Generally Accepted Accounting Principles
GAAP entails laid down as well customarily settled or accepted accounting principles. There is no standard set of policies and procedures related to GAAP. Each nation has its own developed generally accepted accounting principles. Because there are wide varieties of pronouncements that are issued providing information about generally accepted accounting principles, two or more of these pronouncements may provide conflicting information as to how a transaction is to be accounted for. To avoid a misunderstanding a hierarchy of GAAP has been established in each nation. For example, in US there are four types of pronouncement that are at the highest level of authority according to GAAP hierarchy. These are:
- FASB statements of Financial Accounting Standards
- FASB Interpretations
- AICPA Accounting Principle Board (APB) opinions, and
- AICPA Accounting Research Bulletins.
On the international circuit Financial Accounting Reporting Standards (FARSs), earlier known as International Accounting Standards (IASs), are treated as the main source of GAAP and efforts are being made to converge these standards with national GAAP.
Historical cost is the cost that is based on actual event. It is not a predicted or estimated cost. Historical costs are the costs are that are actually incurred or due to be incurred and not measured as fair values of assets or liabilities on a particular date. Historical cost accounting is also called GAAP accounting. Accordingly historical cost income is the difference between realized revenues and their corresponding costs, when both revenue and costs are expressed in units of general purchasing power.
Accrual vs. Cash Basis Accounting
Under the accrual basis of accounting, revenues are recognized when they are earned, regardless of when they are received. Expenses are recognized when they are incurred regardless of when they are paid. Gains and losses resulting from incidental transactions of the enterprise are recognized in the periods in which they occur. In keeping with the concept of conservatism, the risks inherent in being in business are considered. Simply, resources are included, even though they may not have been converted into cash. Cash payments that will provide future benefits are treated as resources.
Under the cash basis, only those transactions that result from cash receipts and disbursement are presented. Although financial statements prepared under the cash basis are generally considered less meaningful than those prepared under the accrual basis, entities use it due to the simplicity of maintaining their books of accounts.
Current Assets and Liabilities vs. Non- Current Items
An asset will be classified as current if it will be used up or converted into cash within one year or within one accounting cycle, whichever is longer. Common examples of current assets are cash, accounts receivable, investments in trading securities, inventories and prepaid expenses. A non-current asset takes more than one year to get converted into cash. Some current assets are treated specially. Cash that is restricted for the acquisition of non-current assets or repayment of non-current debts is not considered current. An asset that is traditionally reported as noncurrent may be held for resale. If it is sold after the balance sheet date but before the issuance of financial statements, it will be reported as current.
A liability that will be settled within one year or one accounting cycle, whichever is longer, is considered a current liability. In addition, a liability that will require use of the current asset is current. Common examples of current liabilities include accounts payable, accrued expenses, dividend payable, income tax payable, and current portion of long-term debts. That means liabilities that are required to be settled beyond one year are treated as non-current liabilities. But billings on long-term constructions in excess of costs incurred are reported as a current liability. Similarly, deposits received from customers are reposted as current liabilities until goods or services are provided.
Balance Sheet, Income Statement, and Statement of Cash Flows
Income statements, balance sheets, and cash flow statements each have a distinct and different role to play in analyzing the operating and other performances as well as presenting the financial position of the entity.
An income statement, also called the profit and loss account, presents the operating results of entity over its financial or fiscal period. ‘It summarizes the two parts of a company’s financial flows that determine its profits: revenue and expenses. By relating its expenses to its revenue over some time, the income statement presents the economic results of the firm’s activities for that period (i.e., its profits)’ (Karl F. Seidman, page 50)i
The balance sheet presents the financial status or position of an entity on a particular date. As per Ronald C. Spurga (page 7)ii ‘the balance sheet presents a financial picture of the business- its assets, liabilities, and its ownership, on a given date.’
The cash flow statement presents how cash flowed into the entity and how that cash was used during the financial period. Inflow and outflow of cash are described under the operating, investing, and financing activities of the entity during the financial period.
Though each of the three financial statements plays different roles these roles are integrated into a fashion that to analyze the financial performance and position, all the three statements are studied together by the users of financial statements to arrive at certain financial decisions.
BP’s financial statements for the year 2008 indicate that the company performed exceedingly well and that is why its earnings per share (both basic and diluted) have shown a rising trend in 2008. Reading 2008 financial statements in comparison with 2007 and 2006, it is predicted that earning per share will show the same rising trend in future as well.
Quick Silver incorporation is having problems on liquidity front. Its current ratio was 1.71:1 in 2007 and that was lower than the required standard 2:1. The company improved upon in 2008 by increasing current assets. With the result current ratio improved to 1.89:1 in 2008. It is predicted that this rising trend will continue in 2009 as well. The balance sheet was the source of this information.
Though the net profits (before taxes) of RTL Group have gown down from £844m in 2007 to £528m in 2008 its net cash flow from operating activities has increased from £860m in 2007 to £1065m in 2008. The company is playing safe by involving more liquid assets in its operational activities, and it is hoped this trend will continue in the coming years. Such information comes from cash flow statements.
- Karl F. Seidman, Economic Development Finance, SAGE, 2004,page 50
- Ronald C. Spurga, Balance Sheet Basics, Ronald C. Spurga, 2004, page 7