You are on page 1of 33

BBA 3002

FINANCIAL STATEMENT

ANALYSIS

KHOO YU TING

921227015896

200080

MR. LOH YONG CHIANG

SEPTEMBER 2013

TABLE OF CONTENT
TOPIC PAGES

1 Contents 2

2 Background of each company 3-8

-Prepare simplified balance sheet for each


3 8-22
company
-Draw up common-size statement
-Compute the principle financial ratio
-Compare and contrast the companies
Conclusion
4 23-24

5 References 25

6 Coursework 26-33

2.0 Background of company

Page 2 of 33
Toyota

Toyota Motor Corporation is a Japanese multinational automaker headquartered

in Toyota, Aichi, Japan. In 2010, Toyota employed 325,905 people worldwide, and was

the third-largest manufacturer in 2011 by production behind General

Motors and Volkswagen Group. Toyota is the eleventh-largest company in the world by

revenue. In July 2012, the company reported it had manufactured its 200-millionth

vehicle.

The company was founded by Kiichiro Toyoda in 1937 as a spinoff from his

father's company Toyota Industries to create automobiles. Three years earlier, in 1934,

while still a department of Toyota Industries, it created its first product, the Type A

engine, and, in 1936, its first passenger car, the Toyota AA. Toyota Motor Corporation

group companies are Toyota (including the Scion brand), Lexus, Daihatsu, and Hino

Motors, along with several "nonautomotive" companies. TMC is part of the Toyota

Group, one of the largest conglomerates in the world.

Mazda

Page 3 of 33
Mazda began as the Toyo Cork Kogyo Co., Ltd, founded in Japan in 1920. Toyo Cork

Kogyo renamed itself to Toyo Kogyo Co., Ltd. in 1927. Toyo Kogyo moved from

manufacturing machine tools to vehicles with the introduction of the Mazda-Go in 1931.

Toyo Kogyo produced weapons for the Japanese military throughout the Second World

War, most notably the series 30 through 35 Type 99 rifle. The company formally adopted

the Mazda name in 1984, though every automobile sold from the beginning bore that

name. The Mazda R360 was introduced in 1960, followed by the Mazda engines in 1962.

Beginning in the 1960s, Mazda put a major engineering effort into development of

the Wankel rotary engine as a way of differentiating itself from other Japanese auto

companies. Beginning with the limited-production Cosmo Sport of 1967 and continuing

to the present day with the Pro Mazda Championship, Mazda has become the sole

manufacturer of Wankel-type engines mainly by way of attrition (NSU and Citron both

gave up on the design during the 1970s, and prototype Corvette efforts by General

Motors never made it to production.)This effort to bring attention to itself apparently

helped, as Mazda rapidly began to export its vehicles. Both piston-powered and rotary-

powered models made their way around the world. The rotary models quickly became

popular for their combination of good power and light weight when compared to piston-

engined competitors that required heavier V6 or V8 engines to produce the same power.

The R100 and the famed RX series (RX-2, RX-3, and RX-4) led the company's export

efforts.

During 1968, Mazda started formal operations in Canada (MazdaCanada) although

Mazdas were seen in Canada as early as 1959. In 1970, Mazda formally entered the

American market (Mazda North American Operations) and was very successful there,

Page 4 of 33
going so far as to create the Mazda Rotary Pickup (based on the conventional piston-

powered B-Series model) solely for North American buyers. To this day, Mazda remains

the only automaker to have produced a Wankel-powered pickup truck. Additionally, it is

also the only marque to have ever offered a rotary-powered bus (the Mazda Parkway,

offered only in Japan) or station wagon (within the RX-3 & RX-4 line for US markets).

