Financial Statements

This essay highlights issues that are relevant to the discussion of financial statements and financial reporting. In particular, this article will review the current state of GAAP (Generally Accepted Accounting Principals, or American accounting standards) and the trend toward adoption of IFRS (International Financial Reporting Standards). Mandatory auditing and reporting of company financials has been a major focus of public companies since adoption of Sarbanes-Oxley in 2002. Years after it became law, Sarbanes-Oxley requirements continue to challenge companies in terms of meeting internal reporting and accountability standards. Federal mandates have impacted companies in terms of costs, information technology requirements, and added responsibilities for CFOs (chief financial officers). Companies must adapt to changing auditing and reporting requirements in terms of globalization and the need to raise the capital to compete in global marketplaces.

Keywords Accounting Standards; Chief Financial Officer (CFO); Collective Bargaining; Compliance Initiatives; Financial Statements; Generally Accepted Accounting Principals (GAAP or US-GAAP); Global Accounting Standards; Independent Auditor; Internal Controls; International Financial Reporting Standards (IFRS); Investor Confidence; Public Company Accounting Oversight Board (PCAOB); Remediation; Securities & Exchange Commission (SEC)

Accounting > Financial Statements

Overview

Financial statements document the status of a company's assets, expenses, revenues, and liabilities. The overall financial health of a company can be ascertained from the quantitative analysis of financial statements—which serve as the complete record for an organization's financial records. A financial statement is an internal business tool that tracks the intake and outflow of money and illustrates changes in financial status over time. Financial statements are used for both short-term and long-term planning, for business forecasting, and for raising capital.

Types of Financial Statements

There are four main types of financial statements that document the financial aspects of a company (SEC, 2007).

  • Balance sheets, which portray how much a company owns and the amount of money it owes at a certain point in time.
  • Income statements, which demonstrate the amount of money a company earned and spent during a certain period of time.
  • Cash flow statements, which display the amount of money flowing into a company and the money flowing out of the company during a certain period of time.
  • Statements of shareholder equity, which present all the changes in the interests of the company’s shareholders that have taken place over time.

Users of Financial Statements

Depending upon the size and nature of a company there may be different users of the information on a financial statement. Internal users of financial information include

  • Owners or managers, who use financials to determine future operations and planning.
  • Individual employees, who may be negotiating compensation or groups of employees (unions) who are involved in collective bargaining.
  • Stockholders, who review annual report figures.

External users of financial statements include

  • Prospective investors, who may want to invest personal money.
  • Banks or financial institutions, who may lend capital (money).
  • Government bodies, which ensure compliance and accurate reporting.

The audience of an organization's financial statement will differ, often depending upon the size and complexity of an organization. In small companies, financial statements are used primarily for the benefit of the business owner in documenting the cash flow (revenue and expenses) of the company. The basic information on the financial statement allows owners or managers to see financial trends over time and to plan accordingly. For large organizations or corporations, financial statements can be complex documents and often include footnotes that provide additional information about each item on the balance sheet, income statement, and cash flow statement. Larger organizations will likely have more external users accessing their financial information and will therefore have much more complexity in their statements.

Two trends have profoundly shaped how companies are required to compile and report on their financial status.

  • The rise of global organizations and markets has highlighted the need for the adoption of worldwide accounting standards—Americans use GAAP, and much of the rest of the world uses IFRS.
  • Corporate scandals involving financial mismanagement and accounting fraud led to the adoption of the Sarbanes-Oxley Act of 2002.

The changing role of the CFO (chief financial officer) in organizations is also a topic that is closely related to the topic of financial reporting and disclosure. Regulatory burdens have added much to the plate of finance departments and CFOs.Changes in accounting standards and stringent compliance mandates are only two of the many tasks facing CFOs, even as they are taking on a greater strategic role within organizations.

The affects of compliance and reporting are also discussed in terms of the implications for investors who have become increasingly wary of risky capital investments. Organizations are balancing the need to loosen compliance and auditing standards with the desire for potential investors to have confidence in the organizations that they are seeking to invest in.

Applications

Accounting Standards

GAAP

Accounting standards or principals have been put into place as guidelines for helping companies to prepare, present, and report financial statements. American companies use GAAP or US-GAAP standards for this purpose; GAAP standards are applied to financial reporting for all publicly traded companies in the United States and many privately held companies too. The SEC (Securities and Exchange Commission) requires that US-GAAP principals be followed for publicly traded companies. The GAAP standards are not directly set by the U.S. government but are overseen by the FASB (Financial Accounting Standards Board). The FASB is a nonprofit organization that has been designated by the SEC as the entity responsible for setting accounting principals in the public interest.

