examine and analyze the enterprises financial statements. In the general sense of the word, a statement is simply a declaration of something believed to be true. A financial statementA monetary declaration of what is believed to be true about an enterprise., therefore, is simply a monetary declaration of what is believed to be true about an enterprise. When accountants prepare financial statements, they are describing in financial terms certain attributes of the enterprise that they believe fairly represent its financial activities.
Financial statements prepared for periods of time shorter than one year (for example, for three months or one month) are referred to as interim financial statements. Throughout this text, we use both annual and interim financial statements. As you approach a companys financial statementseither as a user or as a preparerit is important to establish the time period those statements are intended to cover.
The primary financial statements are the following:
- Statement of financial position (balance sheet). The balance sheetA position statement that shows where the company stands in financial terms at a specific date. (Also called the statement of financial position.) is a position statement that shows where the company stands in financial terms at a specific date.
- Income statement. The income statementAn activity statement that shows details and results of the companys profit-related activities for a period of time. is an activity statement that shows details and results of the companys profit-related activities for a period of time (for example, a month, quarter [three months], or year).
- Statement of cash flows. The statement of cash flowsAn activity statement that shows the details of the companys activities involving cash during a period of time. is an activity statement that shows the details of the companys activities involving cash during a period of time.
The names of the three primary financial statements are descriptive of the information you find in each. The statement of financial positionA position statement that shows where the company stands in financial terms at a specific date. (Also called the balance sheet.), or balance sheet, for example, is sometimes described as a snapshot of the business in financial or dollar terms (that is, what the enterprise looks like at a specific date). An income statement is an activity statement that depicts the profitability of an enterprise for a designated period of time. The statement of cash flows is particularly important in understanding an enterprise for purposes of investment and credit decisions. As its name implies, the statement of cash flows depicts the ways cash has changed during a designated period. While the interest of investors and creditors is in cash flows to themselves rather than to the enterprise, information about cash activity of the enterprise is considered to be an important signal to investors and creditors.
At this early stage in your study of accounting, you are not expected to understand these financial statements or how they precisely help you assess the cash flow prospects of a company. The statement of financial position (balance sheet), income statement, and statement of cash flows are introduced more fully to you in the next chapter. Thereafter, you will learn a great deal about how these statements are prepared and how the information contained in them can be used to help you understand the underlying business activities they represent.
CHARACTERISTICS OF EXTERNALLY REPORTED INFORMATION
Financial information that is reported to investors, creditors, and others external to the reporting enterprise has certain qualities that must be understood for the information to have maximum usefulness. Some of these qualities are discussed in the following paragraphs.
Financial ReportingA Means As we learned in the introduction to this chapter, financial information is a means to an end, not an end in and of itself. The ultimate outcome of providing financial information is to improve the quality of decision making by external parties. Financial statements themselves are simply a means by which that end is achieved.
Financial Reporting versus Financial Statements Financial reporting is broader than financial statements. Stated another way, financial statements are a subset of the total information encompassed by financial reporting. Investors, creditors, and other external users of financial information learn about an enterprise in a variety of ways in addition to its formal financial statements (for example, press releases sent directly to investors and creditors, articles in The Wall Street Journal, and more recently open communications via the Internet). Serious investors, creditors, and other external users take advantage of many sources of information that are available to support their economic decisions about an enterprise.
Historical in Nature Externally reported financial information is largely historical in nature. It looks back in time and reports the results of events and transactions that already have occurred. While historical information is very useful in assessing the future, the information itself is more about the past than it is about the future.
Inexact and Approximate Measures Externally reported financial information may have a look of great precision, but in fact much of it is based on estimates, judgments, and assumptions that must be made about both the past and the future. For example, assume a company purchases a piece of equipment for use in its business. To account for that asset and to incorporate the impact of it into the companys externally reported financial information, some assumptions must be made about how long it will be used by the companyhow many years it will be used, how many machine-hours it will provide, and so on. The fact that a great deal of judgment underlies most accounting information is a limitation that is sometimes misunderstood.
General-Purpose Assumption As we have already mentioned, we assume that, by providing information that meets the needs of investors and creditors, we also meet the information needs of other external parties. We might be able to provide superior information if we were to treat each potential group of external users separately and prepare different information for each group. This approach is impractical, however, and we instead opt for preparing what is referred to as general-purpose informationInformation that is intended to meet the needs of multiple users that have an interest in the financial activities of an enterprise rather than tailored to the specific information needs of one user. that we believe is useful to multiple user groups (that is, one size fits all).
Usefulness Enhanced via Explanation The accounting profession believes that the value of externally reported financial information is enhanced by including explanations from management. This information is often nonquantitative and helps to interpret the financial numbers that are presented. For this reason, financial information, including financial statements, is accompanied by a number of notes and other explanations that help explain and interpret the numerical information.
Exercise 1.2, 1.3, 1.6, 1.7, 1.9, 1.16
Critical Thinking Cases 1.2, 1.5
2FASB Statement of Financial Accounting Concepts No. 1, Objectives of Financial Reporting by Business Enterprises (Norwalk, Conn.: 1978), p. 4.