Learn something new every day More Info... by email
The financial statement method can relate to the time at which transactions are recorded, the way depreciation is calculated, and the way inventory is tracked. When preparing accounts, companies often have to choose between several different ways of calculating and presenting each set of information. Which financial statement method to use in a particular case may be subject to legal restrictions or tax regulations.
Most people think of a financial statement as a statement of a company's accounts. It usually contains three main sections: the income statement, cashflow statement and balance sheet. The income statement is better known as a profit and loss account and lists the totals for particular types of transactions during a period. The cashflow statement tracks the actual payments made and received during the same period. The balance sheet shows a company's assets and liabilities at the end of that period, giving a snapshot of its overall financial health.
Arguably the biggest choice of financial statement method is whether to use the cash or accrual basis. The cash basis entails listing purchases and sales only when the money actually is exchanged. The accrual basis refers to listing transactions as soon as the money becomes due, for example when delivering goods sold on credit, even if the money isn't paid straight away. For companies that have a lot of transactions where payment is delayed, this can make a significant difference to how profitable the company appears to be during the accounting period. While some companies have a choice of which method to use, accounts filed for tax reporting purposes in many countries must use the accrual basis, as must those prepared by companies whose stock is publicly traded.
Another potential variation comes with depreciation. This is an accounting technique designed to cover the fact that assets lose all or much of their value over time. It involves deciding in advance to reduce the listed value of the asset by a certain amount or proportion each year for a set period. As well as reducing the valuation on the balance sheet, the amount of the deduction each year is listed as a loss on the income statement. There are several different ways to decide how to split the total deduction over time, including simply dividing it equally, using a fixed proportion of the remaining balance each year, and applying more of the deduction in the earlier years. These methods can affect a company's profits: as a result tax regulations often set down what method can or must be used.
Inventory is another area where a financial statement method must be chosen. The issue is what to do when a company has multiple units of the same item in stock, but did not pay the same price for each, for example when prices rose between buying batches. One solution, "First In First Out," works on the assumption that each unit sold is from the oldest batch in stock, with the value of the remaining stock and the profit margin on the sold unit calculated accordingly. In contrast, "Last In First Out" works on the assumption that each unit sold is from the most recent batch. In both cases, this is purely an accounting method and it makes no difference which batch the unit actually came from.