Mazda's rotary success continued until the onset of the 1973 oil crisis. As American

buyers (as well as those in other nations) quickly turned to vehicles with better fuel

efficiency, the relatively thirsty rotary-powered models began to fall out of favor. An

already heavily indebted Toyo Kogyo was on the verge of bankruptcy and was only saved

through the intervention of Sumitomo Bank. Wisely, the company had not totally turned

its back on piston engines, as it continued to produce a variety of four-cylinder models

throughout the 1970s. The smaller Familia line in particular became very important to

Mazda's worldwide sales after 1973, as did the somewhat larger Capella series.Mazda

refocused its efforts and made the rotary engine a choice for the sporting motorist rather

than a mainstream powerplant. Starting with the lightweight RX-7 in 1978 and

continuing with the modern RX-8, Mazda has continued its dedication to this unique

powerplant. This switch in focus also resulted in the development of another lightweight

sports car, the piston-powered Mazda Roadster (perhaps better known by its worldwide

names as the MX-5 or Miata), inspired by the concept 'jinba ittai'. Introduced in 1989 to

worldwide acclaim, the Roadster has been widely credited with reviving the concept of

the small sports car after its decline in the late 1970s.

Hyundai

Page 5 of 33
Chung Ju-Yung founded the Hyundai Engineering and Construction Company in 1947.

Hyundai Motor Company was later established in 1967. The company's first model,

the Cortina, was released in cooperation with Ford Motor Company in 1968. When

Hyundai wanted to develop their own car, they hired George Turnbull, the former

Managing Director of Austin Morris at British Leyland. He in turn hired five other top

British car engineers. They were Kenneth Barnett body design, engineers John Simpson

and Edward Chapman, John Crosthwaite ex-BRM as chassis engineer and Peter Slater as

chief development engineer.[8][9][10][11] In 1975, the Pony, the first Korean car, was released,

with styling by Giorgio Giugiaro of ItalDesign and powertrain technology provided by

Japan's Mitsubishi Motors. Exports began in the following year to Ecuador and soon

thereafter to the Benelux countries.

In 1984, Hyundai exported the Pony to Canada, but not to the United States, because the

Pony didn't pass emissions standards there. Canadian sales greatly exceeded expectations,

and it was at one point the top-selling car on the Canadian market. The Pony afforded a

much higher degree of quality and refinement in the lowest price auto segment than the

Eastern-bloc imports of the period then available. In 1985, the one millionth Hyundai car

was built.[12]

In 1986, Hyundai began to sell cars in the United States, and the Excel was nominated as

"Best Product #10" by Fortune magazine, largely because of its affordability. The

company began to produce models with its own technology in 1988, beginning with the

midsize Sonata. In the spring of 1990, aggregate production of Hyundai automobiles

reached the four million mark.[12] In 1991, the company succeeded in developing its first

Page 6 of 33
proprietary gasoline engine, the four-cylinder Alpha, and also its own transmission, thus

paving the way for technological independence.

In 1996, Hyundai Motor India Limited was established with a production plant in

Irungattukottai near Chennai, India.[13]

In 1998, Hyundai began to overhaul its image in an attempt to establish itself as a world-

class brand. Chung Ju Yung transferred leadership of Hyundai Motor to his son, Chung

Mong Koo, in 1999.[14] Hyundai's parent company, Hyundai Motor Group, invested

heavily in the quality, design, manufacturing, and long-term research of its vehicles. It

added a 10-year or 100,000-mile (160,000 km) warranty to cars sold in the United States

and launched an aggressive marketing campaign.

In 2004, Hyundai was ranked second in "initial quality" in a survey/study by J.D. Power

and Associates. Hyundai is now one of the top 100 most valuable brands worldwide.

Since 2002, Hyundai has also been one of the worldwide official sponsors of the FIFA

World Cup.

In 2006, the South Korean government initiated an investigation of Chung Mong Koo's

practices as head of Hyundai, suspecting him of corruption. On 28 April 2006, Chung

was arrested, and charged for embezzlement of 100 billion South Korean

won (US$106 million).[15] As a result, Hyundai Vice Chairman and CEO, Kim Dong-jin,

replaced him as head of the company. On 30 September 2011, Yang Seung Suk

announced his retirement as CEO of Hyundai Motor Co. In the interim replacement

period, Chung Mong-koo and Kim Eok-jo will divide the duties of the CEO position.

