Accounting principles and practices

Accounting

From an investor's perspective, what is the most important information on the income statement? Why? From management's perspective, what is the most important information on the income statement? Why?

The income statement, also called the profit and loss statement is the financial statement that details a company's sales and earnings. When evaluating an income statement, the savvy investor usually wishes to maximize his or her immediate or long-term ability to make a profit on a stock. Thus, conventional wisdom holds that investors should buy when a stock's price to earnings ratios are low and sell when these ratios are high. In other words, if a stock stands to earn a great deal and has a strong track record of doing so, yet is priced relatively cheaply in relation to those future earnings, it is wise for an investor to buy that stock. The reverse is true as well, though -- if the stock is priced relatively high, but shows a poor record of earning dividends for shareholders in the long-term, in ratio to the asking price, the investor should not purchase the stock.

For management, the most important information is about sales and expenses at the company, over which the manger must keep a watchful eye. The manager has the responsibility to the company to make sure that both sales and expenses are recorded accurately and that the market regarding the company's products is not softening in the long-term. Management Discussion and Analysis section of the income statement must contribute additional important data such as about segmented sales, references to accounting method changes in company policy, and discussions about new company costs. Management must keep a watchful eye over technically legal variations in GAAP (Generally Accepted Accounting Principles) that indicate trouble. For example, standard GAAP states that sales revenue must first be earned before it can be recorded. But a company gives discounts to encourage customers to make early purchases of goods to disguise a decline in demand. A company can relax its credit requirements to increase sales that will eventually need to be written off as bad debt. A company can deliberately understate its expenses on the income statement, thereby overstating its net income. Managers must be cognizant, even more so than investors, of such potentially ethically troubling recourses and also because the frequent use of such practices indicates a weakening economy and marketplace for the company's goods overall.

Given the abuses we've seen in the application of recognition criteria, should the FASB allow only one way to recognize revenues or expenses? Why or why not?

Given such potential abuses or tricks, an investor who is not able to fully appreciate such accounting variations might exclaim that only one way of recording company data should be legally allowed amongst corporate accountants. Yet different industries are subject to different outside pressures. For example, the greater fragility of goods in the food and restaurant trades may mean that inventories of various fresh foodstuffs may vary greatly, in answer to the question if the goods sold being correctly valued and recorded on the income statement. An inventory of fresh produce may be overstated as an artificially high inventory balance of goods that are ultimately spoiled and not sellable.

Thus, some industries benefit on the balance sheet from using Last in, First Out (or LIFO) while others from FIFO (First in, First Out) methods of dispensing and recording inventory, and there is no singular way to record expenses in such a fashion that will be equally beneficial or revealing to all investors in all industries.

Lastly, there are inevitable seasonal variations in demand that affect certain industries (such as retail and the travel industry) more than others, which could create misleading pictures for investors in and of themselves to the eyes of potential shareholders, as there might seem to be significant uptakes in sales and growth that are purely related to expected market increases and/or decreases.

Recognition Position Paper

To finance a company, various stock options are possible to raise revenue. One option is to extend short-term exchange-traded options of common stock. But for a new firm these stocks cede control to many individuals and have a high level of volatility. Another option is to issue employee stock options or call options given by employing firms to their employees in compensation for labor services. The price of such options is usually set as equal the firm's current stock price. This way, additionally, employees have a more vested interest in the firm's success, especially in an early firm's start up. The employee cannot exercise his stock options at the beginning of his or her commitment to the firm and must give up the options before a set date. However, there is a fear that employee stock options can cause a company to seem over or undervalued in the marketplace, as the stocks cannot be sold to investors in a volatile fashion to increase revenue.