Introduction to bookkeeping: The Users of Financial Accounting Information

Recall that the primary goal of financial accounting is to provide decision makers with useful information. This topic  identifies the major users of financial statements and describes the decisions they make.

The predominant users of financial accounting information are those parties who have a financial interest in the organization and hence are concerned with its economic status. All organizations, whether not-for-profit or investor owned, have stakeholders who have an interest in the business. In a not-for-profit organization, such as a community hospital, the stakeholders include managers - staff physicians - employees - suppliers - creditors - patients - and even the community at large. 

Investor-owned organizations have essentially the same set of stakeholders - plus owners. Because all stakeholders, by definition, have an interest in the organization, all stakeholders have an interest in its
financial condition.

Of all the outside stakeholders, investors - who supply the capital (funds) needed by businesses - Investors fall into two categories: (1) owners (often stockholders )  (2) creditors (or lenders) 

1- Owners :

 Owners Present and potential owners (investors) are prime users of  financial statements. They continually assess and compare the prospects of alternative investments. 

The assessment of each investment is often based on two variables: expected return and risk. 

Expected return refers to the increase in the investor’s wealth that is expected over the investment’s time horizon. This wealth increase is comprised of two parts: 

(1) increases in the market value of the investment

(2) dividends (periodic cash distributions from the firm to its owners). 

Both of these sources of wealth depend on the firm’s ability to generate cash. Accordingly, financial statements can improve decision making by providing information that helps current and potential investors estimate a firm’s future cash flows.

Risk refers to the uncertainty surrounding estimates of expected return. The term expected implies that the return is not guaranteed. For most investments, numerous alternative  future  returns are possible. For example, an  investor may project  that a firm’s most likely return for the upcoming year is $100,000. However, the investor recognizes that this is not the only possibility. There is some chance that the firm might
generate returns of $95,000 or $115,000. Still other possibilities might be $85,000 and $125,000. 

The greater the difference among these estimates, the greater the risk. Financial statements help investors assess risk by providing information about the historical pattern of past income and cash flows.

Investment selection  involves a trade-off between expected return and risk. Investments with high expected returns generally have a high risk. Each investor must assess whether  investments with greater  risk offer  sufficiently higher expected  returns.

2- Creditors :

 The lending decision involves two issues: whether or not credit should be extended - and  the specification of a  loan’s  terms. For example, consider a bank loan officer evaluating a loan application. 

The officer must make decisions about the amount of the loan (if any)- interest rate - payment schedule - and collateral. Because repayment of the loan and interest will rest on the applicant’s ability to generate cash, lenders need to estimate a firm’s future cash flows and the uncertainty surrounding those flows. 

Although investors generally take a long-term view of a firm’s cash generating ability, creditors are concerned about this ability only during the loan period.

Lenders are not the only creditors who find financial statements useful. Suppliers often sell on credit - and  they must decide which customers will or will not honor their obligations.

Other Users : 

A variety of other decision makers find financial statements helpful. Some of these decision makers and their decisions include the following:
1. Financial analysts and advisors. Many investors and creditors seek expert advice when making their investment and lending decisions. These experts use financial statements as a basis for their recommendations.

2. Customers. The customers of a business are interested in a stable source of supply. They  can use  financial  statements  to  identify  suppliers  that  are  financially sound.

3. Employees and labor unions. These groups have an interest in the viability and profitability of firms that employ them or their members - As described in Reality Check 1-1 - unions in the airline industry have recently made several important decisions based - in part - on financial statements.

REALITY CHECK 1-1

United Airlines: Employees of United Airlines gained  controlling ownership of United’s parent, UAL Corporation, by agreeing to billions of dollars in wage and benefit concessions. The employees needed to estimate the value of UAL so that they could determine the extent of the wages and benefits to sacrifice. Financial statements are frequently used in valuing businesses.
Northwest Airlines: In 1993, Northwest asked its pilots to forgo $886 million in wages and benefits over three years. Northwest’s  reported 1993  loss of $115 million played a  role  in  securing  the pilots’ agreement. However,  in 1997, Northwest reported a profit of $597 million. As you might imagine, the pilots became much more assertive in their bargaining, asking for wage increases, profit sharing, and bonuses.

4. Regulatory authorities. Federal and state governments regulate a large array of business activities. The Securities and Exchange Commission (SEC) is a prominent example. Its responsibility is to ensure that capital markets, such as the New York Stock Exchange, operate smoothly. To help achieve this, corporations are required to make full and fair financial disclosures. The SEC regularly reviews firms’ financial statements to evaluate the adequacy of their disclosures. Reality Check 1-2 describes another regulatory use of accounting information.

REALITY CHECK 1-2

California has perhaps the country’s toughest standards for vehicle emissions. One aspect of its program requires the major automakers to generate 10% of their California sales from electric vehicles by 2003. Compliance with this regulation will be assessed from financial accounting information.

In general, there is only one category of owners. However, creditors constitute a diverse group of investors including banks, suppliers granting trade credit, and bondholders. 

Investors are the primary outside users of financial accounting information. They use the information to make judgments pertaining to whether or not to make a particular investment, as well as to set the return required on the investment.

Although financial accounting developed primarily to meet the information needs of outside parties, the managers of an organization, including its board of directors (trustees), also are important users of the information. After all, managers are charged with ensuring that the organization has the financial strength to accomplish its mission, whether that mission is to maximize the wealth of its owners or to provide healthcare services to the community at large. 

Thus, an organization’s managers are not only involved with creating financial statements - but they are also important users of the statements, both to assess current financial condition and to formulate plans to ensure that the future financial condition of the organization will support its goals.

