The difference between Gross Profit and Net ProfitThe difference between the total sales of goods and services and the related costs incurred during the production and selling of goods and services is the gross profit. Gross profit may also refer to gross income or margin. It is imperative to comprehend gross margin to see how efficient a firm is in managing its production resources and costs directly related to the production of goods and services. It measures profitability from the primary activities of a firm (Baskerville 1).
Conversely, net profit refers to all earnings or incomes after deduction of all costs incurred from total sales after a given fiscal period. Generally, net profit is calculated on a quarterly or yearly basis. Organizations use their net profits to make comparisons with other periods to assess profitability and determine the performance of employees and the management team.
What the Statement of Financial Position tells us about a business
Commonly referred to as the Balance Sheet, the Statement of Financial Position indicates the financial position of a firm for a specific financial period (Illinois Small Business Development Center 2). It generally captures items that a company owns, its liabilities, and owners’ equity. Assets are vital components of the Balance Sheet because they are what a firm owns. Items such as plant, cash, and machinery are some of the assets found in the Balance Sheet. Liabilities reflect what a company owes other businesses. These items may be bank loans and creditors among others. Finally, equity may also be found in the Balance Sheet. Equity typically is what the business owes its owners, and it captures capital left after liquidation to pay off organizational liabilities. Equity is the difference between assets and liabilities. Overall, information in the Statement of Financial Position determines working capital and the extent of a firm’s leverage.
The difference between non-current assets and current assets
Firms expect to convert their current assets into cash within the year. Items such as cash, inventories, and accounts receivable are some examples of current assets. Any assets, which are easy to liquidate, are considered current assets because a company can change them into cash for any of its needs. Cash is only regarded as a current asset because it can be readily used to meet short-term obligations. Companies collect their earnings periodically in some instances and, therefore, any cash to be collected within the fiscal year is noted as accounts receivable while inventories are current assets because they consist of goods that can be converted into cash and raw materials for production.
On the other hand, concurrent assets or long-term assets are assets that a firm may hold for more than a single financial year. Intangible assets, fixed assets such as plants, machinery, and equipment, and intangible assets are examples of noncurrent assets. They are held and cannot be converted into cash within the financial year.
The purpose of GAAP
GAAP (Generally Accepted Accounting Principles) refers to a series of standards, rules, and practices expected in professional accounting across industries. Organizations use GAAP to prepare and ensure standardization in financial statements of companies for other users outside organizations (Arline 1). GAAP provides standards that can assist users of financial information such as creditors and investors to make comparisons and under the position of a firm in the industry. On this note, organizations are expected to use GAAP for reporting purposes. Standardization of accounting practices ensures that ‘creative accounting’ and other questionable practices are avoided. Thus, users of financial information may quickly gain insights into the financial position of a company while accountants and managers will understand accounting reporting practices. Hence, GAAP ensures that all businesses have similar reporting patterns and accounting practices. In addition, GAAP may be applied to measure economic activities, provide information, prepare, present and record economic information (Arline 1).
Prudence concept requires accountants not to underestimate or overestimate expenses and revenues, assets, and liabilities to give conservatively reported financial information.
Accountants should only record elements such as revenues and assets when they are certain. Any expenses and liabilities should only be recorded when they are probable. Prudence concept also requires accountants to delay revenue recognition until certainty is determined while costs and liabilities should be recorded at once when they are identified as probable. Accountants should review the values of assets and liabilities to ascertain their values. In addition, profits should only be recognized when they are certain.
The prudence concept requires accountants to record only transactions that are considered realistic with a high probability of realization. Prudence concept is vital for creating doubtful accounts or inventories regarded as obsolete. In such instances, a prudent accountant would recognize potential costs most likely to be incurred in the future.
GAAP incorporates several aspects of the prudence concept in its laws and standards. For instance, fixed assets should only be recorded once their fair values are below the book values but not when the opposite happens.
Going Concern Concept
The going concern principle shows that a business will continue to operate into the future and, therefore, it may not be forced to stop operations, liquidate assets and wind up shortly. The assumption is useful when transaction deferring is necessary until later when the business will most probably be in operations (CPA Australia 59).
Accountants should determine whether a business is no longer a going concern and assess the assets to determine their record values for liquidation. The following issues could show that a firm is no longer a going concern. Sequences of losses due to operations, payment or loan defaults, trade credit denials, unprofitable long-term engagements, and legal proceedings are instances that could indicate a no-longer going concern state.
