In preparing financial statements, the accountant has several measurement
systems to choose from. Assets, for example, may be measured at what they
cost in the past or what they could be sold for now, to mention only two
possibilities. To enable users to interpret statements with confidence,
companies in similar industries should use the same measurement concepts or
In some countries these concepts or principles are prescribed by government
bodies; in the United States they are embodied in “generally accepted
accounting principles” (GAAP), which represent partly the consensus of
experts and partly the work of the Financial Accounting Standards Board
(FASB), a private body. The principles or standards issued by the FASB can be
overridden by the SEC. In practice, however, the SEC generally requires
corporations within its jurisdiction to conform to the standards of the FASB.
One principle that accountants may adopt is to measure assets at their value
to their owners. The economic value of an asset is the maximum amount that
the company would be willing to pay for it. This amount depends on what the
company expects to be able to do with the asset. For business assets, these
expectations are usually expressed in terms of forecasts of the inflows of
cash the company will receive in the future. If, for example, the company
believes that by spending $1 on advertising and other forms of sales
promotion it can sell a certain product for $5, then this product is worth $4
to the company.
When cash inflows are expected to be delayed, value is less than the
anticipated cash flow. For example, if the company has to pay interest at the
rate of 10 percent a year, an investment of $100 in a one-year asset today
will not be worthwhile unless it will return at least $110 a year from now
($100 plus 10 percent interest for one year). In this example, $100 is the
present value of the right to receive $110 one year later. Present value is
the maximum amount the company would be willing to pay for a future inflow of
cash after deducting interest on the investment at a specified rate for the
time the company has to wait before it receives its cash.
Value, in other words, depends on three factors: (1) the amount of the
anticipated future cash flows, (2) their timing, and (3) the interest rate.
The lower the expectation, the more distant the timing, or the higher the
interest rate, the less valuable the asset will be.
Value may also be represented by the amount the company could obtain by
selling its assets. This sale price is seldom a good measure of the assets'
value to the company, however, because few companies are likely to keep many
assets that are worth no more to the company than their market value.
Continued ownership of an asset implies that its present value to the owner
exceeds its market value, which is its apparent value to outsiders.
Accountants are traditionally reluctant to accept value as the basis of asset
measurement in the going concern. Although monetary assets such as cash or
accounts receivable are usually measured by their value, most other assets
are measured at cost. The reason is that the accountant finds it difficult to
verify the forecasts upon which a generalized value measurement system would
have to be based. As a result, the balance sheet does not pretend to show how
much the company's assets are worth; it shows how much the company has
invested in them.
The historical cost of an asset is the sum of all the expenditures the company
made to acquire it. This amount is not always easily measurable. If, for
example, a company has built a special-purpose machine in one of its own
factories for use in manufacturing other products, and the project required
logistical support from all parts of the factory organization, from purchasing
to quality control, then a good deal of judgment must be reflected in any
estimate of how much of the costs of these logistical activities should be
“capitalized” (i.e., placed on the balance sheet) as part of the cost of
From an economic point of view, income is defined as the change in the
company's wealth during a period of time, from all sources other than the
injection or withdrawal of investment funds. Income is the amount the company
could consume during the period and still have as much real wealth at the end
of the period as it had at the beginning. For example, if the value of the
net assets (assets minus liabilities) has gone from $1,000 to $1,200 during a
period and dividends of $100 have been distributed, income measured on a
value basis would be $300 ($1,200 minus $1,000, plus $100).
Accountants generally have rejected this approach for the same reason that
they have found value an unacceptable basis for asset measurement: Such a
measure would rely too much on estimates of what will happen in the future,
estimates that would not be readily susceptible to independent verification.
Instead, accountants have adopted what might be called a transactions
approach to income measurement. They recognize as income only those increases
in wealth that can be substantiated from data pertaining to actual
transactions that have taken place with persons outside the company. In such
systems, income is measured when work is performed for an outside customer,
when goods are delivered, or when the customer is billed.
