Financial statements are prepared in conformity with standards that have been established over the years called generally accepted accounting principles (GAAP). Rarely, if ever, would you come across financial statements of a business prepared according to accounting methods other than GAAP. The minor exceptions to this general comment are not worth mentioning. (Financial statements of non-profit organizations and government entities follow somewhat different accounting principles and practices.)
Audits by independent certified public accountants (CPAs) are precisely for the purpose of making sure than GAAP have been followed in preparing the financial statements (see Chapter 17). In short, anytime you pick up the financial report of a business you are entitled to assume that its financial statements have been prepared according to GAAP.
The fundamental idea is to provide a well-defined set of general accounting methods and practices that all businesses should follow faithfully for measuring their profit and for presenting their financial condition and cash flows. The twofold purpose is to have all businesses play by the same accounting rules regarding how they keep score financially and to make financial statements of different businesses comparable with one another. You can imagine the confusion if every business were to choose its own unique accounting methods. For instance, one business may use historical cost basis depreciation and another may use current replacement cost basis depreciation.
The six basic steps in the accounting process of a business are as follows:
1. Identify and analyze all transactions and operations of the business during the period.
2. Determine the correct accounting method for each basic type of transaction and operation according to GAAP.
3. Record and accumulate the transactions and operations of the business during the period, using the correct accounting methods, of course.
4. At the end of the period assemble the accounts for sales revenue, expenses, assets, liabilities, and owners' equity, and make sure their ending balances are up-to-date and accurate.
5. Prepare the financial statements for the period and write the footnotes for the statements according to the prescribed rules of presentation and disclosure. (Include the CPA's report if the statements have been audited.)
6. Distribute the financial report to everyone entitled to receive a copy.
This chapter focuses on step 2—which, to be more precise, should say choose one of the alternative methods allowed under GAAP for each basic type of transaction and operation of the business.
Suppose, purely hypothetically, that a business employs two equally qualified accountants and neither knows of the other's presence. Suppose both accountants keep the books, entirely independent of one another. This company would have two sets of books but only one set of transactions and operations during the year to account for.
Now the critical question: Would both accountants come up with the same net income (profit) number for the year? Would their ending balance sheets be virtually the same? Would their footnotes be the same? You can probably see what's coming here.
The two accountants, in all likelihood, would come up with different net incomes for the year. One or more of their expenses would be different, and their sales revenue for the year also might be different. This means that their balance sheets would be different. Sales revenue and expenses cause increases and decreases in assets and liabilities. So, if expenses are different, then assets and liabilities will be different. And, if net income for the year is different, then the retained earnings balance in the ending balance sheet will be different.
Does this mean that one of the company's accountants is wrong and has made mistakes in applying generally accepted accounting principles? No, assume not; neither has made a mistake. Then, how can the two of them come up with different accounting numbers? The answer is that for many expenses, and even for sales revenue, the GAAP rule book does not prescribe one and only one accounting method, but allows two or three alternative methods to be used.
Financial accounting would seem to be like measuring a person's weight on a scale that gives correct readings, wouldn't it? But, as a matter of fact, financial accounting according to GAAP allows a business to select which kind of scale to use—one that weighs light or one that weighs heavy.
We can think of the GAAP set of rules as an official cookbook for financial accounting that has more than one recipe for many dishes (expenses and sales revenue). For example, cost of goods sold expense and depreciation expense can be accounted for by different but equally accepted methods. Chapter 16 explains that a company's choices of accounting methods for these two key expenses are disclosed in footnotes to the company's financial statements. Chapter 20 explains cost of goods sold expense methods, and Chapter 21 explains depreciation methods.
This chapter discusses the diversity within GAAP that permits more than one accounting method to be used to record the transactions and operations of a business. The activities of the business are the same, but the accounting for them is different depending on which methods are selected. The financial reporting game can be played using different methods of scorekeeping.
Virtually every business has to pick and choose among different accounting methods for several of its expenses and perhaps for recording its sales revenue as well. For most businesses the profit result is the dominate factor in choosing among accounting methods. How will net income be affected by the choice between accounting methods? This is the main question on the minds of most business managers.
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