Final accounts, also known as financial statements, are the balance sheets and profit and loss statements compiled by an organization that together show not only its net worth (total value of what is owned minus debts or obligations) but also the number and types of transactions made and profits earned over a specified accounting period. Final accounts are often prepared for the end of the fiscal year and give a financial overview of the year. They provide internal stakeholders (such as owners and managers) with valuable information to use in strategizing for the upcoming fiscal year. They also provide external stakeholders (such as shareholders and potential investors) with an overview of the company's health and profitability.
A balance sheet shows information about an organization's assets (resources owned, including cash, inventory, machinery, accounts receivable, and other valuable property), liabilities (amounts owed to outside entities, including debts, taxes owed, and accounts payable), and shareholder equity (the net worth of the company, determined by subtracting liabilities from assets). The balance sheet, however, does not provide any details about whether a company is regularly generating a profit. For this, organizations rely on income statements, which are sometimes known as profit and loss accounts. Profit and loss accounts describe the financial outcomes of an organization's trading operations and present the calculation of profit by showing information about expenses and revenues. Together, the balance sheets and profit and loss accounts are known as final accounts or financial statements.
Final accounts are important because they can affect a business's internal decisions as well as its public perception. For example, if a financial statement reveals that a business is operating at a loss, the business may respond by reducing discretionary expenses in order to mitigate the losses. Final accounts can also prove that an organization is compliant with financial and tax rules. At the same time, they may affect how others perceive a business. Investors, for example, can use financial statements to see how well an investment is performing and how the company is spending money. Employees may make decisions about staying with or leaving a company depending on the financial stability they see in final accounts. Competitors may use financial statements to make decisions about their own business management.
Historical BackgroundThe Birth of Accounting: Luca Pacioli
At the end of the 11th century, trade in Italy, especially in Venice, was booming. As trade continued to thrive in the new northern Italian city-states through the 15th century, it also became more complex, requiring new record-keeping practices. Merchants in Venice gradually developed what is known as double-entry bookkeeping, recording each transaction as both a debit to one account and a credit to another account (a debit is an increase in assets or a decrease in liabilities, while a credit is a decrease in assets or an increase liabilities). Receiving a loan worth 5 florins, for example, would be recorded as both a 5 florin debit in the cash account and a 5 florin credit in the notes payable account. This allowed businesses to ensure that all inflows and outflows of cash were accounted for and that debits and credits balanced out to zero at the end of an accounting period.
Although double-entry bookkeeping had been in use for several centuries, it was Franciscan friar and mathematician Luca Pacioli (1445?–1517?) who made the method popular by writing about it in Summa de arithmetica, geometria, proportioni et proportionalita (Everything about arithmetic, geometry, and proportion), published in 1494. Pacioli's book describes Page 105 | Top of Articlealgebra and Hindu-Arabic arithmetic, which subsequently became important for accounting, as well as popular accounting practices in Venice. The book was so influential that accountants consider him to be the father of accounting. The book had a wide-reaching impact due to the invention of the printing press, and by the start of the 19th century, double-entry bookkeeping was standard all over Europe.
In Europe during the late 18th and early 19th centuries, the Industrial Revolution led to the development of factories, railroads, and increasingly complex business practices, requiring more complex accounting methods. For example, Josiah Wedgwood (1730–1795) and his business partner Thomas Bentley (1731–1780) developed a pottery-manufacturing business in England that became increasingly successful. By 1769 Wedgwood was facing cash-flow issues, problems meeting demand, and difficulties with accumulating stock. In 1772 he began to use his bookkeeping records not just to track what receipts and sales he had made but also to examine the business practices and accounts of his company. As a result of this analysis, Wedgwood determined that the company's production runs needed to be longer and that the company was collecting bills too slowly to pay for more production. Wedgwood also noticed that the company was spending too much on costs such as labor and raw materials and was pricing items randomly.
Wedgwood's analysis is important for a few reasons. First, it was a way of looking at accounts as part of a decision-making process. Secondly, through his analysis Wedgwood was able to discover the difference between variable and fixed costs as well as their significance for management and manufacturing decisions. He saw that some costs, such as wages and fuel, remained the same no matter how much pottery was made. Therefore, making more pottery would essentially make these costs less per piece of pottery. This information led Wedgwood to develop some of the earliest mass-production techniques.
