To be well-informed, a businessperson needs to review more than the balance sheet, income statement, and statement of cash flows. The financial accounting and reporting (FAR) test covers information on other financial statements and disclosures, such as the statement of comprehensive income and the statement of changes in equity.
Comprehensive income differs from net income. Net income, or profit, is revenue less expenses. Comprehensive income takes net income and adds in other items that haven’t been realized yet. In other words, net income includes only realized income (from completed transactions).
For example, consider a gain or loss on an asset. To realize a gain or loss, there must be both a buy and a sale. If you buy an asset for $10,000 and sell it for $12,000, that’s a $2,000 realized gain. If, instead, you buy an asset for $10,000 and it has a current market value of $13,000, you have a $3,000 unrealized gain. The gain is unrealized because no sale has occurred.
Comprehensive income adds several types of unrealized gains and losses to net income. To report this information to financial statement readers, accountants generate a statement of comprehensive income.
The statement of changes in equity (also called the statement of retained earnings) is another report you need to know. Equity represents ownership in the business. It’s defined in the balance sheet as assets less liabilities. This statement discloses changes in equity during a particular period (month or year). Here are some transactions that change equity:
Net profit or loss for the period: A firm’s net income (earnings) increases equity. A business can keep the earnings for company use; accountants refer to those dollars as retained earnings.
Dividends: Companies can choose to pay a portion of earnings to shareholders through dividends. A dividend payment to shareholders reduces equity.
Gains and losses: A gain or loss is generated when an asset is sold. A gain increases equity, and a loss reduces equity.
Effects ofchanges in accounting policy: Every company should have written accounting policies, which are normally included with the financial statements and in an annual report. For example, management should decide on a policy of how to value inventory.
If a firm changes its inventory valuation policy, the change will impact the cost of goods when inventory is sold and the company’s net income. Accountants are required to present the impact of the change retrospectively, as if the new accounting policy had always been in place. The dollar amount of the impact is presented in the equity statement.
Effect of a correction of a prior period error: If an accountant finds an error in the accounting records for a prior period, he or she posts the financial impact of the error to the equity statement. When a company computes net income for a given period, that amount is posted as an increase to equity. The income statement accounts (revenue and expenses) are adjusted to zero at the end of each period.
Revenue and expense accounts are temporary accounts. The balances do not carry over from one period to the next. When you start the next period (month or year), the revenue and expense accounts all start at zero. Financial-statement readers need to know about errors made in a prior period. Because the income statement starts each new period at zero, accountants post the impact to a prior period’s net income in the equity statement.
Another required disclosure is the notes to financial statements section, which includes a summary of significant accounting policies. That summary notes how the company values its assets and liabilities.
The notes also disclose any related-party transactions. These are transactions in which the parties already have a relationship. For example, if a business bought supplies from a company controlled by a board member, that transaction would be a related-party transaction. Because the parties already have a relationship, the terms of the exchange may be better than if they were not related. Maybe the board member’s firm is able to charge a higher price.
If you search for examples of notes to financial statements on the web, you’ll find many other types of disclosures. The goal in preparing a financial statement is to reveal anything that a financial-statement reader may find important.