Recognition of income at this time requires two sets of estimates: (1)
revenue estimates, representing the value of the cash that the company
expects to receive from the customer; and (2) expense estimates, representing
the resources that have been consumed in the creation of the revenues.
Revenue estimation is the easier of the two, but it still requires judgment.
The main problem is to estimate the percentage of gross sales for which
payment will never be received, either because some customers will not pay
their bills (“bad debts”) or because they will demand and receive credit for
returned merchandise or defective work.
Expense estimates are generally based on the historical cost of the resources
consumed. Net income, in other words, is the difference between the value
received from the use of resources and the cost of the resources that were
consumed in the process. As with asset measurement, the main problem is to
estimate what portion of the cost of an asset has been consumed during the
period in question.
Some assets give up their services gradually rather than all at once. The
cost of the portion of these assets the company uses to produce revenues in
any period is that period's depreciation expense, and the amount shown for
these assets on the balance sheet is their historical cost less an allowance
for depreciation, representing the cost of the portion of the asset's
anticipated lifetime services that has already been used. To estimate
depreciation, the accountant must predict both how long the asset will
continue to provide useful services and how much of its potential to provide
these services will be used up in each period.
Depreciation is usually computed by some simple formula. The two most popular
formulas in the United States are straight-line depreciation, in which the
same amount of depreciation is recognized each year, and declining-charge
depreciation, in which more depreciation is recognized during the early years
of life than during the later years, on the assumption that the value of the
asset's service declines as it gets older.
The role of the independent accountant (the auditor) is to see whether the
company's estimates are based on formulas that seem reasonable in the light
of whatever evidence is available and whether these formulas are applied
consistently from year to year. Again, what is “reasonable” is clearly a
matter of judgment.
Depreciation is not the only expense for which more than one measurement
principle is available. Another is the cost of goods sold. The cost of goods
available for sale in any period is the sum of the cost of the beginning
inventory and the cost of goods purchased in that period. This sum then must
be divided between the cost of goods sold and the cost of the ending
Accountants can make this division by any of three main inventory costing
methods: (1) first in, first out (FIFO), (2) last in, first out (LIFO), or
(3) average cost. The LIFO method is widely used in the United States, where
it is also an acceptable costing method for income tax purposes; companies in
most other countries measure inventory cost and the cost of goods sold by
some variant of the FIFO or average cost methods. Average cost is very
similar in its results to FIFO, so only FIFO and LIFO need be described.
Each purchase of goods constitutes a single batch, acquired at a specific
price. Under FIFO, the cost of goods sold is determined by adding the costs
of various batches of the goods available, starting with the oldest batch in
the beginning inventory, continuing with the next oldest batch, and so on
until the total number of units equals the number of units sold. The ending
inventory, therefore, is assigned the costs of the most recently acquired
Under LIFO, the cost of goods sold is the sum of the most recent purchase,
the next most recent, and so on, until the total number of units equals the
number sold during the period.
The LIFO cost of the ending inventory is the cost of the oldest units in the
cost of goods available.
Problems of measurement
Accounting income does not include all of the company's holding gains or
losses (increases or decreases in the market values of its assets). For
example, construction of a superhighway may increase the value of a company's
land, but neither the income statement nor the balance sheet will report this
holding gain. Similarly, introduction of a successful new product increases
the company's anticipated future cash flows, and this increase makes the
company more valuable. Those additional future sales show up neither in the
conventional income statement nor in the balance sheet.
Accounting reports have also been criticized on the grounds that they confuse
monetary measures with the underlying realities when the prices of many goods
and services have been changing rapidly. For example, if the wholesale price
of an item has risen from $100 to $150 between the time the company bought it
and the time it is sold, many accountants claim that $150 is the better
measure of the amount of resources consumed by the sale. They also contend
that the $50 increase in the item's wholesale value before it is sold is a
special kind of holding gain that should not be classified as ordinary
When inventory purchase prices are rising, LIFO inventory costing keeps many
gains from the holding of inventories out of net income. If purchases equal
the quantity sold, the entire cost of goods sold will be measured at the
higher current prices; the ending inventory will be measured at the lower
prices shown for the beginning-of-year inventory. The difference between the
LIFO inventory cost and the replacement cost at the end of the year is an
unrealized (and unreported) holding gain.