Ford

Page 7 of 33
Ford Motor Company is an American automaker and the world's third largest

automaker based on worldwide vehicle sales. Based in Dearborn, Michigan, a suburb

of Detroit, the automaker was founded by Henry Ford, and incorporated on June 16,

1903. Ford Motor Company would go on to become one of the largest and most

profitable companies in the world, as well as being one of the few to survive the Great

Depression. The largest family-controlled company in the world, the Ford Motor

Company has been in continuous family control for over 110 years. Ford now

encompasses two brands: Ford and Lincoln. Ford once owned 5 other luxury brands, they

were Volvo, Land Rover, Jaguar, Aston Martin and Mercury. But over time those brands

were sold to other companies and Mercury was discontinued.

3.0 Balance Sheet, Common-size statement, Principle


Financial Ratio, Compare and contrast the companies

Balance Sheet
Page 8 of 33
Toyota

Assets
Current Assets
Cash And Cash Equivalents 25,105,000
Short Term Investments 17,246,000
Net Receivables 78,403,000
Inventory 15,737,000
Other Current Assets 6,243,000
Total Current Assets 142,734,000
Long Term Investments 132,933,000
Property Plant and Equipment 76,124,000
Goodwill -
Intangible Assets -
Accumulated Amortization -
Other Assets 7,985,000
Deferred Long Term Asset Charges -
Total Assets 359,775,000

Mazda

Fixed Assets
Gross Block 20.81
Less : Accumulated Depreciation 7.57

Page 9 of 33
Provision for impairment of Assets 0.00
Net Fixed Assets 13.23
Capital Work In Progress 1.33
Total Fixed Assets 14.56
Investments 4.57
Current Assets
Inventories 15.00
Sundry Debtors 14.72
Cash & Bank Balances 3.02
Loans & Advances 20.12
Total Current Assets 52.87
Current Liabilities & Provisions
Current Liabilities 13.24
Provisions 14.12
Total Current Liabilities & Provision 27.36
Net Current Assets 25.51
Miscellaneous Expenditure written off 0.00
Total Assets 42.89

Hyundai
Assets
Non-Current Assets
Intangible 2,296,960,000

Page 10 of 33
Tangible 17,123,284,000
Investments 11,932,235,000
Other 20,934,565,000
Total 52,287,044,000
Stock 5,386,195,000
Debtors 23,180,103,000
Cash and Securities 13,680,790,000
Total 42,247,088,000
Total Assets 94,534,132,000

Ford

Assets

Page 11 of 33
Current Assets

Cash And Cash Equivalents 17,148,000

Short Term Investments 18,618,000

Net Receivables 78,541,000

Inventory 5,901,000

Other Current Assets -

Total Current Assets 120,208,000


Long Term Investments 2,936,000
Property Plant and Equipment 35,209,000
Goodwill -
Intangible Assets 100,000
Accumulated Amortization -
Other Assets 4,770,000
Deferred Long Term Asset Charges 15,125,000
Total Assets 178,348,000

Common-size statement

Toyota

Page 12 of 33
Revenue 5,501,573.00
Other Revenue, Total -
Total Revenue 5,501,573.00
Cost of Revenue, Total 4,672,832.00
Gross Profit 828,741.00
Selling/General/Admin. Expenses, Total 475,598.00
Research & Development -
Depreciation/Amortization -
Interest Expense(Income) - Net Operating -
Unusual Expense (Income) -
Other Operating Expenses, Total -
Total Operating Expense 5,148,430.00

Mazda
Revenues 2,325,689.0
TOTAL REVENUES 2,325,689.0
Cost Of Goods Sold 1,863,678.0