GASB & FASAB

Local and state governments adhere to a set of GAAP standards that is different from those that govern private-sector organizations. The policy board for state and local GAAP standards is the Government Accounting Standards Board (GASB). Financial reporting for federal government entities is regulated by the Federal Accounting Standards Advisory Board (FASAB).

IFRS

The International Financial Reporting Standards (IFRS) is a third set of common accounting standards that have been adopted by more than one hundred countries in the world, including the European Union and many emerging markets. The United States is the only major economy in the world to operate outside IFRS standards, but there is a general agreement that US-GAAP and IFRS standards should be reconciled to move toward a global standard.

Effects of Globalization on Financial Standards

The rise of globalization of markets around the world has increased the interaction among companies in many markets and across supply chains. Many American companies maintain offices outside U.S. borders and still other U.S.-based companies have been acquired by non-American owners. The rise of cross-border and multinational organizations has only highlighted the differences in practices kept by different divisions of multinationals. In the area of financial reporting and accounting, this is illustrated by the differing accounting standards of GAAP versus IFRS.

GAAP vs. IFRS

The United States continues to feel pressure to adopt international accounting standards and to reconcile those standards within GAAP. With emerging markets (such as China) having adopted IFRS, many U.S.-based CFOs are likely to continue to feel intense pressure to adopt too.

Edward E. Nusbaum, CEO of Grant Thornton, LLP, in Chicago, said "I would recommend that U.S. CFOs become acquainted with International Financial Reporting Standards and convergence related issues." He continued: "The impact will be significant, as U.S. companies will see U.S. GAAP written in a revised way. These changes could dramatically affect U.S. companies' financial statements." And "U.S. CFOs may also sense a shift in standards style toward an ever more principles-based approach. For global U.S. companies, foreign statutory reports may be due in IFRS. Overseas controllers will have a better understanding of IFRS than U.S. GAAP, and U.S. CFOs may want to know IFRS to speak the language" (Hansen, 2007).

Integration of International Standards

Japan announced in 2011, and again in 2013, that it was working on converging its accounting standards with international standards (IASPlus, 2013). Capital markets are expected to grow for countries that integrate international standards. The end goal of creating a single high-quality global-accounting standard is only part of the process. Some are already seeing inconsistencies with the way the standards are applied—there will likely be many divergent views about how to apply the new standards. The IASB (International Accounting Standards Board) has been aiming for application consistency.

All European Union countries along with U.S. subsidiaries of EU-owned companies converted to IFRS in 2005. Lessons learned from the EU conversions should help American companies make the conversion with fewer problems. US GAAP rules are considered to be much more detailed than IFRS rules. The reason given is that the chance of litigation is much higher in the United States.

Reconciliation of IFRS & GAAP

The United States realizes how critical it is to remove impediments to non-American companies and the free flow of capital. The use of IFRS on a stand-alone basis is possible for foreign private issuers and American issuers (D.A., 2007).

One important point about reconciliation is that both GAAP and IFRS standards need significant improvement, and the resources being used to try and eliminate the difference could be better applied to developing a new common set of standards.

"Although the transition to global accounting and audit standards creates difficulties for CFOs who must still work with multiple standards, FRS/US GAAP convergence will streamline the capital raising process for U.S.-based companies, reduce costs and risks in the market, and bring greater transparency and comparability to all companies engaged in international business. Investing in the process today will yield high returns in the not-so-distant future" (Hansen, 2007).

Auditing

Internal auditing of company financials has changed radically since 2002, when Sarbanes-Oxley (also referred to as SOA or SarbOx) became law. The infamous corporate accounting scandals including WorldCom and Enron drove lawmakers to implement sweeping changes in the accountability and reporting of corporate finances. The decline in public trust resulting from the well-publicized scandals was the true impetus for the legislation.

The following posting from the Karl Nagel & Company website provides a good layperson's overview of the SarbOx objective.

[SarbOx was made law] "To improve quality and transparency in financial reporting and independent audits and accounting services for public companies, to create a Public Company Accounting Oversight Board, to enhance the standard setting process for accounting practices, to strengthen the independence of firms that audit public companies, to increase corporate responsibility and the usefulness of corporate financial disclosure, to protect the objectivity and independence of securities analysts, to improve Securities and Exchange Commission resources and oversight, and for other purposes" (Nagel, 2002).