The amount of inventory holding gain that is included in net income is
usually called the “inventory profit.” The implication is that this is a
component of net income that is less “real” than other components because it
results from the holding of inventories rather than from trading with
When most of the changes in the prices of the company's resources are in the
same direction, the purchasing power of money is said to change. Conventional
accounting statements are stated in nominal currency units (dollars, francs,
lire, etc.), not in units of constant purchasing power. Changes in purchasing
power—that is, changes in the average level of prices of goods and
services—have two effects. First, net monetary assets (essentially cash and
receivables minus liabilities calling for fixed monetary payments) lose
purchasing power as the general price level rises. These losses do not appear
in conventional accounting statements. Second, holding gains measured in
nominal currency units may merely result from changes in the general price
level. If so, they represent no increase in the company's purchasing power.
In some countries that have experienced severe and prolonged inflation,
companies have been allowed or even required to restate their assets to
reflect the more recent and higher levels of purchase prices. The increment
in the asset balances in such cases has not been reported as income, but
depreciation thereafter has been based on these higher amounts. Companies in
the United States are not allowed to make these adjustments in their primary
Although published financial statements are the most widely visible products
of business accounting systems and the ones with which the public is most
concerned, they are only the tip of the iceberg. Most accounting data and
most accounting reports are generated solely or mainly for the company's
managers. Reports to management may be either summaries of past events,
forecasts of the future, or a combination of the two. Preparation of these
data and reports is the focus of managerial accounting, which consists mainly
of four broad functions: (1) budgetary planning, (2) cost finding, (3) cost
and profit analysis, and (4) performance reporting.
The first major component of internal accounting systems for management's use
is the company's system for establishing budgetary plans and setting
performance standards. The setting of performance standards requires also a
system for measuring actual results and reporting differences between actual
performance and the plans (see below Performance reporting).
The planning process leads to the establishment of explicit plans, which then
are translated into action. The results of these actions are compared with
the plans and reported in comparative form. Management can then respond to
substantial deviations from plan, either by taking corrective action or, if
outside conditions differ from those predicted or assumed in the plans, by
preparing revised plans.
Although plans can be either broad, strategic outlines of the company's
future or schedules of the inputs and outputs associated with specific
independent programs, most business plans are periodic plans—that is, they
refer to company operations for a specified period of time. These periodic
plans are summarized in a series of projected financial statements, or
The two principal budget statements are the profit plan and the cash
forecast. The profit plan is an estimated income statement for the budget
period. It summarizes the planned level of selling effort, shown as selling
expense, and the results of that effort, shown as sales revenue and the
accompanying cost of goods sold. Separate profit plans are ordinarily
prepared for each major segment of the company's operations.
The details underlying the profit plan are contained in departmental sales
and cost budgets, each part identified with the executive or group
responsible for carrying out that part.
Many companies also prepare alternative budgets for operating volumes other
than the volume anticipated for the period. A set of such alternative budgets
is known as the flexible budget. The practice of flexible budgeting has been
adopted widely by factory management to facilitate evaluation of cost
performance at different volume levels and has also been extended to other
elements of the profit plan.
The second major component of the annual budgetary plan, the cash forecast or
cash budget, summarizes the anticipated effects on cash of all the company's
activities. It lists the anticipated cash payments, cash receipts, and amount
of cash on hand, month by month throughout the year. In most companies,
responsibility for cash management rests mainly in the head office rather
than at the divisional level. For this reason, divisional cash forecasts tend
to be less important than divisional profit plans.
