Definition of financial accounting
a discipline in which historical, monetary
transactions are analyzed and recorded for use in the
preparation of the financial statements (balance sheet, income
statement, statement of owners’/stockholders’ equity,
and statement of cash flows); it focuses primarily on the
needs of external users (stockholders, creditors, and regulatory
The production of financial statements, primarily for those interested parties who are external to the business.
This is the currency translation standard currently
used by U.S. firms. It mandates the use of the current rate method. See: Statement of financial accounting
Standards No. 8.
This is a currency translation standard previously in
use by U.S. accounting firms. See: Statement of accounting Standards No. 52.
A special committee of the financial accounting Standards Board established to reach consensus of how to account for new and unusual financial transactions that have the potential for creating differing financial reporting practices.
A separate committee within the financial accounting Standards Board composed of 13 members representing CPA firms and preparers of financial statements
whose purpose is to reach a consensus on how to account for new and unusual financial transactions
that have the potential for creating differing financial reporting practices.
financial accounting Standards Board. Sets accounting standards for U.S. firms.
This important term
refers to the body of authoritative rules for measuring profit and preparing
financial statements that are included in financial reports by a business
to its outside shareowners and lenders. The development of these
guidelines has been evolving for more than 70 years. Congress passed a
law in 1934 that bestowed primary jurisdiction over financial reporting
by publicly owned businesses to the Securities and Exchange Commission
(SEC). But the SEC has largely left the development of GAAP to the
private sector. Presently, the financial accounting Standards Board is
the primary (but not the only) authoritative body that makes pronouncements
on GAAP. One caution: GAAP are like a movable feast. New rules
are issued fairly frequently, old rules are amended from time to time,
and some rules established years ago are discarded on occasion. Professional
accountants have a heck of time keeping up with GAAP, that’s for
sure. Also, new GAAP rules sometimes have the effect of closing the barn
door after the horse has left. accounting abuses occur, and only then,
after the damage has been done, are new rules issued to prevent such
abuses in the future.
A common set of standards and procedures
for the preparation of general-purpose financial statements that either have been established
by an authoritative accounting rule-making body, such as the financial accounting
Standards Board (FASB), or over time have become accepted practice because of their universal
The rate suggested in financial accounting Standard Board (FASB) 87 for discounting the
obligations of a pension plan. The rate at which the pension benefits could be effectively settled off the
pension plan wished to terminate its pension obligation.
Set of books kept by a firm's management for the IRS that follows IRS rules. The stockholder's
books follow financial accounting Standards Board rules.
A collection of systems and processes used to record, report and interpret business transactions.
A broad, all-inclusive term that refers to the methods and procedures
of financial record keeping by a business (or any entity); it also
refers to the main functions and purposes of record keeping, which are
to assist in the operations of the entity, to provide necessary information
to managers for making decisions and exercising control, to measure
profit, to comply with income and other tax laws, and to prepare financial
Administrative proceedings or litigation releases that entail an accounting or auditing-related violation of the securities laws.
An alteration in the accounting methodology or estimates used in
the reporting of financial statements, usually requiring discussion in a footnote
attached to the financial statements.
Earnings of a firm as reported on its income statement.
A business for which a separate set of accounting records is being
The representation of the double-entry system of accounting such that assets are equal to liabilities plus capital.
The formula Assets = Liabilities + Equity.
An equation that reflects the two-sided nature of a
business entity, assets on the one side and the sources of assets on the
other side (assets = liabilities + owners’ equity). The assets of a business
entity are subject to two types of claims that arise from its two basic
sources of capital—liabilities and owners’ equity. The accounting equation
is the foundation for double-entry bookkeeping, which uses a
scheme for recording changes in these basic types of accounts as either
debits or credits such that the total of accounts with debit balances
equals the total of accounts with credit balances. The accounting equation
also serves as the framework for the statement of financial condition,
or balance sheet, which is one of the three fundamental financial
statements reported by a business.
Unintentional mistakes in financial statements. Accounted for by restating
the prior-year financial statements that are in error.
