Investopedia.com– the resource for investing and personal finance education.even though historical cost is reliable, reporting the currentmarket valueof theproperty would be more relevant--but also less reliable.Consider alsoderivative instruments, an area where relevance trumps reliability.Derivatives can be complicated and difficult to value, but some derivatives(speculative nothedgederivatives) increaserisk. Rules therefore require companies
to carry derivatives on the balance sheet at "fair value", which requires an estimate,even if the estimate is not perfectly reliable. Again, the imprecise fair value estimateis more relevant than historical cost. You can see how some of the complexity inaccounting is due to a gradual shift away from "reliable" historical costs to "relevant"market values.
The second reason for the complexity in accounting rules is the unavoidablerestriction on the reporting period: financial statements try to capture operatingperformance over the fixed period of a year.Accrual accountingis the practice of matching expenses incurred during the year with revenue earned, irrespective of cash flows. For example, say a company invests a huge sum of cash to purchase afactory, which is then used over the following 20 years.Depreciationis just a way of allocating the purchase price over each year of the factory's useful life so that profitscan be estimated each year. Cash flows are spent and received in a lumpy patternand, over the long run, total cash flows do tend to equal total accruals. But in asingle year, they are not equivalent. Even an easy reporting question such as "howmuch did the company sell during the year?" requires making estimates thatdistinguish cash received from revenue earned: for example, did the company userebates, attach financing terms, or sell to customers with doubtful credit?
(Please note: throughout this tutorial we refer to U.S. GAAP and U.S.-specificsecurities regulations, unless otherwise noted. While the principles of GAAP aregenerally the same across the world, there are significant differences in GAAP foreach country. Please keep this in mind if you are performing analysis on non-U.S.companies. )
The Financial Statements Are a System (Balance Sheet & Statement of Cash Flow)
Financial statements paint a picture of the transactions that flow through a business.Each transaction or exchange--for example, the sale of a product or the use of arented facility--is a building block that contributes to the whole picture.Let's approach the financial statements by following a flow of cash-basedtransactions. In the illustration below, we have numbered four major steps:
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