Company-wide cash forecasts, on the other hand, are just as important as
company profit plans. Preliminary cash forecasts are used in deciding how
much money will be made available for the payment of dividends, for the
purchase or construction of buildings and equipment, and for other programs
that do not pay for themselves immediately. The amount of short-term
borrowing or short-term investment of temporarily idle funds is then
generally geared to the requirements summarized in the final, adjusted
Other elements of the budgetary plan, in addition to the profit plan and the
cash forecast, include capital expenditure budgets, personnel budgets,
production budgets, and budgeted balance sheets. They all serve the same
purpose: to help management decide upon a course of action and to serve as a
point of reference against which to measure subsequent performance.
Planning is a management responsibility, not an accounting function. To plan
is to decide, and only the manager has the authority to choose the direction
the company is to take. Accounting personnel are nevertheless deeply involved
in the planning process. First, they administer the budgetary planning
system, establishing deadlines for the completion of each part of the process
and seeing that these deadlines are met. Second, they analyze data and help
management at various levels compare the estimated effects of different
courses of action. Third, they are responsible for collating the tentative
plans and proposals coming from the individual departments and divisions and
then reviewing them for consistency and feasibility and sometimes for
desirability as well. Finally, they must assemble the final plans management
has chosen and see that these plans are understood by the operating
A major factor in business planning is the cost of producing the company's
products. Cost finding is the process by which the company obtains estimates
of the costs of producing a product, providing a service, performing a
function, or operating a department. Some of these estimates are
historical—how much did it cost?—while others are predictive—what will it
The basic principle in cost finding is that the cost assigned to any
object—an activity or a product—should represent the amount of cost that
object causes. The most fully developed methods of cost finding are used to
estimate the costs that have been incurred in a factory to manufacture
specific products. The simplest of these methods is known as process costing.
In this method, the accountant first accumulates the costs of each separate
production operation or process for a specified period of time. The total of
these costs is then restated as an average by dividing it by the total output
of the process during the same period.
Process costing can be used whenever the output of individual processes is
reasonably uniform or homogeneous, as in cement manufacturing, flour milling,
and other relatively continuous production processes.
A second method, job order costing, is used when individual production
centres or departments work on a variety of products rather than just one
during a typical time period. Two categories of factory cost are recognized
under this method: prime costs and factory overhead costs. Prime costs are
those that can be traced directly to a specific batch, or job lot, of
products. These are the direct labour and direct materials costs of
production. Overhead costs, on the other hand, are those that can be traced
only to departmental operations or to the factory as a whole and not to
individual job orders. The salary of a departmental supervisor is an example
of an overhead cost.
Direct materials and direct labour costs are recorded directly on the job order
cost sheets, one for each job. Although not traceable to individual jobs,
overhead costs are generally assigned to them by means of overhead rates—
i.e., the ratio of total overhead cost to total production volume for a
given time period. A separate overhead rate is usually calculated for each
production department, and, if the operations of a department are varied, it is
often subdivided into a set of more homogeneous cost centres, each with its own
overhead rate. Separate overhead rates are sometimes used even for individual
processing machines within a department if the machines differ widely in such
factors as power consumption, maintenance cost, and depreciation.
Many production costs are incurred in departments that don't actually produce
goods or provide salable services. Instead, they provide services or support
to the departments that do produce products. Examples include maintenance
departments, quality control departments, and internal power plants.
Estimates of these costs are included in the estimated overhead costs of the
production departments by a process known as allocation—that is, estimated
service department costs are allocated among the production departments in
proportion to the amount of service or support each receives. The
departmental overhead rates then include provisions for these allocated
A third method of cost finding, activity-based costing, is based on the fact
that many costs are driven by factors other than product volume. The first
task is to identify the activities that drive costs. The next step is to
estimate the costs that are driven by each activity and state them as
averages per unit of activity. Management can use these averages to guide its
efforts to reduce costs. In addition, if management wants an estimate of the
cost of a specific product, the accountant can estimate how many of the
activity units are associated with that product and multiply those numbers by
the average costs per activity unit.
Product cost finding under activity-based costing is almost always a process
of estimating costs before production takes place. The method of process
costing and job order costing can be used either in preparing estimates
before the fact or in assigning costs to products as production proceeds.
