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Lenders have no use for the Income statement and the Balance sheet with information relating to past transactions or events for making decisions unless they are accurate.
The Balance sheet is a “statement at one point in time, which shows all the resources controlled by the entity and all the obligations due by the entity.” (Bazely, 2007, p90) Hence it merely provides an outline of the financial strength and asset liquidity of an entity.
The Income statement “summarizes certain transactions that take place during a period of time.” (Bazely, 2007, p125) Hence the income statement provides some of the basic financial information for rational decisions to be made.
Lenders are “people and organizations who lend money in order to earn a return on that money.” (Bazely, 2007, p8) Therefore they are interested in ensuring whether the entity is going to provide with a return due to the entity making sufficient profit.
Therefore even if the balance sheet and income statement provides financial information relating to past transactions or events, lenders will not include the balance sheet and income statement in making decisions as many limitations of these statements affect the decisions to be made.
Lenders are interested in the entities controlled resources and what it owes. Therefore the limitations of the balance sheet clearly affect the accuracy of the statement. These include: the representation of the position of an entity at one particular point. The statement is only relevant at that particular point in time; the utility of the statement diminishes as time passes for providing relevant measures of assets and liabilities of an entity as the values assigned are usually historical cost; and, the valuation method of assets need to be appropriately measured as certain cases lead to an incorrectly stated figure.
Lenders use a variety of approaches to arrive at a lending decision. Therefore the accuracy of the income statement limits the decisions made by lenders. First, the organizational structure, size and type of activity limit the accuracy of the statement as it affects what is being reported and how it should be reported which may omit certain important aspects of the organization. Second, the income statement is normally prepared for internal use by an organization with which these internal reports are generally more detailed than the reports produced for external users, limiting sufficient accuracy of information needed to make a decision.
Even though companies develop balance sheets and income statements they are mainly for internal use.
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As stated in the AASB Framework an expense is defined as “decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrence of liabilities that result in decreases in equity other than those relating to distributions to equity participants.” Consequently the definition of an expense must satisfy two characteristics. There must be: a reduction in assets or increase in liabilities apart from distributions to owners; and, a decrease in equity. As an item meets the definition of an expense, to be recognized in the income statement it must meet recognition criteria of the AASB Framework. These include: the probability that decreases in economic benefits have occurred; and, the amount can be reliably measured.
An asset “..future economic benefits controlled by the entity as a result of past transactions or other past events. ” The new computer system needs to meet three characteristics to satisfy the definition of an asset. There must be a past transaction or event; control by the business; and, future economic benefit. Though the definition of an asset is satisfied by an item, to be included in the income statement it must also satisfy the recognition criteria. That is, there must be a probability greater than 50% likelihood that future economic benefits will eventuate; and, the amount is reliably measured.
The characteristics of an expense are satisfied by the new computer system as there is a reduction in assets with the outlay of cash for purchase (money sacrifice or liability). This results in a reduction of the asset account (wealth), which in turn creates a corresponding reduction in the equity account. However the new computer system does not decrease in economic benefit, which cannot be reliably measured and fails to satisfy recognition criteria.
As a result, for the computer system to be included in the income statement it must satisfy the AASB Framework’s asset definition and recognition criteria. First, the purchasing of the computer system is a past transaction or event. Secondly, benefits obtained and access denied to others of the new computer system through control of the entity. Finally, more efficient and effective reports are prepared as the new computer system provides future economic benefits, thus bringing increased cash inflow. The new computer system must also satisfy the recognition criteria. The probability of greater than 50% to provide a future economic benefit and reliable measure is achieved as the overall running and management of the business improves quality and efficiency which in turn has fewer employees to pay and/or more customers paying. Therefore this implies that the new computer system satisfies all definition and recognition criteria of an asset in the AASB Framework.
A stock broking firm acknowledges a new computer system as one of their assets; it is recognized as an asset on the income statement as it adequately meets the definition and recognition criteria. Therefore is not recognized as an expense as there in no reduction in economic benefit.