Financial Accounting and Reporting

adjustments, similar to changes in accounting principles. Companies record a correction of an
error in the year in which it is discovered.
Net income increases retained earnings. A net loss decreases retained earnings. Both cash and
share dividends decrease retained earnings.
In some cases, companies transfer the amount of retained earnings restricted to an account
titled Appropriated Retained Earnings. The retained earnings section may therefore report two
separate amounts: (1) retained earnings free and (2) retained earnings appropriated. The total of
these two amounts equals the total retained earnings.
Comprehensive income includes all changes in equity during a period except those resulting
from investments by owners and distributions to owners. Comprehensive income, therefore,
includes the following: all revenues and gains, expenses and losses reported in net income, and
all gains and losses that bypass net income but affect equity. These items – non-owner changes
in equity that bypass the income statement – are referred to as other comprehensive income.
Companies must display the components of other comprehensive income in one of two ways: (1)
a single continuous statement (one statement approach) or (2) two separate but consecutive
statements of net income and other comprehensive income (two statement approach). The one
statement approach is often referred to as the statement of comprehensive income. The two
statement approach uses the traditional term income statement for the first statement and the
comprehensive income statement for the second statement.
In addition to a statement of comprehensive income, companies are also required to present a
statement of changes in equity. The statement reports the change in each equity account and in
total equity for the period. The following items are disclosed in the statement:
1. Accumulated other comprehensive income for the period
2. Contributions and distributions to owners
3. Reconciliation of the carrying amount of each component of equity from the beginning to the
end of the period.
This statement is useful for understanding how equity changed during the period.
Chapter 5 – Statement of Financial Position and Statement of Cash Flows
The statement of financial position, also referred to as the balance sheet, reports the assets,
liabilities and equity of a business enterprise at a specific date. This financial statement provides
information about the nature and amounts of investments in enterprise resources, obligations to
creditors, and the equity in net resources. It therefore helps in predicting the amounts, timing,
and uncertainty of future cash flows.
Analysts use the statement of financial position to assess the company’s liquidity, solvency, and
financial flexibility. Liquidity describes the amount of time that is expected to elapse until an
asset is realized or otherwise converted into cash or until a liability has to be paid. Solvency refers
to the ability of a company to pay its debts as they mature. Liquidity and solvency affect a
company’s financial flexibility, which measures the ability of a company to take effective actions
to alter the amounts and timing of cash flows so it can respond to unexpected needs and
opportunities. Generally, the greater an enterprise’s financial flexibility, the lower its risk of
failure.
Some of the major limitations of the statement of financial positions are:
1. Most assets and liabilities are reported at historical cost
2. Companies use judgments and estimates to determine many of the items reported in the
statement of financial position
3. The statement of financial position necessarily omits many items that are of financial value but
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