Page 13 of 33
GROSS PROFIT 462,011.0
Selling General & Admin Expenses, Total 317,826.0

R&D Expenses 90,961.0


Other Operating Expenses 29,389.0
OTHER OPERATING EXPENSES, TOTAL 438,176.0

OPERATING INCOME 23,835.0


Interest Expense -11,840.0
Interest And Investment Income 2,071.0
Other Non-Operating Expenses, Total 22,796.0

Other Non-Operating Income (Expenses) -650.0

Gain (Loss) On Sale Of Investments 717.0


Gain (Loss) On Sale Of Assets -1,908.0
Other Unusual Items, Total -19,590.0
EBT, INCLUDING UNUSUAL ITEMS 16,081.0

Income Tax Expense 75,845.0


Minority Interest In Earnings -278.0
Earnings From Continuing Operations -59,764.0

NET INCOME -60,042.0


NET INCOME TO COMMON INCLUDING EXTRA ITEMS -60,042.0

NET INCOME TO COMMON EXCLUDING EXTRA ITEMS -60,042.0

Hyundai

Revenue 77,797,895
Cost of revenue 58,902,023

Page 14 of 33
Gross profit 18,895,872
Operating expenses
Research and development 632,003
Sales, General and admire 5,881,798
Restructuring, merger 137,507
Other operating expenses 4,142,965
Total operating expenses 10,794,272

Ford

Period Ending Dec 31, 2011

Total Revenue 136,264,000


Cost of Revenue 113,345,000
Gross Profit 22,919,000

Research Development -

Selling General and Administrative 15,192,000

Non Recurring (33,000)

Page 15 of 33
Others -

Total Operating Expenses -

Operating Income or Loss 7,760,000

Total Other Income/Expenses Net 1,238,000

Earnings Before Interest And Taxes 9,498,000

Interest Expense 817,000

Income Before Tax 8,681,000

Income Tax Expense (11,541,000)

Minority Interest (9,000)

Net Income From Continuing Ops 20,713,000

Discontinued Operations -

Extraordinary Items -

Effect Of Accounting Changes -

Other Items -

Net Income 20,213,000


Preferred Stock And Other Adjustments -

Net Income Applicable To Common Shares 20,213,000

Principle Financial Ratio


Fundamental analysis and financial ratio analysis, as you can imagine, is a pretty

powerful thing and is essential for successful investing. Some people may opt for

quantitative or technical analysis methods when it comes to sharemarket investing,

Page 16 of 33
depending upon their personalities, spare time and inclinations, but for most investors,

fundamental analysis offers a sound, intellectual framework for making informed share

investment decisions. Within the broad discipline of fundamental analysis, financial ratio

analysis in turn offers the clearest, easiest and most logical set of indicators for a share

market investor. Empirical and tested evidence suggests that fundamental and ratio

analysis is a powerful ally in the hands of an active and savvy investor.

Liquidity Ratios

Liquidity ratios indicate whether a company has the ability to pay off short-term debt

obligations (debts due to be paid within one year) as they fall due. Generally, a higher

value is desired as this indicates greater capacity to meet debt obligations.

Leverage Ratios

Leverage ratios, also referred to as gearing ratios, measure the extent to which a company

utilizes debt to finance growth. Leverage ratios can provide an indication of a companys

long-term solvency. Whilst most financial experts will acknowledge that debt is a cheaper

form of financing than equity, debt carries risks and investors need to be aware of the

extent of this risk.

Profitability Ratios

Page 17 of 33
Profitability ratios measure a companys performance and provide an indication of its

ability to generate profits. As profits are used to fund business development and pay

dividends to shareholders, a companys profitability and how efficient it is at generating

profits is an important consideration for shareholders.

Valuation Ratios

Valuation ratios are used by investors to determine whether the current share price of a

company is high or low in relation to its true value. Valuation ratios also help us assess if

a company is cheap or expensive relative to earnings, growth prospects and dividend

distributions.