While Wedgwood's ideas were influential, using the traditional double-entry system to make managerial and manufacturing decisions was not easy; the accounting system had been developed to record transactions only. In the 19th century, wages, production costs, changing interest rates and property values, and other factors affecting the business needed to be recorded alongside simple exchanges.
Accounting needs further changed in the 19th century with the rise of new types of companies. Companies such as railways were created with huge investments managed by joint stock companies and paid for by investors using stock exchanges. Investors demanded regular and reliable information about the health of their investments, but no standard financial-reporting practices were in place.
In Great Britain concern about financial transparency grew until 1841, when Parliament established a select committee to examine the laws and practices concerning joint stock companies. In 1844 the committee published its findings and recommendations, which included suggesting that joint stock companies hold regular meetings and register auditor reports and balance sheets so that they would be accessible to shareholders. The findings led to the passage that year of the Joint Stock Companies Act.
In the first decade of the 20th century, companies in the United States such as U.S. Steel and the International Harvester Company began to issue annual financial reports voluntarily in order to attract investment. In 1917 the Federal Reserve attempted to introduce some regularity into financial reporting by publishing a document titled “Uniform Accounting.” It was not, however, until the establishment of the Securities and Exchange Commission in 1933, at the height of the Great Depression (1929–1939), that a legal foundation for financial reporting was established in the United States.
Partly as a result of these new demands, the 19th and early 20th centuries saw the development of accounting as a profession. The Society of Accountants in Edinburgh was established in 1854, and professional associations for accountants in the United States were developed by 1900.
As global commerce grew and accounting became an important profession, final accounts and other financial documentation became more important for businesses and investors. After World War II (1939–1945), companies that wanted to attract international investments were spending more on preparing their financial statements. During this period accountants around the world recognized the need to unify their accounting practices in order to facilitate international investment. In 1973 accounting firms from Australia, Canada, France, Germany, Japan, Mexico, the Netherlands, the United Kingdom, and the United States formed the International Accounting Standards Committee, issuing an annual set of guidelines known as International Accounting Standards. In 2001 the committee was replaced by the International Accounting Standards Board, which began distributing the International Financial Reporting Standards.
Although financial reporting standards were largely normalized during the second half of the 20th century, the growing complexity of business practices, particularly in the era of globalization that occurred toward the end of the century, allowed for greater manipulation of final accounts reporting. Following a number of accounting scandals around the turn of the century, such as the 2001 Enron scandal (in which the U.S. energy company Enron failed to report debts of up to US$8 billion on its balance sheets), the U.S. Congress passed a comprehensive set of laws known as the Sarbanes-Oxley Act of 2002. The act set harsh penalties for accounting fraud and established a new organization responsible for auditing financial reports, the Public Company Accounting Oversight Board. Countries throughout Europe and Asia passed similar laws in the first decade of the 21st century.
Impacts and IssuesDepreciation and Financial Statements
Many core decisions can affect the results of final accounts. For example, depreciation of any fixed assets can have a significant effect on the profit and loss account. If an organization uses machinery, vehicles, or other fixed assets during a period of time, those assets will generally lose value, or depreciate, due to wear and tear or the introduction of new technology. Accountants therefore estimate the loss of value and record it in the profit and loss account.
Because depreciation is a noncash expense that is tax deductible, it can affect profitability. Depreciation may be far more rapid in some industries than in others. For example, at a Web design company, new computer equipment and software may lose value very quickly because the company may need to have the latest technology to offer its clients.
Depreciation happens gradually, so accountants spread out the depreciation as a cost over the expected life cycle of a specific asset. This means that two things need to be estimated: the expected life cycle of an asset and the expected annual depreciation of the asset. Following are two commonly used depreciation methods.
Straight-Line Method of Depreciation The straight-line method of depreciation (the more common of the two) involves estimating the expected useful life of an asset and allocating the purchase cost to equal portions of that time, with any residual cost left over at the end. If a company buys a $2,000 computer, for example, and it is estimated that the computer will last two years and be worth $100 at the end of that time, then the computer has a depreciation of $950 per year. The main advantage of the straight-line method is its simplicity. The main disadvantage is that it is not highly accurate; an asset's value does not really drop by the same amount each year.