The change in the value of a firm's foreign currency denominated accounts due to a
change in exchange rates.
Total liabilities exceed total assets. A firm with a negative net worth is insolvent on
Intentional misstatements or omissions of amounts or disclosures in
financial statements done to deceive financial statement users. The term is used interchangeably with fraudulent financial reporting.
The ease and quickness with which assets can be converted to cash.
The period of time for which financial statements are produced – see also financial year.
The principles, bases, conventions, rules and procedures adopted by management in preparing and presenting financial statements.
Accounting rate of return (ARR)
A method of investment appraisal that measures
the profit generated as a percentage of the
investment – see return on investment.
accounting rate of return (ARR)
the rate of earnings obtained on the average capital investment over the life of a capital project; computed as average annual profits divided by average investment; not based on cash flow
A set of accounts that summarize the transactions of a business that have been recorded on source documents.
The recording of revenue when earned and expenses when
incurred, irrespective of the dates on which the associated cash flows occur.
Well, frankly, accrual is not a good descriptive
term. Perhaps the best way to begin is to mention that accrual-basis
accounting is much more than cash-basis accounting. Recording only the
cash receipts and cash disbursement of a business would be grossly
inadequate. A business has many assets other than cash, as well as
many liabilities, that must be recorded. Measuring profit for a period as
the difference between cash inflows from sales and cash outflows for
expenses would be wrong, and in fact is not allowed for most businesses
by the income tax law. For management, income tax, and financial
reporting purposes, a business needs a comprehensive record-keeping
system—one that recognizes, records, and reports all the assets and liabilities
of a business. This all-inclusive scope of financial record keeping
is referred to as accrual-basis accounting. Accrual-basis accounting
records sales revenue when sales are made (though cash is received
before or after the sales) and records expenses when costs are incurred
(though cash is paid before or after expenses are recorded). Established
financial reporting standards require that profit for a period
must be recorded using accrual-basis accounting methods. Also, these
authoritative standards require that in reporting its financial condition a
business must use accrual-basis accounting.
A method of accounting in which profit is calculated as the difference between income when it is earned and expenses when they are incurred.
A forceful and intentional choice and application of accounting principles
done in an effort to achieve desired results, typically higher current earnings, whether the practices followed are in accordance with generally accepted accounting principles or not. Aggressive
accounting practices are not alleged to be fraudulent until an administrative, civil, or criminal proceeding takes that step and alleges, in particular, that an intentional, material misstatement
has taken place in an effort to deceive financial statement readers.
Average accounting return
The average project earnings after taxes and depreciation divided by the average
book value of the investment during its life.
A method of accounting in which profit is calculated as the difference between income
when it is received and expenses when they are paid.
Change in Accounting Estimate
A change in accounting that occurs as the result of new information
or as additional experience is acquired—for example, a change in the residual values
or useful lives of fixed assets. A change in accounting estimate is accounted for prospectively,
over the current and future accounting periods affected by the change.
Change in Accounting Estimate
A change in the implementation of an existing accounting
policy. A common example would be extending the useful life or changing the expected residual
value of a fixed asset. Another would be making any necessary adjustments to allowances for
uncollectible accounts, warranty obligations, and reserves for inventory obsolescense.
Change in Accounting Principle
A change from one generally accepted accounting principle to another generally accepted accounting principle—for example, a change from capitalizing expenditures
to expensing them. A change in accounting principle is accounted for in most instances
as a cumulative-effect–type adjustment.
Changes in Financial Position
Sources of funds internally provided from operations that alter a company's
cash flow position: depreciation, deferred taxes, other sources, and capital expenditures.
chief financial officer (CFO)
Officer who oversees the treasurer and controller and sets overall financial strategy.
Constant dollar accounting
A method for restating financial statements by reducing or
increasing reported revenues and expenses by changes in the consumer price index,
thereby achieving greater comparability between accounting periods.
Method of accounting for sales or service agreements where completion
requires an extended period.
Corporate financial management
The application of financial principals within a corporation to create and
maintain value through decision making and proper resource management.
