Three-Dimensional Accounting
To really appreciate the meaning of financial reports (balance sheet, income statement, statement of owner’s/partners’/stockholders’ equity, statement of cash flows) we need to remember that these financial statements are actually three-dimensional pictures of financial condition and operating results. This might seem a little strange at first, because we are so conditioned to seeing these reports in the usual format of account names with numbers in columns. However here, as with a good painting, there is far more than first meets the eye.
Financial statements are condensed summaries of the many events that change the financial condition of a business over a specified period of time. A large corporation can have tens or hundreds of thousands of these events and even a small business needing only small business bookkeeping and accounting can have hundreds of recordable events.
In every case, large or small, every recordable event consists of these three dimensions:
Understanding the significance of how the three dimensions affect financial reporting will greatly improve your understanding of essential and basic accounting concepts. All qualities of financial information relate in some way to the three dimensions.
So, for a financial event to be recordable, it must create a change in financial condition that consists of the three dimensions. (For those of you who have taken some accounting, the event has to create a change somewhere in the accounting equation.) Let’s take a closer look.
Classification
The classification dimension of an event refers to identifying what particular financial items are affected by an event: assets, liabilities, revenues, expenses, etc. These are the elements of financial statements. For example, there is a big difference between recording an expenditure of cash as an expense or deciding to classify it as the purchase of an asset (that was WorldCom’s undoing). You really don't want to mistake a bear for a bunny rabbit, and the consequences can be no less disastrous on financial statements. In practice, businesses maintain a detailed chart of accounts to classify each possible item; these classifications are then reviewed when events are analyzed. For audited statements, auditors review how the events were classified.
Valuation
Accountants don’t exactly have a reputation as militants, but they can get pretty excited when discussing valuation. Usually when an event is first recorded its value is clear, because documents and other objective evidence support the transaction value. But what happens later? Should we record changes in value that happen as time passes? How much, and what value? (There are at least five accepted values that can be used depending on the particular item involved: original transaction value, what an item would sell for (fair market value), what it would cost to replace, the potential collectible amount of an item, and the present value of future cash flows created by an item.) AND...many of these different values can be found on a financial report, depending on its complexity. As a lender, investor, or other stakeholder it can be pretty important to understand this dimension of a financial picture. Also, give some thought to the fact that not only are there these different value types (called “attributes”) that are required, but then the amount of the value has to be determined. Who decides this? The management? Do auditors check the values? Does management ‘negotiate’ with the auditors? Valuation often requires estimates.
Timing
“Timing is everything” as we all have heard (usually after bad timing). It’s definitely true in accounting. The third dimension of an event is the time that it is recorded. The financial life of a business is divided into regular reporting periods, so that makes the effects of the timing dimension very powerful. Stakeholders are very interested in trends. This is most critical with revenues and expenses, particularly accrued (unpaid) revenues and expenses. Often businesses are eager to record revenues prematurely and defer expenses as long as possible: “Hey — we really did earn all the revenue in December and not in January!” Other more sophisticated managements have developed the fine art of revenue and expense management via “cookie jar” accounts in which by timing the effects on these accounts, they increase or decrease net income in an attempt to maintain a smooth upward trend of earnings (net income), that they know their investors like to see. Subjective estimates also play a role in timing; for example, estimating how long plant and equipment assets will last and how they will be used up (the timing of depreciation expense).
So, when you think of events being recorded and when you think of financial statements that summarize all these events, keep in mind the three dimensional nature of accounting information, and how each dimension can affect the picture that you are looking at.
By Greg Mostyn, Mission College