In summary, investors and managers are the predominant users of financial accounting information as a result of their direct financial interest in the organization. Furthermore, investors are not merely passive users of financial accounting information - they do more than just read and interpret the statements. 

Often, they create financial targets based on the numbers reported in financial statements that managers must attain or suffer some undesirable consequence. For example,many debt agreements require borrowers tomaintain stated financial standards - such as a minimum earnings level - to keep the debt in force. 

If the standards are not met - the lender can demand that the
business immediately repay the full amount of the loan - If the business fails to do so, it may be forced into bankruptcy.

The accounting profession views financial statements as being general purpose. They are intended to meet the common information needs of a wide variety of users - such as those in the preceding list.

Accounting for intangible assets - Self-generated intangible assets

Recently, while browing through the financial article, we noticed one interesting article from www.investopedia.com relating to intangible assets. We have extracted some paragraphs as below:

"Any business professor will tell you that the value of companies has been shifting markedly from tangible assets, "bricks and mortar", to intangible assets like intellectual capital. These invisible assets are the key drivers of shareholder value in the knowledge economy, but accounting rules do not acknowledge this shift in the valuation of companies. Statements prepared under generally accepted accounting principles do not record these assets. Left in the dark, investors must rely largely on guesswork to judge the accuracy of a company's value.
But although companies' percentage of intangible assets has increased, accounting rules have not kept pace. For instance, if the R&D efforts of a pharmaceuticals company create a new drug that passes clinical trials, the value of that development is not found in the financial statements. It doesn't show up until sales are actually made, which could be several years down the road. Or consider the value of an e-commerce retailer. Arguably, almost all of its value comes from software development, copyrights and its user base. While the market reacts immediately to clinical trial results or online retailers' customer churn, these assets slip through financial statements.

As a result, there is a serious disconnect between what happens in capital markets and what accounting systems reflect. Accounting value is based on the historical costs of equipment and inventory, whereas market value comes from expectations about a company's future cash flow, which comes in large part from intangibles such as R&D efforts, patents and good ol' workforce "know-how". "

Our audit client may have invested research & development costs, payroll costs in developing intangible assets, e.g. new drugs, software, new machines. The invention may subsequently lead the Company to apply for patents, which is essentially the intangible assets of the Company. According to IFRS, internally generated goodwill should not be recognised on the balance sheet of the Company. Some of the readers may wonder why this asset should not be recognised on the balance sheet of the Company.

Let us answer this question by giving you a scenario by assuming intangible assets can be recognised. The Company would capitalise the costs incurred as an intangible assets, i.e.

Dr. Intangible Assets
Cr. Costs (i.e. R&D costs, payroll costs)

By capitalising the intangible assets, the Company will be able to reduce the costs and increase the profitability. There's a incentive for certain Company to capitalise intangible assets as much as possible, in order to reduce the costs incurred, even for certain costs that may not yiled economic benefits to the Company.

Sometimes, it is hard to measure the real economic benefit of an intangible assets. A Company should not recognise intangible assets if it is not econmical benificial to the Company. This is the issue with the recognition. Also, for the measurement, how should intangible assets be measured. Some might argue that, it should be the full amount of costs incurred. However, what if the full amonut of costs is not 100% beneficial to the Company? Do we still recognise the full amount?

It will be a challenge for the accountant, auditor, and even general invenstor to understand the nature or amount of the intangible assets being recognised on the balance sheet. Hence, in order to protect financial statement user, self generated intangible assets should not be recognised. However, this amount can be disclosed in the financial statement for financial statement user to understand the Company better.

Presentation & Disclosure: Gross revenue vs net revenue - Principal vs Agency Relationship

Revenue recognition is a crucial and important topic in the auditing profession. One of the key challenges auditor face is: auditor need to review the substance of the transaction to determine if an entity is a principal or an agent in certain business arrangement. An entity need to present the revenue on a gross basis if the entity is deemed to be a principal, whereas an entity need to present the revenue on a net basis if the entity is deemed to be an agent.

To illustrate, insurance agent is selling insurance contract worth US$300 dollar. Insurance agent is able to earn a commission of US$20 dollar by selling such contract. What should be the revenue for insurance agent upon successful selling of this insurance contract ? US$300 or US$20? IAS18 states that 'in an agency relationship, the gross inflows of economic benefits include amounts collected on behalf of the principal and which do not result in increases in equity for the entity. The amounts collected on behalf of the principal are not revenue. Instead, revenue is the amount of commission.

Determining whether an entity is acting as a principal or as an agent requires judgement and consideration of all relevant facts and circumstances. An entity is acting as a principal when it has exposure to the significant risks and rewards associated with the sale of goods or the rendering of services.

Features that indicate that an entity is acting as a principal include: (a) the entity has the primary responsibility for providing the goods or services to the customer or for fulfilling the order, for example by being responsible for the acceptability of the products or services ordered or purchased by the customer; (b) the entity has inventory risk before or after the customer order, during shipping or on return; (c) the entity has latitude in establishing prices, either directly or indirectly, for example by providing additional goods or services; and (d) the entity bears the customer's credit risk for the amount receivable from the customer.

An entity is acting as an agent when it does not have exposure to the significant risks and rewards associated with the sale of goods or the rendering of services. One feature indicating that an entity is acting as an agent is that the amount the entity earns is predetermined, being either a fixed fee per transaction or a stated percentage of the amount billed to the customer. In the example above, insurance agent should recognise US$20 as its revenue (instead of US$300) as the insurance agent is not entitled to the full economic benefit of entire US$300.