Accounting Principles – Purpose and Use of Financial Statements

The difference between the totals of the two schedules gives the present or net worth of the business. It is not sufficient in making a financial statement to give simply the figures of proprietorship or net worth, but schedules must be drawn up to show the items that make up that net worth. From the viewpoint of an investor, a prospective purchaser, a banker to whom application for a loan has been made, or a concern considering the advisability of extending credit on a bill of goods purchased from them, it makes all the difference in the world to know that a particular business having a net value of $10,000 has assets of $15,000 and liabilities of $5,000; or to know that its assets are $260,000 and its liabilities are $250,000. The ratio of total assets to total liabilities holds a large place in the determination of questions raised above by the investor, purchaser, banker,or creditor. Furthermore, the character of the assets and of the liabilities has an important bearing. If the assets are in properties for which there is not a ready market and the liabilities are claims which mature soon and will have to be met, the situation is unfavorable. If there are large values invested in easily salable assets; if there is a large balance of cash on hand after meeting current claims and providing for those which will soon mature; if other liabilities are of a more permanent nature, such as mortgages or long time notes not requiring immediate attention—the situation might show evidence of too large a capital, or of inefficiency in management as shown by the failure to invest some of the surplus cash in properties from which some return might be secured.

Its Content and Subdivisions
It will therefore be seen that the financial statement must serve a very definite purpose or purposes, and that to serve these purposes it must have a very particular content. Any statement which lists assets and liabilities and shows their difference as proprietorship is a financial statement. The form or the method of scheduling has nothing to do with the fact of its being a statement of financial condition, but the statement which, because of its form, gives the most information for the purpose for which it was drawn is, in comparison with all others which might be drawn, the best statement. Hence, keeping always in mind as a functioning or guiding principle the use to which the statement is to be put, the form, the method of showing and marshalling the items, is of great importance. For this purpose we shall classify assets and liabilities roughly into two groups, current and fixed, whose connotation has been sufficiently indicated on the basis of ease of convertibility into cash, or salability, for the assets, and relative urgency of meeting the claim for the liabilities. Therefore, in any presentation of financial facts, the data should be shown grouped into the two classes of current and fixed, both for the assets and for the liabilities, so as to render easy comparison possible. In this way a basis can be secured for judging of the efficiency of the management in making provision for meeting the claims against the business as they fall due and in having as nearly as possible a proper balance between the two groups. While there is not entire uniformity at present in the matter of precedence of either group, the weight of authority would indicate the placing of current assets first, followed by the fixed assets, and a similar marshalling of the liabilities.

Its Titles, Principal and Group
Various terms are in use to indicate the main groups of items in the financial statement and as names for the statement itself. “Balance Sheet,” “Statement of Resources and Liabilities,” “Statement of Assets and Liabilities,” are frequently used instead of “Financial Statement.” Within the statement itself, Resources is used as an alternative title with Assets; and Net Worth, Present Worth, and Net Assets are used for Proprietorship. For the present the forms shown will be used with the substitution of the term Net Worth for Proprietorship. The title of a statement should be full; it should include the name of the business enterprise and date, and would appear somewhat as follows:

Shongood & Goodwell Financial Statement, December 31, 1916
This should be followed by the lists or schedules of Assets, Liabilities, and Net Worth as has been indicated. Since the statement is a formal one, due regard should be had for neatness and general appearance on the page. Further consideration of headings and titles will be taken up in Chapter XXX.

Principles Governing Fulness of Detail
Mention has been made of the importance of full information in the financial statement. The degree of fulness is determined first by the general purpose which the statement is to serve; secondly, by the likelihood of obscuring essential data through too great detail; and thirdly, by the general appearance. If it can be shown on the statement that the business makes a careful valuation of its assets by taking into account the wear and tear on certain of its properties and the loss apt to occur through failure to collect all debts due the business, that statement points towards a policy of conservatism and efficiency not indicated by one failing to give that information. If a management has paid some of its expense bill in advance, e.g., rent for January paid during December, in showing financial condition as at the end of December it is right and proper and necessary, in order to make an accurate showing, that all such prepaid expenses be listed as assets; for had the prepayment not been made the cash would now be larger by the amount of the prepaid expenses. Similarly, if expenses have been incurred that properly belong to the present period but whose payment has been postponed to a later period, such as wages due but unpaid, those expenses should be listed among the liabilities, for the cash would be smaller by the amount of such postponed or accrued items had this claim been met during the current period. Hence, to take care of these prepaid and accrued items on the financial statement, we make a third group headed “Deferred Charges” for the assets, but usually show expense accruals under the head of Current Liabilities, listing under these heads by name the prepaid and accrued items.

To give the fullest information, an additional column to carry the totals of each group of assets and liabilities is frequently shown. This would make comparison of the groups somewhat easier and so make the statement more intelligible and valuable, although for a small business the information is easily obtained from the above showing.

One or two items, perhaps, need additional explanation. Reference has been made to the detailed information which the financial statement may give. In the one shown above it will be noticed that the proprietors, although having outstanding claims against customers for $8,500, recognize that, as their past experience has shown, they will be unable to collect all of these claims. Their estimate of the uncollectible portion is 2%, or $170, which is shown deducted from the face value of the asset in order to show a conservative realizable value. Similarly, it is estimated that furniture and fixtures, costing $750, have depreciated 10% in value and buildings 2l/2c/o. This statement, which shows the basis for valuing the assets, is more useful than one merely giving the net estimated values without showing how such values were obtained. The term “reserve” is used in the above in Nthe sense of the estimated amount needed to make good the loss.