Compare and contrast the companies

i. Balance sheet

In financial accounting, a balance sheet or statement of financial position is a summary of

the financial balances of a sole proprietorship, a business partnership, a corporation or


Page 18 of 33
other business organization, such as an LLC or an LLP. Assets, liabilities andownership

equity are listed as of a specific date, such as the end of its financial year. A balance sheet

is often described as a "snapshot of a company's financial condition".Of the four

basic financial statements, the balance sheet is the only statement which applies to a

single point in time of a business' calendar year.

A standard company balance sheet has three parts: assets, liabilities and ownership equity.

The main categories of assets are usually listed first and typically in order of liquidity.

Assets are followed by the liabilities. The difference between the assets and the liabilities

is known as equity or the net assets or the net worth or capital of the company and

according to the accounting equation, net worth must equal assets minus liabilities.

Another way to look at the same equation is that assets equal liabilities plus owner's

equity. Looking at the equation in this way shows how assets were financed: either by

borrowing money (liability) or by using the owner's money (owner's equity). Balance

sheets are usually presented with assets in one section and liabilities and net worth in the

other section with the two sections "balancing".

A business operating entirely in cash can measure its profits by withdrawing the entire

bank balance at the end of the period, plus any cash in hand. However, many businesses

are not paid immediately; they build up inventories of goods and they acquire buildings

and equipment. In other words: businesses have assets and so they cannot, even if they

want to, immediately turn these into cash at the end of each period. Often, these

businesses owe money to suppliers and to tax authorities, and the proprietors do not

withdraw all their original capital and profits at the end of each period. In other words

businesses also have liabilities.

Page 19 of 33
ii. Financial ratio

A financial ratio (or accounting ratio) is a relative magnitude of two selected numerical

values taken from an enterprise's financial statements. Often used in accounting, there are

many standard ratios used to try to evaluate the overall financial condition of a

corporation or other organization. Financial ratios may be used by managers within a

firm, by current and potential shareholders (owners) of a firm, and by a

firm's creditors. Financial analysts use financial ratios to compare the strengths and

weaknesses in various companies. If shares in a company are traded in a financial market,

the market price of the shares is used in certain financial ratios.Ratios can be expressed as

a decimal value, such as 0.10, or given as an equivalent percent value, such as 10%.

Some ratios are usually quoted as percentages, especially ratios that are usually or always

less than 1, such as earnings yield, while others are usually quoted as decimal numbers,

especially ratios that are usually more than 1, such as P/E ratio; these latter are also

called multiples. Given any ratio, one can take its reciprocal; if the ratio was above 1, the

reciprocal will be below 1, and conversely. The reciprocal expresses the same

information, but may be more understandable: for instance, the earnings yield can be

compared with bond yields, while the P/E ratio cannot be: for example, a P/E ratio of 20

corresponds to an earnings yield of 5%.

iii. Ratio of analysis

Page 20 of 33
Financial statement analysis (or financial analysis) the process of understanding the risk

and profitability of a firm (business, sub-business or project) through analysis of reported

financial information, by using different accounting tools and techniques.

Financial statement analysis consists of 1) reformulating reported financial statements, 2)

analysis and adjustments of measurement errors, and 3) financial ratio analysis on the

basis of reformulated and adjusted financial statements. The first two steps are often

dropped in practice, meaning that financial ratios are just calculated on the basis of the

reported numbers, perhaps with some adjustments. Financial statement analysis is the

foundation for evaluating and pricing credit risk and for doing fundamental company

valuation.

1) Financial statement analysis typically starts with reformulating the reported financial

information. In relation to the income statement, one common reformulation is to divide

reported items into recurring or normal items and non-recurring or special items. In this

way, earnings could be separated into normal or core earnings and transitory earnings.