Even when job order costing is used to tally the costs actually incurred on
individual jobs, the overhead rates are usually predetermined—that is, they
represent the average planned overhead cost at some production volume. The
main reason for this is that actual overhead cost averages depend on the
total volume and efficiency of operations and not on any one job alone. The
relevance of job order cost information will be impaired if these external
fluctuations are allowed to change the amount of overhead cost assigned to a
Many systems go even farther than this. Estimates of the average costs of
each type of material, each operation, and each product are prepared
routinely and identified as standard costs. These are then readily available
whenever estimates are needed and can also serve as an important element in
the company's performance reporting system, as described below.
Similar methods of cost finding can be used to determine or estimate the cost
of providing services rather than physical goods. Most advertising agencies
and consulting firms, for example, maintain some form of job cost records,
either as a basis for billing their clients or as a means of estimating the
profitability of individual jobs or accounts.
The methods of cost finding described in the preceding paragraphs are known
as full, or absorption, costing methods, in that the overhead rates are
intended to include provisions for all manufacturing costs. Both process and
job order costing methods can also be adapted to variable costing in which
only variable manufacturing costs are included in product cost. Variable
costs are those that will be greater in total in the upper portions of the
company's normal range of volumes than in the lower portion. Total fixed
costs, in contrast, are the same at all volume levels within the normal
Unit cost under variable costing represents the average variable cost of
making the product. The main argument for the variable costing approach is
that average variable cost is more relevant to short-horizon managerial
decisions than average full cost. In deciding whether to manufacture goods in
large lots, for example, management needs to estimate the cost of carrying
larger amounts of finished goods in inventory. More variable costs will have
to be incurred to build the inventory to a higher level; fixed manufacturing
costs presumably will be unaffected.
Furthermore, when a management decision changes the company's fixed costs,
the change is unlikely to be proportional to the change in volume; therefore,
average fixed cost is seldom a valid basis for estimating the cost effects of
such decisions. Variable costing eliminates the temptation to assume without
question that average fixed cost can be used to estimate changes in total
fixed cost. When variable costing is used, supplemental rates for fixed
overhead production costs must be provided to measure the costs to be
assigned to end-of-year inventories because generally accepted accounting
principles in the United States and in most other countries require that
inventories be measured at full product cost for external financial
Cost and profit analysis
Accountants share with many other people the task of analyzing cost and
profit data in order to provide guidance in managerial decision making. Even
if the analytical work is done largely by others, they have an interest in
analytical methods because the systems they design must collect data in forms
suitable for analysis.
Managerial decisions are based on comparisons of the estimated future results
of the alternative courses of action that the decision maker is choosing
among. Recorded historical accounting data, in contrast, reflect conditions
and experience of the past. Furthermore, they are absolute, not comparative,
in that they show the effects of one course of action but not whether these
were better or worse than those that would have resulted from some other
For decision making, therefore, historical accounting data must be examined,
modified, and placed on a comparative basis. Even estimated data, such as
budgets and standard costs, must be examined to see whether the estimates are
still valid and relevant to managerial comparisons. To a large extent, this
job of review and restatement is an accounting responsibility. Accordingly, a
major part of the accountant's preparation for the profession is devoted to
the study of methods and principles of analysis for managerial decision
Once the budgetary plan has been adopted, accounting's next task is to
prepare information on the results of company activities and make it
available to management. The manager's main interest in this information
centres on three questions: Have his or her own actions had the results
expected, and, if not, why not? How successful have subordinates been in
managing the activities entrusted to them? What problems and opportunities
seem to have arisen since the budgetary plan was prepared? For these
purposes, the information must be comparative, relating actual results to the
level of results that management regards as satisfactory. In each case, the
standard for comparison is provided by the budgetary plan.
Much of this information is contained in periodic financial reports. At the
top management and divisional levels, the most important of these is the
comparative income statement, one of which is illustrated in Table 4. This
shows the profit that was planned for this period, the actual results
received for this period, and the differences, or variances, between the two.
