七 Investment Tools: Financial Statement Analysis: Basic Concepts
1.A: Preliminary Reading Measuring Business Income
a: Explain why financial statements are prepared at the end of the regular accounting period, why accounts must be adjusted at the end of each period, and why the accrual basis of accounting produces more useful income statements & balance sheets than the cash basis.
To be relevant, information must be reliable. This means information must be
consistent and comparable over time and be provided on a timely basis. According to the relevancy principle, a firm needs to identify its activities in a timely fashion within a specific period, such as a quarter or year.
Normal accounting procedure is to record during the accounting period those economic events that occurred as the result of external transactions. At the end of the period after all the external transactions have been recorded, several of the accounts in the ledger need to be updated before their balances can be posted to the financial statements.
The adjusting process is consistent with two important accounting principles:
1. The revenue recognition principle, which requires that revenue be reported in the income statement only when it is earned, not before and not after.
2. The matching principle reports expenses on the income statement in the same accounting period as the revenues that were earned as a result of the expenses.
Accrual basis accounting assigns revenues to the accounting period in which they are earned and matches expenses with the revenues generated by those expenses. The objective of the accrual basis is to report the economic effects of revenues and expenses when they are earned or incurred, not when cash is received or paid.
Cash basis accounting recognizes revenues when cash is received and expenses when cash is paid. Under the cash basis net income for the period is the difference between revenues received in cash and expenses paid with cash.
Accrual accounting generally provides a better indication of performance than information based on the receipt and disbursement of cash. Accrual accounting increases the comparability of income statements and balance sheets from one period to another period. The accrual basis reflects the understanding that the economic effect of revenue generally occurs when it is earned and not when cash is received. The revenue recognition principle is the basis for making adjusting entries that pertain to unearned and accrued revenues. Adjusting entries are necessary to better match revenues and expenses that occurred during the accounting period. Adjusting entries are used to record the effects of internal economic events.