The idea is that normal earnings are more permanent and hence more relevant for

prediction and valuation. Normal earnings are also separated into net operational profit

after taxes (NOPAT) and net financial costs. The balance sheet is grouped, for example,

in net operating assets (NOA), net financial debt and equity.

2) Analysis and adjustment of measurement errors question the quality of the reported

accounting numbers. The reported numbers can for example be a bad or noisy

representation of invested capital, for example in terms of NOA, which means that the

return on net operating assets (RNOA) will be a noisy measure of the underlying

profitability (the internal rate of return, IRR). Expensing of R&D is an example when

Page 21 of 33
such investment expenditures are expected to yield future economic benefits, suggesting

that R&D creates assets which should have been capitalized in the balance sheet. An

example of an adjustment for measurement errors is when the analyst removes the R&D

expenses from the income statement and put them in the balance sheet. The R&D

expenditures are then replaced by amortization of the R&D capital in the balance sheet.

Another example is to adjust the reported numbers when the analyst suspects earnings

management.

3) Financial ratio analysis should be based on regrouped and adjusted financial

statements. Two types of ratio analysis are performed: 3.1) Analysis of risk and 3.2)

analysis of profitability

4.0 Conclusion

Toyota, Mazda, Hyundai, Ford are experiencing contrasting fortunes across the world and

have had their share of economic jolts in the last few years. In this article, I aim to deliver

Page 22 of 33
where the four car makers stand; our argument made a largely statistical case for

suggesting which stock was the best bet for your profits.

Ford recently has been in a fix where the company recalled around 465,000 vehicles to

fix minor faults, under their corporate social responsibility, realizing the responsibility the

company bears to provide the best to their customers. This has spurred a positive image

of Ford Motors, resultantly enhancing customer loyalty. Ford Motors has a strong market

demand, a 13% rise in its U.S. sales testifies to that, leading to increased sales and profit

margins.

U.S. sales of hybrid cars rose by 23% recently, Ford with its Hybrid Sedan and C-Max

Wagon was able to capture a major chunk of this market, by selling 46,197 hybrid units.

Expansion in hybrid and battery-only cars exposes Ford Motors to a wide market, with its

potential to grow rapidly. Moreover, adopting the 3D printing technology Ford Motors is

saving up to 25% of manufacturing time as well as cut the production costs by 30%. All

in all, Ford Motors has brighter prospects.

Toyota Motors had hurt its reputation back when it was recalling not just a few, but

millions of its vehicles due to a glitch in the clutch and floor mat. A slow response in the

most damagingly manner had hurt the reputation of the company. Moreover, the company

is exposed to the risk of reduced production due to a rise in the inventories of vehicles

produced.

Furthermore, Toyota was unable to realize the 4.4% year-on-year increase in sales in

China, which is the roaring car market. To top that its position in North America has also

Page 23 of 33
deteriorated, this accounts for 25% of its total revenues. Due to the devaluation of the

Japanese Yen, Toyota did well over the fiscal year. Apart from that, Toyota Motors is

facing real troubles.

Compared to the rest, Ford Motors clearly has greater growth prospects with minimal

dilemma. Moreover, the company sales have increased more than those of its rivals,

which would lead to a rise in revenue, resulting in increased profit margins available to

appease the investors. In my judgment Ford is comprehensible Buy.

5.0 References

1. text book
2. http://www.google.com/
3. http://en.wikiversity.org/wiki/
4. http://investing.money.msn.com

Page 24 of 33
6.0 Coursework

Twelve Basic Principles

Accountants have some basic rules and assumptions upon which rest all their work in

preparing financial statements. These accounting rules and assumptions dictate what

financial items to measure and when and how to measure them. By the end of this

Page 25 of 33
discussion, you will see how necessary these rules and assumptions are to accounting

and financial reporting.