Declining Balance Method of Depreciation Also known as the reducing balance method, this method involves depreciating the asset by a set annual depreciation rate rather than a flat amount each year. That is, if a company buys a $2,000 computer and expects it to decline in value by 50 percent over a period of two years, the computer would depreciate by $1,000 in the first year (50 percent of $2,000) and $500 (50 percent of $1,000) in the second year. The main advantage of the reducing balance method of depreciation is that it acknowledges that depreciation does not stay static and that an asset is more valuable in the early years of its use. In some cases, accountants will place even greater emphasis on the early value of an asset by using what is called the double declining balance method, in which the depreciation rate is multiplied by two.
For tax purposes, this method can result in a lower tax payment because the net income will be seen as lower. One disadvantage of this method is that it is more complex. Another is that it may cause net income to appear lower the first year or two after acquiring a large asset, which may in turn discourage investment.
Inventory (goods available for sale) totals can also affect final accounts. The value of inventory listed on the books is often an estimate. Its real value may be far more changeable than a final figure suggests. In some cases, the value of inventory may be inflated. In any event, the true value of an organization's inventory is only important to future operations, since the value of inventory is generally only realized if a company is a going concern (a business that has the resources needed to operate indefinitely). If a company stops selling or using inventory, the full value of the inventory will not be realized.
For example, if a vintage store is in business and states on its final accounts that it has inventory valued at $3,000, that dollar value may change significantly depending on what method was used to estimate the value of inventory. If the value was calculated based on past sales but customers' fashion preferences suddenly change, the value of inventory may change as well. If the vintage store goes out of business, it is unlikely that the company will recoup the full value of the inventory. It is more likely that it will hold a final closing sale and will sell some assets and inventory below value. Some inventory may not be sold at all.
The challenge of determining the value of a business's inventory is that it will vary depending on the method of inventory costing used. Inventory costing refers to the methods of estimating the value of inventory, especially the value of the inventory that remains after some of it has been purchased. This latter inventory, sometimes known as ending inventory, is an asset. There are four main methods of inventory costing.
- Last in, first out method. This method is not allowed under International Financial Reporting Standards. It assumes that the most recently acquired inventory items are sold first and that ending inventory is oldest.
- First in, first out method. This method assumes that the inventory that comes in first will be purchased first and that the remaining inventory is also newest.
- Weighted average method. In this method, existing inventory and new inventory are combined to create a weighted average cost. As new inventory comes in, this average cost must be adjusted again.
- Specific identification method. In this system, each item in inventory is tracked individually. When an item is sold, the cost of the item is charged to the cost of goods sold. This type of method is usually only possible for smaller inventories of large-ticket items such as cars. A business that has a large inventory of products would generally find this method too time consuming.
Final accounts seem to offer a factual statement of an organization's finances and to be based on scientific numbers. However, as evidenced by the number of accounting scandals in the early 21st century, these statements can be subject to significant manipulation. When examining final accounts, it is especially important to look at discretionary expenses and debt write-offs (deeming an amount owed to the company uncollectable). Some companies may attempt to appear more profitable and stable by manipulating these two areas of a financial statement.
Discretionary expenses, for example, are those costs that can be eradicated from a business's expenses without affecting short-term profits. Examples include marketing costs, employee education or training, research and development, and related costs. In a profit and loss statement, these expenses may be listed separately since they can be, and often are, reduced to minimize the appearance of low profits or increased expenses. Listing essential and discretionary costs can show a business where spending can be cut, which can help with decision making. In some cases, however, organizations reduce discretionary expenses to lower overall expenditures, resulting in a “profit” on paper even when sales low.