It also gives an explanation of some of the reasons for the difference
between a planned and an actual income.
The report in this exhibit employs the widely used profit contribution
format, in which divisional results reflect sales and expenses traceable to
the individual divisions, with no deduction for head office expenses. Company
net income is then obtained by deducting head office expenses as a lump sum
from the total of the divisional profit contributions. A similar format can
be used within the division, reporting the profit contribution of each of the
division's product lines, with divisional headquarters expenses deducted at
By far the greatest number of reports, however, are cost or sales reports,
mostly on a departmental basis. Departmental sales reports usually compare
actual sales with the volumes planned for the period. Departmental cost
performance reports, in contrast, typically compare actual costs incurred
with standards or budgets that have been adjusted to correspond to the actual
volume of work done during the period. This practice reflects a recognition
that volume fluctuations generally originate outside the department and that
the department head's responsibility is ordinarily limited to minimizing cost
while meeting the delivery schedules imposed by higher management.
In most cases, the labour rate variance would not be reported to the
department head, because it is not subject to his or her control.
Standard costing systems no longer have the central importance they commanded
in many industries up to the 1970s. One reason is that significant changes in
management technology have shifted the focus of cost control from the
individual production department to larger, more interdependent groups. Just-
in-time production systems require changes in factory layouts to reduce the
time it takes to move work from one station to the next. They also reduce the
number of partly processed units at each work station, thereby requiring
greater station-to-station coordination.
At the same time, management's emphasis has shifted from cost control to cost
reduction, quality enhancement, and closer coordination of production and
customer deliveries. Most large manufacturing companies and many service
companies have launched programs of total quality control and continuous
improvement, and many have replaced standard costs with a more flexible
approach using prior period results as current performance standards.
Management is also likely to focus on the amount of system waste by
identifying and minimizing activities that contribute nothing to the value
that customers place on the product.
Reducing set-up time, inspection time, and time spent moving work from place
to place while maintaining or improving quality are some of the results of
these programs. Advances in computer-based models have enabled companies to
tie production schedules more closely to customer delivery schedules while
increasing the rate of plant utilization. Some of these changes actually
increase variances from standard costs in some departments but are undertaken
because they benefit the company as a whole.
The overall result is that control systems are likely to focus in the first
instance on operational controls (real-time signals to operating personnel
that some immediate remedial action is required), with after-the-fact
analysis of results focusing on aggregate comparisons with past performance
and the planned results of current improvement programs.
Accounting is the systematic development and analysis of information about the economic affairs of an organization. This information may be used in a number of ways: by the organization's managers to help them plan and control the organization's operations; by owners and legislative or regulatory bodies to help them appraise the organization's performance and make decisions as to its future; by owners, lenders, suppliers, employees, and others to help them decide how much time or money to devote to the organization; by governmental bodies to determine how much tax the organization must pay; and occasionally by customers to determine the price to be paid when contracts call for cost-based payments.
Accounting provides information for all these purposes through the maintenance of files of data, analysis and interpretation of these data, and the preparation of various kinds of reports. Most accounting information is historical—that is, the accountant observes the things that the organization does, records their effects, and prepares reports summarizing what has been recorded; the rest consists of forecasts and plans for current and future periods.
Accounting information can be developed for any kind of organization, not just for privately owned, profit-seeking businesses. One branch of accounting deals with the economic operations of entire nations. The remainder of this article, however, will be devoted primarily to business accounting.
Company financial statements
Among the most common accounting reports are those sent to investors and others outside the management group. The reports most likely to go to investors are called financial statements, and their preparation is the province of the branch of accounting known as financial accounting. Three financial statements will be discussed: the balance sheet, the income statement, and the statement of cash flows.
The balance sheet
A balance sheet describes the resources that are under a company's control on a specified date and indicates where these resources have come from. It consists of three major sections: (1) the assets: valuable rights owned by the company; (2) the liabilities: the funds that have been provided by outside lenders and other creditors in exchange for the company's promise to make payments or to provide services in the future; and (3) the owners' equity: the funds that have been provided by the company's owners or on their behalf.