So, here are the 12 very important accounting principles:

1. accounting entity

2. going concern

3. measurement

4. units of measure

5. historical cost

6. materiality

7. estimates and judgments

8. consistency

9. conservatism

10. periodicity

11. substance over form

12. accrual basis of presentation

These rules and assumptions define and qualify all that accountants do and all that

financial reporting reports. We will deal with each in turn.

1. Accounting Entity. The accounting entity is the business unit (regardless of the

legal business form) for which the financial statements are being prepared.

The accounting entity principle states that there is a "business entity" separate

Page 26 of 33
from its owners... a fictional "person" called a company for which the books

are written.

2. Going Concern. Unless there is evidence to the contrary, accountants assume

that the life of the business entity is infinitely long. Obviously this assumption

can not be verified and is hardly ever true. But this assumption does greatly

simplify the presentation of the financial position of the firm and aids in the

preparation of financial statements.

If during the review of a corporation's books, the accountant has reason to believe

that the company may go bankrupt, he must issue a "qualified opinion" stating the

potential of the company's demise. More on this concept later.

3. Measurement. Accounting deals with things that can be quantifiedresources

and obligations upon which there is an agreed-upon value. Accounting only

deals with things that can be measured.

This assumption leaves out many very valuable company "assets." For example, loyal

customers, while necessary for company success, still cannot be quantified and assigned a

value and thus are not stated in the books.

Financial statements contain only the quantifiable estimates of assets (what the

business owns) and liabilities (what the business owes). The difference between the two

equals owner's equity.

4. Units of Measure. U.S. dollars are the units of value reported in the financial

statements of U.S. companies. Results of any foreign subsidiaries are

translated into dollars for consolidated reporting of results. As exchange rates

Page 27 of 33
vary, so do the values of any foreign currency denominated assets and

liabilities.

5. Historical Cost. What a company owns and what it owes are recorded at their

original (historical) cost with no adjustment for inflation.

A company can own a building valued at $50 million yet carry it on the books at

its $5 million original purchase price (less accumulated depreciation), a gross

understatement of value.

This assumption can greatly understate the value of some assets purchased in the

past and depreciated to a very low amount on the books. Why, you ask, do accountants

demand that we obviously understate assets? Basically, it is the easiest thing to do. You

do not have to appraise and reappraise all the time.

6. Materiality. Materiality refers to the relative importance of different financial

information. Accountants don't sweat the small stuff. But all transactions must

be reported if they would materially affect the financial condition of the

company.

Remember, what is material for a corner drug store is not material for IBM (lost

in the rounding errors). Materiality is a straightforward judgment call.

7. Estimates and Judgments. Complexity and uncertainty make any

measurement less than exact. Estimates and judgments must often be made

for financial reporting. It is okay to guess if (1) that is the best you can do and

(2) the expected error would not matter much anyway. But accountants should

Page 28 of 33
use the same guessing method for each period. Be consistent in your guesses

and do the best you can.

8. Consistency. Sometimes identical transactions can be accounted for

differently. You could do it this way or that way, depending upon some

preference. The principle of consistency states that each individual enterprise

must choose a single method of reporting and use it consistently over time.

You cannot switch back and forth. Measurement techniques must be

consistent from any one fiscal period to another.

9. Conservatism. Accountants have a downward measurement bias, preferring

understatement to overvaluation. For example, losses are- recorded when you

feel that they have a great probability of occurring, not later, when they

actually do occur. Conversely, the recording of a gain is postponed until it

actually occurs, not when it is only anticipated.

10. Periodicity. Accountants assume that the life of a corporation can be divided

into periods of time for which profits and losses can be reported, usually a

month, quarter or year.

What is so special about a month, quarter or year? They are just convenient

periods; short enough so that management can remember what has happened, long

enough to have meaning and not just be random fluctuations. These periods are called

"fiscal" periods. For example, a "fiscal year" could extend from October 1 in one year till

September 30 in the next year. Or a company's fiscal year could be the same as the

calendar year starting on January 1 and ending on December 31.