Accruals (Matching) Concept
Accruals Concept requires accountants to recognize and record expenses and revenues within the accounting periods they relate with and not when the cash is realized. Accruals Concept is vital for a cash flow statement (Accounting Simplified 1).
Income must be recorded when it is earned within the accounting fiscal period. Hence, incomes should only be noted when it is realized and not when it is received. Prepaid incomes can only be started when the services or goods are supplied.
Conversely, accountants should only record expenses within the fiscal time in which they are incurred. Hence, accrued expenses have to be recorded within the financial period when they take place while prepaid costs must be noted within the period when the service is provided.
The purpose of the Accruals Concept is to ensure that all items, revenues, and expenses match with the accounting period, and it is, therefore, a matching principle.
The Objective Concept asserts that the financial statements of a firm should be based on factual evidence. As such, the Objective Concept aims to inhibit accountants and managers from presenting biased information to users of financial information. For instance, management executives should not present whatever they have not earned or what they expect to earn into their financial information. Instead, they should ensure that only realistic, objective information is presented.
In some instances, a lack of objectivity may also arise when financial information is skewed by reporting impressive figures and optimistic results to attract investments while a more objective approach would produce the realistic information.
The objectivity Concept ensures that users of financial information can rely on the provided information to make objective investment decisions.
The Materiality Concept requires accountants to discard trivial issues whereas all vital issues should be disclosed. In this sense, any matters considered as important are material matters.
Materiality Concept assists users of financial statements to determine the extent of details suitable for financial reporting while noting the relevance of errors. Errors may occur during expenses, revenues, assets, equities, or liabilities reporting in the wrong accounts, recording such items within the wrong financial period (Rodriguez 451).
Failing or omitting vital financial data is also a case for Materiality Concept. The Materiality Concept ensures that accountants can account for misstatements and omissions in financial statements and business cases.
Comparability through Consistency Concept
Financial statements obtained from a specific financial time should be comparable to others from different periods to ensure that users of such information can obtain useful logical conclusions concerning the performance trends of an organization over time.
It is only possible to observe this concept when similar and consistent accounting policies are used to prepare financial statements over specific financial periods. Thus, diverse accounting practices and standards cannot guarantee the consistency of financial statements.
If an entity notices irregularity in its financial statements, it may change accounting policies to enhance the reliability and comparability of financial statements. Such adjustments in accounting policies often lead to adjustments in accounting standards. It is imperative to disclose such changes, their nature, and the conditions causing them.
At the same time, it should be possible to compare financial statements of entities in the same industry. Consequently, users of financial information can determine the performance of companies for comparative purposes. Thus, accounting practices should be consistent across a given industry.
Separate Determination Concept
This concept asserts that every element of any given category of liabilities or assets should be independently valued when aggregates are determined for a given category. For instance, the value of inventory items should be determined individually using the lowest costs and possible net values and these values should be aggregated to provide the inventory figure to be recorded in the accounts.
Conclusion, Recommendations, and Suggestions
Accounting Principles and Concepts are a wide range of conventions, which were formulated to offer the basic guideline for financial recording and reporting. The accounting profession is based on the specific spirit to promote transparency. Thus, these concepts guide accountants to ensure that they provide objective and realistic financial information without misleading others because of poor judgments. It is therefore recommended that accountants and organizations should adopt accounting concepts that capture the spirit of standardization in financial reporting.
It is also suggested that global accounting standard organizations should integrate and promote the use of these principles and concepts in financial reporting.
Accounting Simplified. Accounting Concepts, Principles & Conventions. 2015. Web.
Arline, Katherine. “GAAP: Standards & Rules for Accountants.” Business News Daily. 2015. Web.
Baskerville, Peter. What is the difference between the gross profit margin and net profit margin of a firm? 2010. Web.
CPA Australia. Accounting Concepts and Principles. Australia: BPP Learning Media Ltd, 2012. Print.
Illinois Small Business Development Center. Understanding Where You Stand: A Simple Guide to Your Company’s Financial Statements. Springfield, Illinois: Illinois Department of Commerce and Economic Opportunity, n.d. Print.
Rodriguez, Manuel A. “The Numbers Game: Manipulation of Financial Reporting by Corporations and Their Executives.” University of Miami Business Law Review 10.2 (2014): 451-482. Print.