Corporate financial planning
financial planning conducted by a firm that encompasses preparation of both
long- and short-term financial plans.
a discipline that focuses on techniques or
methods for determining the cost of a project, process, or
thing through direct measurement, arbitrary assignment, or
systematic and rational allocation
Cost Accounting Standards Board (CASB)
a body established by Congress in 1970 to promulgate cost accounting
standards for defense contractors and federal agencies; disbanded
in 1980 and reestablished in 1988; it previously issued
pronouncements still carry the weight of law for those
organizations within its jurisdiction
costs of financial distress
Costs arising from bankruptcy or distorted business decisions before bankruptcy.
Country financial risk
The ability of the national economy to generate enough foreign exchange to meet
payments of interest and principal on its foreign debt.
Creative Accounting Practices
Any and all steps used to play the financial numbers game, including
the aggressive choice and application of accounting principles, both within and beyond
the boundaries of generally accepted accounting principles, and fraudulent financial reporting.
Also included are steps taken toward earnings management and income smoothing. See financial
Creative Acquisition Accounting
The allocation to expense of a greater portion of the price
paid for another company in an acquisition in an effort to reduce acquisition-year earnings and
boost future-year earnings. Acquisition-year expense charges include purchased in-process research
and development and an overly aggressive accrual of costs required to effect the acquisition.
Cumulative Effect of a Change in Accounting Principle
The change in earnings of previous years
based on the assumption that a newly adopted accounting principle had previously been in use.
Cumulative Effect of Accounting Change
The change in earnings of previous years assuming
that the newly adopted accounting principle had previously been in use.
See accrual-basis accounting.
Dupont system of financial control
Highlights the fact that return on assets (ROA) can be expressed in terms
of the profit margin and asset turnover.
External Financial Statements
Corporate financial statements that have been reported on by an external independent accountant.
Also called securities analysts and investment analysts, professionals who analyze
financial statements, interview corporate executives, and attend trade shows, in order to write reports
recommending either purchasing, selling, or holding various stocks.
Claims on real assets.
Claims to the income generated by real assets. Also called securities.
Economic assistance provided by unrelated third parties, typically government agencies. They may take the form of loans, loan guarantees, subsidies, tax allowances, contributions, or cost-sharing arrangements.
a plan that aggregates monetary details
from the operating budgets; includes the cash and capital
budgets of a company as well as the pro forma financial
The management of a firm's costs and expenses in order to control them in relation to
A feature of a debt or credit agreement that is designed to protect the lender or creditor. It is common to characterize covenants as either positive or negative covenants.
A positive covenant might require that the debtor maintain a minimum amount of working capital.
A negative covenant might limit dividend payments that may be made.
A promise made related to financial conditions or events. Often a promise not to allow certain balance sheet items or ratios to fall below an agreed level. Usually found in loan documents, as a protection mechanism.
Events preceding and including bankruptcy, such as violation of loan contracts.
Financial distress costs
Legal and administrative costs of liquidation or reorganization. Also includes
implied costs associated with impaired ability to do business (indirect costs).
Combining or dividing existing instruments to create new financial products.
A contract entered into now that provides for the delivery of a specified asset in exchange
for the selling price at some specified future date.
a monetary reward provided for performance
above targeted objectives
An expression of economic benefit that motivates behavior that might otherwise not take place.
Institutions that provide the market function of matching borrowers and lenders or
Firm that raises money from many small investors and provides financing to businesses or other
organizations by investing in their securities.
Any institution, such as a bank, that takes deposits from savers and loans them to borrowers.
The process whereby financial intermediaries channel funds from lender/savers to borrower/spenders.
Long-term, non-cancelable lease.
Lease in which the service provided by the lessor to the lessee is limited to financing equipment. All other responsibilities related to the possession of equipment, such as maintenance, insurance, and taxes, are borne by the lessee. A financial lease is usually noncancellable and is fully paid out amortized over its term.
Use of debt to increase the expected return on equity. financial leverage is measured by
the ratio of debt to debt plus equity.