Page 29 of 33
"Lines" are perhaps not as important as principles, but they can be confusing if you don't

know how accountants use them in financial statements. Financial statements often have

two types of lines to indicate types of numeric computations.

Single lines on a financial statement indicate that a calculation (addition or

subtraction) has been made on the numbers just preceding in the column.

The double underline is saved for the last. That is, use of a double underline

signifies the very last amount in the statement.

Note that while all the numbers in the statement represent currency, only the top

line and the bottom line normally show a dollar sign.

FASB1 makes the rules and they are called GAAP.2

Financial Accounting Standard Board ;2Generally Accepted Principles

11. Substance over Form. Accountants report the economic "substance" of a

transaction rather than just its form. For example, an equipment lease that is really

a purchase dressed in a costume is booked as a purchase and not as a lease on

financial statements. This substance over form rule states that if it's a duck... then

you must report it as a duck.

Page 30 of 33
12. Accrual Basis of Presentation. This concept is very important to understand.

Accountants translate into dollars of profit or loss all the money-making (or

losing) activities that take place during a fiscal period. In accrual accounting, if a

business action in a period makes money, then all its product costs and its

business expenses should be reported in that period. Otherwise, profits and losses

could flop around depending on which period entries were made.

In accrual accounting, this documentation is accomplished by matching for

presentation: (1) the revenue received in selling product and (2) the costs to make that

specific product sold. Fiscal period expenses such as selling, legal, administrative and so

forth are then subtracted.

Key to accrual accounting is determining: (1) when you may report a sale on the

financial statements, (2) matching and then reporting the appropriate costs of products

sold and (3) using a systematic and rational method allocating all the other costs of being

in business for the period. We .will deal with each point separately:

Revenue recognition. In accrual accounting, a sale is recorded when all the

necessary activities to provide the good or service have been completed regardless of

when cash changes hands. A customer just ordering a product has not yet generated any

revenue. Revenue is recorded when the product is shipped.

Matching principle. In accrual accounting, the costs associated with making

products (Cost of Goods Sold) are recorded at the same time the matching revenue is

recorded.

Page 31 of 33
Allocation. Many costs are not specifically associated with a product. These costs

must be allocated to fiscal periods in a reasonable fashion. For example, each month can

be charged with one-twelfth of the general business insurance policy even though the

policy was paid in full at the beginning of the year. Other expenses are recorded when

they arise (period expenses).

Note that all businesses with inventory must use the accrual basis of accounting.

Other businesses may use a "cash basis" if they desire. Cash basis financial statements

are just like the Cash Flow Statement or a simple check book. We'll describe features of

accrual accounting in the chapters that follow.

Who makes all these rules? The simple answer is that "FASB" makes the rules

and they are called "GAAP." Note also that FASB is made up of "CPAs." Got that?

Financial statements in the United States must be prepared according to the

accounting profession's set of rules and guiding principles called the Generally Accepted

Accounting Principles, GAAP for short. Other countries use different rules.

GAAP is a series of conventions, rules and procedures for preparing and reporting

financial statements. The Financial Accounting Standards Board, FASB for short, lays

out the GAAP conventions, rules and procedures.

The FASB's mission is "to establish and improve standards of financial

accounting and reporting for guidance and education of the public, including issuers,

auditors, and users of financial information." The Securities and Exchange Commission

(SEC) designates FASB as the organization responsible for setting accounting standards

for all U.S. public companies.

Page 32 of 33
CPAs CPAs are, of course, Certified Public Accountants. These very exalted individuals

are specially trained in college, and have practiced auditing companies for a number of

years. In addition, they have passed a series of exams testing their clear understanding of

both accounting principles and auditing procedures. Note that FASB is made up mostly of

CPAs and that CPAs both develop, interpret and apply GAAP when they audit a

company. All this is fairly incestuous.

Page 33 of 33