Section 302 and 404 of SarbOx are discussed here; these two sections cover the establishment of internal controls and the auditing of the same. Section 302 specifically requires that the "signing" officers of the company have established mandates that ensure the establishment and maintenance of internal controls (and internal control certifications). Section 404 requires that company management produce an internal audit report. Without question, section 404 of SarbOx is the most costly and labor intensive aspect of the legislation for companies to enact. Section 404 requires that companies test all manual and automated controls having to do with financial reporting. A report, issued by company management and external auditors, must be compiled to show due diligence in meeting the auditing requirements.

Company Issues with SarbOx & Remediation

With the passage of SarbOx legislation in 2002, many companies were acknowledged to have "over-reacted" by putting excessive processes in place to avert any potential accounting issues or any semblance of impropriety by the organization in its financial disclosure. Both external auditors and CEOs are blamed for a "cover your behind" approach to SarbOx implementation and the high costs associated with this strategy.

Remediation of issues has provided significant feedback and self-accountability for companies. Remediation allows companies to identify internal deficiencies in the design or operation of the internal controls. Many organizations have had trouble distinguishing between operational and design weaknesses, but the identification and rectification of issues is valuable. Some of the processes cited as deficient included insufficient staffing, inefficient division of work, problems in the financial closing process and, application of accounting principals. Key trouble areas included revenue recognition, management of contracts, and application of complex financial transactions (Fargher & Gramling, 2005).

"SOA represents an opportunity to restore investor confidence. Some companies have previously operated with less than satisfactory internal controls. Implementing SOA sections 302 and 404 can provide benefits through the identification of control deficiencies and, more importantly, through the improvement of internal controls which often result in improved corporate governance" (Fargher & Gramling, 2005).

The pendulum has swung back toward the center in terms of reactions to SarbOx legislation. Calls for less stringent oversight cite the following (Woellert, 2006):

  • Compliance costs are too high.
  • Testing of internal controls should be based on risk (focus on the assessment for most critical risk areas)
  • Audit requirements for small companies should be scaled back.
  • Loosen the yearly requirement for some tests that are not high risk.
  • Clarification of terminology and rules need to be assessed regularly.
  • SEC and PCAOB feedback has helped to streamline the process.
  • Increased confidence, judgment, and experience of auditors and management is growing as scandals recede into history and memory.

Surveys indicate that the cost of compliance is falling for companies, but will remain a significant cost. Regulators will need to work within existing statues for the time being; changes in auditing standards will require a change in law. It is widely acknowledged that changing the regulation will not help cut compliance costs.

"The real benefit of change could be a legal one—a shield from exposure to shareholder lawsuits. Without specific direction from regulators, companies fret that anything intimating even the slightest hint of a shortcut could leave them vulnerable to expensive shareholder litigation. It's that fear, probably as much or more than actual compliance costs, that's driving the call for change" (Woellert, 2006).

Issues

Role of CFO

"Few people have been more profoundly affected by the wave of regulation that followed America's post bubble corporate scandals than chief financial officers. Beginning with the landmark Sarbanes-Oxley Act of 2002, which was designed to prevent fraud in the wake of debacles at Enron, WorldCom and other companies, new rules and laws have rained down on CFOs, requiring them to pay more attention to even the smallest details of financial reporting and accounting. Most daunting of these: Sarbanes-Oxley's Section 404, which requires public companies to document and have audited all internal financial controls" (Taub, 2007).

CFOs are frustrated in many organizations. While many can manage both the big picture (strategic planning) and the minutiae (spreadsheets and regulatory issues), many CFOs dislike the continuing regulatory weight of SarbOx. CFOs are being tasked with playing a more strategic role within organizations, but their attention is divided. CFO expertise is needed to help organizations gain efficiencies, integrate supply chains, and approve acquisition of technology and additional staff. CFOs also figure prominently in succession planning, and many are considered to be CEOs “in waiting.”

Job churn has been high at Fortune 500 companies in the years since SarbOx was made into law. The lasting burdens are blamed for high turnover of CFOs, many of whom admit that they are "too consumed with regulatory compliance and without enough time for corporate strategy" (Leone, 2006). Many organizations are hesitant to promote trusted CFOs in a time when capital markets are volatile and compliance risks are still looming. The Catch-22 for companies is that without being able to focus CFOs on overall financial strategy and management and away from compliance issues, corporate finance departments may be at risk.