The equity (ownership) capital of a business can serve
as the basis for securing debt capital (borrowing money). In this way, a
business increases the total capital available to invest in its assets and
can make more sales and more profit. The strategy is to earn operating
profit, or earnings before interest and income tax (EBIT), on the capital
supplied from debt that is more than the interest paid on the debt capital.
A financial leverage gain equals the EBIT earned on debt capital
minus the interest on the debt. A financial leverage gain augments earnings
on equity capital. A business must earn a rate of return on its assets
(ROA) that is greater than the interest rate on its debt to make a financial
leverage gain. If the spread between its ROA and interest rate is unfavorable,
a business suffers a financial leverage loss.
Debt financing amplifies the effects of changes in operating income on the returns to stockholders.
Financial leverage clientele
A group of investors who have a preference for investing in firms that adhere to
a particular financial leverage policy.
Financial leverage ratios
Related: capitalization ratios.
An organized institutional structure or mechanism for creating and exchanging financial assets.
Markets in which financial assets are traded.
Financial Numbers Game
The use of creative accounting practices to alter a financial statement
reader's impression of a firm's business performance.
Objectives of a financial nature that the firm will strive to accomplish during the period
covered by its financial plan.
A financial blueprint for the financial future of a firm.
The process of evaluating the investing and financing options available to a firm. It
includes attempting to make optimal decisions, projecting the consequences of these decisions for the firm in
the form of a financial plan, and then comparing future performance against that plan.
Status of a firm's assets, liabilities, and equity accounts as of a certain time, as shown in its financial statement.
That portion of the media devoted to reporting financial news.
The result of dividing one financial statement item by another. Ratios help analysts interpret
financial statements by focussing on specific relationships.
financial reports and statements
financial means having to do with
money and economic wealth. Statement means a formal presentation.
financial reports are printed and a copy is sent to each owner and each
major lender of the business. Most public corporations make their financial
reports available on a web site, so all or part of the financial report
can be downloaded by anyone. Businesses prepare three primary financial
statements: the statement of financial condition, or balance sheet;
the statement of cash flows; and the income statement. These three key
financial statements constitute the core of the periodic financial reports
that are distributed outside a business to its shareowners and lenders.
financial reports also include footnotes to the financial statements and
much other information. financial statements are prepared according to
generally accepted accounting principles (GAAP), which are the authoritative
rules that govern the measurement of net income and the reporting
of profit-making activities, financial condition, and cash flows.
Internal financial statements, although based on the same profit
accounting methods, report more information to managers for decision
making and control. Sometimes, financial statements are called simply
Financial reports or statements
The Profit and Loss account, Balance Sheet and Cash Flow statement of a business.
The risk that the cash flow of an issuer will not be adequate to meet its financial obligations.
Also referred to as the additional risk that a firm's stockholder bears when the firm utilizes debt and equity.
Risk to shareholders resulting from the use of debt.
Ready access to cash or debt financing.
Financial Trend Analysis
Process of analyzing financial statements of a company for any continuing relationship.
The accounting period adopted by a business for the production of its financial statements.
Finished goods Inventory that is ready for sale, either having been purchased as such or the result of a conversion from raw materials through a manufacturing process.
Fraudulent Financial Reporting
Intentional misstatements or omissions of amounts or disclosures
in financial statements done to deceive financial statement users. The term is used interchangeably
with accounting irregularities. A technical difference exists in that with fraud, it
must be shown that a reader of financial statements that contain intentional and material misstatements
must have used those financial statements to his or her detriment. In this book, accounting
practices are not alleged to be fraudulent until done so by an administrative, civil, or
criminal proceeding, such as that of the Securities and Exchange Commission, or a court.
Future-Oriented Financial Information
Information about prospective results of operations, financial position and/or changes in financial position, based on assumptions about future economic conditions and courses of action. Future-oriented financial information is presented as either a forecast or a projection.
Up-front gain recognized from the securitization and sale of a pool
of loans. Profit is recorded for the excess of the sales price and the present value of the estimated
interest income that is expected to be received on the loans above the amounts funded on the loans
and the present value of the interest agreed to be paid to the buyers of the loan-backed securities.
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