Debt write-offs are also included in the profit and loss account. Bad debts are those debts that cannot be paid by a customer or client. Bad debt write-offs can be handled in one of two ways. In the allowance method of write-offs, a company estimates the amount of bad debt it will accumulate during a year, creating a bad debt allowance amount that is subtracted from the accounts receivable amount on the profit and loss statement, reducing total assets even when it is not certain that the company will incur bad debt. When the company determines that it will in fact be unable to collect an amount owed to it, it will add the amount owed to its expense account and subtract it from the bad debt allowance. In calculating taxes, however, a direct method is required. This involves subtracting bad debt from sales revenues only after an organization is certain that it cannot collect the bad debts. While the direct method is a simpler way of reporting debt write-offs, it may mean that a company will overreport its assets in a given fiscal year if the debt is not written off (and thus not accounted for) until the following year.
In some cases, organizations can manipulate when and how they write off bad debts, in part because it is impossible in many cases to tell exactly when a debt can be definitely labeled as one that will not be collected. An organization can technically post a bad debt as soon as a payment is not made on time or when a final bankruptcy filing comes in. Some companies use this fact when preparing their financial statements. For example, banks will often not charge off all loans or may charge off some debts when collection is possible or is ongoing. This careful manipulation of bad-debt accounts can create the illusion of income stability and can boost investor confidence even when banks have thin margins or have extended too many high-risk loans.
In some cases, inaccurate final accounts may not be the result of intentional manipulation of financial data but simply the result of an accounting error. In Page 109 | Top of Articlecompanies that have complicated financial statements, it can be easy for accountants to make mistakes. An example of this was seen in April 2014, when Bank of America admitted that an accounting error resulted in the bank reporting US$4 billion in capital that it did not have. Part of the problem occurred after the bank acquired financial firm Merrill Lynch along with the bonds it had issued. Bank of America placed the Merrill Lynch bonds, including US$60 billion in structured notes, on its balance sheet at less than their original value. As a result, the bank owed bondholders more than was reported, and the final account showed a higher capital amount than should have been recorded.
One of the problems with final accounts is that they do rely on hard numbers. In many cases, however, organizations have assets that cannot be easily quantified but may still be valuable. Also known as intangible assets, these assets are the parts of a business that can be valuable while a business is a growing concern but cannot be readily classified as tangible assets. Examples of intangible assets include:
- Intellectual property
- Trademarks and trade names
- Trade secrets
- Customer contact information
- Customer loyalty
- Information infrastructure
- Research and development
- Noncompete and nondisclosure agreements
- Advantageous financing rates
- Company image and brand recognition
- Proprietary information and technology
While it is difficult to assign a specific value to intangible assets, they are often listed on a company's financial statements. Indeed, with the growth of businesses that are focused more on information than on services and products, intangible assets may increasingly become some companies' most valuable assets. An online company, for example, may have no brick-and-mortar presence but rather software and a subscriber list that is responsible for most of its profits and revenues.
As the history of accounting has shown, accounting practices change as a result of new understandings of finance and new developments in business. New business contexts in the 21st century are changing the way that final accounts are presented and developed. E-commerce, for example, is shifting the focus of assets and inventory. E-commerce businesses may use drop shipping or may have a third party handling inventory. In some e-commerce businesses, orders come in and only then do the companies produce or develop a product. Print-on-demand books are one example of this. As a result of this type of business model, some companies have very small inventories or even no tangible inventory. Some e-commerce companies focus almost entirely on intangible assets. A business that flips (purchases at a low price and sells for a higher price) Internet domain names, for example, has virtually no inventory and may have mostly intangible assets.
Globalization is also changing final accounts by creating larger, multinational companies that have a very wide scope and are hard to evaluate using traditional final accounts. The delivery system of final accounts is changing as well. To make it easier for investors to access information, many companies make their final accounts and financial statements available online, sometimes as online reports or as presentations with video and other marketing tools. Anyone online is able to access this information.
In the early 21st century the accuracy of accounting is also being examined. In the United States, for example, after the financial crisis of 2007–2009, the Federal Reserve started focusing on corporation financial transparency and on increasing capital at banks. Each year the Federal Reserve performs what are known as “stress tests” on banks to see whether they have capital to absorb losses. Following the accounting mistakes found at Bank of America and Citicorp in the 2010s, however, the Federal Reserve may reconsider how capital calculation is calculated and how bank stress tests are conducted.
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SEE ALSO Costs and Revenues