Post Enron and Worldcom, CFOs are sometimes being referred to as the chief police officers of their respective organizations. There is zero tolerance in the accounting world for financial mismanagement, and a company's financial statement is the record. A CFO is responsible for more than management of a company's financial statement; a CFO is also responsible for a company's reputation. "A CFO sets the integrity bar in an organization" and, as such, can make or break a company's ability to raise and maintain the capital needed for expansion (Taub, 2007). Investors are one of the many "customers" of an organization's financial statement and are particularly concerned with transparency in compliance reporting.

Implications for Investors

"Information regarding a company's earnings is one of the most important factors that many investors consider in making an investment decision, and it is essential that the information companies provide be clear and accurate," said Linda Chatman Thomsen, former director of the SEC's division of enforcement (Taylor, 2007).

An ongoing tug of war exists between businesses and investors regarding the amendment of rules on internal controls and procedures for financial reporting. In the wake of corporate accounting scandals, investor confidence was shaken in light of improprieties in financial reporting.

Investors may be one of the few groups that are actually fans of increased regulatory scrutiny for auditing and compliance. The more transparency available in financial reporting, the more likely investors are to loosen the purse strings.

Companies also realize that investors have raised the bar in terms of reporting on financial statements. Investors are holding companies liable for the accuracy of their reporting.

CFOs and other executives understand their role in regaining and maintaining investor confidence. Without access to (worldwide) capital, companies are at a strategic disadvantage. In dealing with investors, one CFO stated, "We get very high marks for our disclosure. We try to be a transparent company" (Taub, 2007).

It may not be necessary for executives to tie every action to the bottom line. "Most investor rating services include an assessment of the control environment as a part of their overall evaluation of the company. Scores from these services can have a significant impact-—either positive or negative—on investor sentiment and the company's cost of capital" (Wagner & Dittmer, 2006).

Conclusion

Financial statements document the overall financial status of an organization and include information about assets, liabilities, revenue, and expenses. This essay focused on the trends in accounting and auditing standards that are influenced by globalization. Customers, collaborators, and capital sources are increasingly "borderless" in the global economy. American companies need to adapt to international standards in accounting practices to manage non-American subsidiaries, and to gain access to foreign capital. Good compliance practices, financial disclosure, and transparency are also required to partake in global business and attract much needed investment money.

The role of the CFOis multifaceted and is one of the most strategic roles within an organization. CFOs are responsible for setting the vision of an organization, for gaining investor confidence, and for overseeing regulatory policies. A company's financial statements can be equated to an annual physical, which shows how well the company has functioned as a holistic entity and how likely it is to grow and thrive in the future.

Terms & Concepts

  • Chief Financial Officer (CFO): Person in an organization who directs the corporation's finances. CFOs are responsible for overseeing financial statements and reporting and for overseeing compliance issues.
  • Collective Bargaining: The process whereby workers organize collectively and bargain with employers regarding the workplace (employment, wages, and benefits).
  • Financial Statements: Financial statements are documents that note the status of a company's assets, expenses, revenues, and liabilities.
  • Generally Accepted Accounting Principals (GAAP or US-GAAP): The standard framework of guidelines for financial accounting. Includes standards, conventions, and rules. GAAP accommodates variation in accounting methods, further allowing the results of financial reporting to vary depending upon the purpose.
  • International Financial Reporting Standards (IFRS): Known by its former term, International Accounting Standards (IAS), and as International GAAP, these accounting standards have been adopted by more than one hundred countries, excluding the United States.
  • Investor Confidence: The attitude of investors regarding risk. Investor confidence in markets and companies is essential to raising the capital necessary to expand infrastructure and enter new markets.
  • Public Company Accounting Oversight Board (PCAOB): A private sector, nonprofit, self-regulatory body overseeing the auditors of public companies. The PCAOB was created when Sarbanes-Oxley became law.
  • Remediation: In the context of Sarbanes-Oxley, remediation is the process by which companies identify errors and omissions in compliance processes and go about correcting the actions.
  • Securities & Exchange Commission (SEC): The U.S. government agency that enforces the federal securities industry and the stock market.