The list of assets shows the forms in which the company's resources are lodged; the lists of liabilities and the owners' equity indicate where these same resources have come from. The balance sheet, in other words, shows the company's resources from two points of view, and the following relationship must always exist: total assets equals total liabilities plus total owners' equity.
This same identity is also expressed in another way: total assets minus total liabilities equals total owners' equity. In this form, the equation emphasizes that the owners' equity in the company is always equal to the net assets (assets minus liabilities). Any increase in one will inevitably be accompanied by an increase in the other, and the only way to increase the owners' equity is to increase the net assets.
Assets are ordinarily subdivided into current assets and noncurrent assets. The former include cash, amounts receivable from customers, inventories, and other assets that are expected to be consumed or can be readily converted into cash during the next operating cycle (production, sale, and collection). Noncurrent assets may include noncurrent receivables, fixed assets (such as land and buildings), and long-term investments.
The liabilities are similarly divided into current liabilities and noncurrent liabilities. Most amounts payable to the company's suppliers (accounts payable), to employees (wages payable), or to governments (taxes payable) are included among the current liabilities. Noncurrent liabilities consist mainly of amounts payable to holders of the company's long-term bonds and such items as obligations to employees under company pension plans. The difference between total current assets and total current liabilities is known as net current assets, or working capital.
The owners' equity of an American company is divided between paid-in capital and retained earnings. Paid-in capital represents the amounts paid to the corporation in exchange for shares of the company's preferred and common stock. The major part of this, the capital paid in by the common shareholders, is usually divided into two parts, one representing the par value, or stated value, of the shares, the other representing the excess over this amount. The amount of retained earnings is the difference between the amounts earned by the company in the past and the dividends that have been distributed to the owners.
A slightly different breakdown of the owners' equity is used in most of continental Europe and in other parts of the world. The classification distinguishes between those amounts that cannot be distributed except as part of a formal liquidation of all or part of the company (capital and legal reserves) and those amounts that are not restricted in this way (free reserves and undistributed profits).
The income statement
The company uses its assets to produce goods and services. Its success depends on whether it is wise or lucky in the assets it chooses to hold and in the ways it uses these assets to produce goods and services.
The company's success is measured by the amount of profit it earns—that is, the growth or decline in its stock of assets from all sources other than contributions or withdrawals of funds by owners and creditors. Net income is the accountant's term for the amount of profit that is reported for a particular time period.
The company's income statement for a period of time shows how the net income for that period was derived.
Net income summarizes all the gains and losses recognized during the period, including both the results of the company's normal, day-by-day activities and any other events. If net income is negative, it is referred to as a net loss.
The income statement is usually accompanied by a statement that shows how the company's retained earnings has changed during the year. Net income increases retained earnings; net operating loss or the distribution of cash dividends reduces it.
The statement of cash flows
Companies also prepare a third financial statement, the statement of cash flows. Cash flows result from three major groups of activities: (1) operating activities, (2) investing activities, and (3) financing activities.
Cash from operations is not the same as net income (revenues minus expenses). For one thing, not all revenues are collected in cash. Revenue is usually recorded when a customer receives merchandise and either pays for it or promises to pay the company in the future (in which case the revenue is recorded in accounts receivable). Cash from operating activities, on the other hand, reflects the actual cash collected, not the inflow of accounts receivable. Similarly, an expense may be recorded without an actual cash payment.
The purpose of the statement of cash flows is to throw light on management's use of the financial resources available to it and to help the users of the statements to evaluate the company's liquidity, its ability to pay its bills when they come due.
Most large corporations in the United States and other industrialized countries own other corporations. Their primary financial statements are consolidated statements, reflecting the total assets, liabilities, owners' equity, net income, and cash flows of all the corporations in the group. Thus, for example, the consolidated balance sheet of the parent corporation (the corporation that owns the others) does not list its investments in its subsidiaries (the companies it owns) as assets; instead, it includes their assets and liabilities with its own.
