Question

GAAP are standards developed by the profession to ensure that readers of financial statements receive a complete and accurate assessment of the financial status of a company?

Answer 1

Solution :-

It is very important that financial statement prepared by the accountants of their respective business enterprises should prepare them on the basis of sound and uniform accounting principles and concepts. Also there should be consistency of accounting policies over a period of time in the preparation of these financial statements. If every accountant starts following his own norms and notions for accounting treatment of different items then there will be utter confusion. To avoid confusion & to achieve uniformity, accounting process is applied within the well developed conceptual framework of 'Generally Accepted Accounting Principles' (GAAP).

These GAAPs are the backbone of the accounting information system without which the whole system cannot even stand erect. These are basically accounting principles, concepts, rules and guidelines developed over a period of time to bring uniformity and consistency to the process of accounting in order to enhance its utility to various users of accounting information.   

There are four basic financial statements which are required under GAAP -

1. Income statement

2. Balance sheet

3. Statement of Cash flows

4. Statement of Retained Earnings

1. Income statement - The objective of income statement is to display the details of items of income & expenditure which have contributed in making the profit or loss. Profit or loss arrived is disclosed in the income statement which is prepared at the close of the accounting period. The income statement discloses the net profit of the business entity for the accounting period after adjusting the income earned & matching expenses incurred during the accounting period. It is basically sub divided into two parts for a Non Manufacturing companies namely (i). Trading account (ii). Profit and Loss account. For Manufacturing companies a separate Manufacturing account which is also a part of income statement is also prepared in addition to the above stated Trading account and Profit and Loss account.

2. Balance Sheet - Balance sheet is a statement which reflects the assets and liabilities of the business enterprise as at a certain date. Generally the balances of all the personal accounts, real accounts & some nominal accounts which are deferred to transfer to Profit and Loss account are shown on a sheet known as Balance Sheet. It is divided into two parts (i). Liabilities are shown on the left hand side of the of the balance sheet & (ii). Assets on the right hand side of the balance sheet.   

3. Statement of Cash flows - A cash flow statement is a statement which shows inflows & outflows of cash and cash equivalents during the accounting period. It generally shows the sources of receipt of cash & cash equivalents and the purpose for which their payments are made. Its is classified in three categories (i). Operating Activities - It depicts the cash inflows and outflows which are related to main revenue earning activities of the business entity. (ii). Investing activities - It is related to cash investment in and sale of the fixed assets & investment in shares & securities of the business entity. (iii). Financing Activities - It relates to cash funds obtained from raising capital or short term or long term borrowings and repayments of capital & borrowings by the business entity.

4. Statement of Retained Earnings - It depicts the changes in the owners equity during the accounting period. It generally includes changes in the share capital, accumulated reserves & retained earnings which belong to the owners.

Accounting concepts underlying the financial reporting & formation of GAAP are as follows -

1. Business Entity Concept - Entity concept states that business enterprise is a separate entity and must treat a business as distinct from the owner. Only business transaction are recorded in business books of accounts & owner's personal and domestic transactions are recorded in his personal books of accounts.

2. Money Measurement Concept - As per this concept only those transactions which can be measured in terms of money are recorded in the books of accounts. Any transaction which cannot be measured in monetary terms are not required to be recorded in books of accounts even if they affect the financial position or financial result of the business.

3. Accrual Concept - As per accrual concept, the effects of transactions are recognized on mercantile basis i.e. as and when they occur (and not when cash or cash equivalents are received /paid). It means each and every transaction is recorded in books of accounts on the date of their occurance and reported in the financial statements related to that accounting period.

4. Matching Concept - As per this concept all expenses is matched with the revenues earned during the accounting period should be considered while ascertaining the profit/Loss for that accounting period. It means that if any revenue is recognized than expenses related to earn that revenue should also be recognized.

5. Going Concern Concept - As per this concept business operations of the entity will continue to exist for the foreseeable future i.e. for a long period in the future. It means transactions were recorded in the books of accounts of the business entity on the assumption that it is a continuing enterprise.

6. Cost Concept - As per this concept an asset is ordinarily recorded in the books of accounts at the price at which it was acquired/purchased/manufactured/constructed. The acquisition cost is of asset is called historical cost of the asset i.e. cost of the acquisition/manufacture/construction.

7. Realization Concept - This concept is related to recognition of reasonable certainty about the receipt of revenue, appreciation in the value of any asset, decrease in the liability. It means when right is established to demand advantage than it is termed as realization of revenue, appreciation in value of asset & decrease in liability.

8. Dual Aspect Concept - This concept is the backbone of entire accounting process. It states that every business transaction affects two or more accounts in such a way that total of debit side is equal to total amount of credit side while recording a transaction in the books of accounts of a business enterprise. Every debit must have a corresponding credit and vice versa.    

9. Conservatism - This concept states that do not recognize anticipated incomes/gains and provide for all probable expenses/losses.

10. Consistency Concept - In order to achieve comparability of the financial statements of the enterprise through time, the accounting policies are followed consistently from one period to another. Also a change is accounting policy is made only in exceptional circumstances.

11. Full Disclosure Concept - This concept requires that all significant economic information relating to business activities of the enterprise should be completely disclosed. It means all the the information which is of significant interest to the users of the financial statements should be disclosed.   

12. Materiality Concept - This concept states that items having an insignificant effect or irrelevant to the users need not to be disclosed. It helps to save the financial statement from unnecessary over burdened.