Bibliography

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Fargher, N., & Gramling, A. (2005). Toward improved internal controls. CPA Journal, 75, 26-29. Retrieved August 16, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=17869833&site=ehost-live

Hansen, F. (2007). Convergence come together. Business Finance, 13, 16-19. Retrieved August 16, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=24519956&site=ehost-live

Harper, D. (n.d.) Financial statements introduction. Investopedia .Retrieved August 16, 2007, from http://www.investopedia.com/university/financialstatements/default.asp

IASPlus. (2013). Japan. IASPlus.com. Retrieved November 24, 2013, from http://www.iasplus.com/en/jurisdictions/asia/japan

Johnson, S. (2007). What if IFRS replaced GAAP? CFO.com. Retrieved August 16, 2007, from http://www.cfo.com/article.cfm/9634508/c%5f2984368?f=singlepage

Leone, M. (2006). SarbOx Burdens Prompt CFO Job Churn. CFO.com. Retrieved August 20, 2007, from http://www.cfo.com/article.cfm/7051704/c%5f2984409

Libby, R., & Brown, T. (2013). Financial statement disaggregation decisions and auditors' tolerance for misstatement. Accounting Review, 88, 641-665. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=86040372&site=ehost-live

Nagel, K. (2002). Sarbanes-Oxley financial and accounting disclosure information. Retrieved August 20, 2007, from http://www.sarbanes-oxley.com/section.php

SEC establishes advisory committee. (2007, June). ComplyNet, 21. Retrieved August 16, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=25900730&site=ehost-live

SEC. (2007). Beginner's guide to Financial Statements. US Securities and Exchange Comission.. Retrieved August 15, 2007, from http://www.sec.gov/investor/pubs/begfinstmtguide.htm

Taub, S. (2007). The toughest job in corporate America. Institutional Investor, 41, 37-44. Retrieved August 16, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=24202687&site=ehost-live

Taylor, C. (2007). SEC: IBM withheld earnings info, misled investors. Electronic News, 53, 21-21. Retrieved August 16, 2007, from EBSCO Online Database Academic Search Premier. http://search.ebscohost.com/login.aspx?direct=true&db=aph&AN=25487252&site=ehost-live

Wagner, S., & Dittmar, L. (2006). The unexpected benefits of Sarbanes-Oxley. Harvard Business Review, 84, 133-140. Retrieved August 16, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=19998923&site=ehost-live

Ward, S.P., & Ward, D.R. (2013). A proposed new vision for financial statements: A primer for non-financial executives. Business Studies Journal, 5, 77-94. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=87717982&site=ehost-live

Woellert, L. (2006, December 5). The SEC opens up SarbOx. Business Week Online, 1. Retrieved August 16, 2007, from EBSCO Online Database Academic Search Premier. http://search.ebscohost.com/login.aspx?direct=true&db=aph&AN=23365473&site=ehost-live

Suggested Reading

Accounting & auditing. (2007). Practical Accountant, 40, 21-22. Retrieved August 15, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=26011587&site=ehost-live

Brodkin, J. (2007). SOX: Five years of headaches. Network World, 24, 1-16. Retrieved August 16, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=25985000&site=ehost-live

Carlino, B. (2007). Who needs GAAP? Accounting Today, 21, 1-30. Retrieved August 15, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=25898455&site=ehost-live

Government Accounting Standards Board. (2006; rev. 2013). Why governmental accounting and financial reporting is-and should be-different. Retrieved November 24, 2013, from http://www.gasb.org/cs/ContentServer?c=Document%5FC&pagename=GASB%2FDocument%5FC%2FGASBDocumentPage&cid=1176162354189

Miller, R. (2007). Implementing the new internal control audit standards the time is now. Are you ready? Sum News, 18, 18-21. Retrieved August 16, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=25753382&site=ehost-live

Tysiac, K. (2013). New mechanisms eyed by FASB, IASB in long march toward global comparability. Journal of Accountancy (November, 2013). Retrieved November 24, 2013, from http://www.journalofaccountancy.com/News/20137119.htm

Essay by Carolyn Sprague, MLS

Carolyn Sprague holds a BA from the University of New Hampshire and an MA in Library Science from Simmons College. Carolyn gained valuable business experience as owner of her own restaurant, which she operated for 10 years. Since earning her graduate degree, Carolyn has worked in numerous library and information settings within the academic, corporate, and consulting worlds. Her operational experience as a manager at a global high-tech firm and her work as a web content researcher have afforded Carolyn insights into many aspects of today's challenging and fast-changing business climate.