Some subsidiary corporations are not wholly owned by the parent; that is, some shares of their common stock are owned by others. The equity of these minority shareholders in the subsidiary companies is shown separately on the balance sheet.
The consolidated income statement also must show the minority owners' equity in the earnings of a subsidiary as a deduction in the determination of net income.
Disclosure and auditing requirements
A corporation's obligations to issue financial statements are prescribed in the company's own statutes or bylaws and in public laws and regulations. The financial statements of most large and medium-size companies in the United States fall primarily within the jurisdiction of the federal Securities and Exchange Commission (SEC). The SEC has a good deal of authority to prescribe the content and structure of the financial statements that are submitted to it. Similar authority is vested in provincial regulatory bodies and the stock exchanges in Canada; disclosure in the United Kingdom is governed by the provisions of the Companies Act.
A company's financial statements are ordinarily prepared initially by its own accountants. Outsiders review, or audit, the statements and the systems the company used to accumulate the data from which the statements were prepared. In most countries, including the United States, these outside auditors are selected by the company's shareholders. The audit of a company's statements is ordinarily performed by professionally qualified, independent accountants who bear the title of certified public accountant (CPA) in the United States and chartered accountant (CA) in the United Kingdom and many other countries with British-based accounting traditions. Their primary task is to investigate the company's accounting data and methods carefully enough to permit them to give their opinion that the financial statements present fairly the company's position, results, and cash flows.
Other purposes of accounting systems
Accounting systems are designed mainly to provide information that managers and outsiders can use in decision making. They also serve other purposes: to produce operating documents, to protect the company's assets, to provide data for company tax returns, and, in some cases, to provide the basis for reimbursement of costs by clients or customers.
The accounting organization is responsible for preparing documents that contain instructions for a variety of tasks, such as payment of customer bills or preparing employee payrolls. It also must prepare documents that serve what might be called private information purposes, such as the employees' own records of their salaries and wages. Many of these documents also serve other accounting purposes, but they would have to be prepared even if no information reports were necessary. Measured by the number of people involved and the amount of time required, document preparation is one of accounting's biggest jobs.
Accounting systems must provide means of reducing the chance of losses of assets due to carelessness or dishonesty on the part of employees, suppliers, and customers. Asset protection devices are often very simple; for example, many restaurants use numbered meal checks so that waiters will not be able to submit one check to the customer and another, with a lower total, to the cashier. Other devices entail a partial duplication of effort or a division of tasks between two individuals to reduce the opportunity for unobserved thefts.
These are all part of the company's system of internal controls. Another important element in the internal control system is internal auditing. The task of internal auditors is to see whether prescribed data handling and asset protection procedures are being followed. To accomplish this, they usually observe some of the work as it is being performed and examine a sample of past transactions for accuracy and fidelity to the system. They may insert a set of fictitious data into the system to see whether the resulting output meets a predetermined standard. This technique is particularly useful in testing the validity of the programs that are used to process data through electronic computers.
The accounting system must also provide data for use in the completion of the company's tax returns. This function is the concern of tax accounting. In some countries financial accounting must obey rules laid down for tax accounting by national tax laws and regulations, but no such requirement is imposed in the United States, and tabulations prepared for tax purposes often diverge from those submitted to shareholders and others. “Taxable income” is a legal concept rather than an accounting concept. Tax laws include incentives to encourage companies to do certain things and discourage them from doing others. Accordingly, what is “income” or “capital” to a tax agency may be far different from the accountant's measures of these same concepts.
Finally, accounting systems in some companies must provide cost data in the forms required for submission to customers who have agreed to reimburse the companies for the costs they have incurred on the customers' behalf. The primary example of these is work performed under cost-based contracts with U.S. military agencies. The measurement rules for this purpose are contained in the Armed Services Procurement Regulations, which embody standards issued by the Cost Accounting Standards Board. In general, these standards conform to the principles underlying conventional product costing systems, but they go beyond them in incorporating provisions for corporate and divisional head office administrative costs.