Term Paper: Financial Statements. Generally Accepted Accounting Principles

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¶ … financial statements.

Generally Accepted Accounting Principles: As accountants go about their daily tasks of record-keeping, monitoring business transactions, preparing tax reports, and other financial work, they are obliged, of course, to follow the specific fiscal and accounting guidelines of the company or client they are working for. But beyond those company guidelines, accountants often base their decisions on the Generally Accepted Accounting Principles (GAAP).

The GAAP are not rules set in stone; rather, they are guidelines, or you might call them a group of objectives and conventions "that have evolved over time to govern how financial statements are prepared and presented," according to www.allbusiness.com.Theses principles are set by the Financial Accounting Standards Board (FASB), and the Securities and Exchange Commission (SEC) also provides input and guidance regarding the amendments to acceptable accounting practices.

The GAAP serves as a guiding light for every business: when an accountant from outside the company is looking into its financial data and record-keeping, the company expects that accountant to be using GAAP. "Compliance with GAAP helps maintain creditability with creditors and stockholders," AllBusiness.com explains, "because it reassures outsiders that a company's financial reports accurately portray its financial position."

Any agency or stockholder reading the financial reports of a company assumes from the start that GAAP have been applied to any and all reports. Indeed, "banks and finance companies often require their clients to use GAAP or have audited financial statements," AllBusiness.com continues. Meantime, investors "who are accustomed to using financial information prepared according to GAAP might balk if your statements don't meet their expectations."

Historical Cost: this is the "original cost" of any asset to a company. And "historical cost accounting" is the situation where assets are valued at their original cost, less depreciation. In order to explain why "historical cost" might or might not be relevant to a financial report, an examination of an editorial in the Government Finance Review journal (Brubaker, 1999) will be instructive.

In his editorial, Brubaker is recounting a business meeting of the Government Finance Officers Association (GFOA) in which the discussion turned to the new "infrastructure policy" proposal changes brought forward by the Government Accounting Standards Board (GASB). Members of the GFOA "made it clear" that the infrastructure requirement the GASB was trying to implement "is widely opposed," Brubaker wrote, "and in many cases, will not be followed by state and local governments."

Why are members of the GFOA rejecting the GASB proposal? The problem is the proposal to have financial reports include "the historical cost of infrastructure," Brubaker explains. "I sense a level of frustration over gathering totally useless information and putting bad information in our financial reports," Brubaker continues. "Clearly, information on what a government once paid to acquire an infrastructure asset is of no practical value to decision makers."

Continuing his editorial against using historical cost data in current financial reports, Brubaker adds: "What decision could possibly be made today based upon what a mile of road cost in 1917? How would knowing the past costs incurred for infrastructure assets help anyone evaluate a government's financial well-being... " Moreover, Brubaker wonders if allocating the historical cost of a road to "subsequent periods (i.e., depreciation)" provides any practical information, since "price increases over time inevitably render such data irrelevant and potentially misleading." Is one-sixtieth of the "original cost of a mile of pipe placed in the ground in 1981" truly useful as a measure of the dollars that pipe would cost in 1999, he asks?

Accrual Basis vs. Cash Basis Accounting: This is an important distinction to make especially for the small business that normally just keeps summaries of cash received and disbursed, but when that business wishes to learn just what it is really worth, and what are the true cost of goods, a decision should be made between accrual basis and cash basis accounting. An article in Doors and Hardware spells out the difference very plainly, and the information from the Doors and Hardware piece is paraphrased and portions quoted below:

For bad debts: (cash basis, no provision made for bad debts; accrual basis, set up a "bad debt reserve fund" or "establish criteria for writing off uncollectible debts" (Ensman, 1999). For bills: (cash basis, unpaid bills are not part of the accounting system; accrual basis, unpaid bills are expensed, whether you paid them or not). For compensation: (cash basis, unpaid compensation is not figured into accounting; accrual basis, all unpaid salaries, benefits, etc., are "booked" at end of month). For depreciation: (cash basis, pay cash and expense the item at the time of purchase; accrual basis, "expense purchases of major assets over their useful lives," typically on a 5-year schedule, Ensman explains). For financial statements: (cash basis, produce a "statement of receipts and disbursements"; accrual basis, create "full-fledged profit-and-loss statements and balance sheets"). For receivables: (cash basis, income is recognized as it is received; accrual basis, income is not recognized until it's earned). For inventory: (cash basis, items are listed as expense upon purchase; accrual basis, book inventory "as an asset and only charge inventory items to expense when they're actually used," Ensman asserts).

Current Assets and Liabilities vs. Non-Current Items: "Assets" (likely future economic benefits obtained by a company or entity resulting from past transactions); "Liabilities" (probably future sacrifices of financial benefits resulting from current obligations of one entity to transfer assets or provide services to other entities). "Current" means it is expected to convert in a year or whatever the operating cycle is, whichever is the longer window of time. "Non-current" assets are usually items used by a company to produce or distribute their products; the items in question will usually be property, plant and equipment assets (PPE). According to Motley Fool (www.fool.com)"PPE will generally appear on the balance sheet grouped together at original cost, minus net accumulated depreciation" (Hanks, 2000). This is another example of the use of concept of "historic cost"; it is used instead of current market value because, Motley Fool explains, "usually a company does not intend to sell these assets, so their current worth is not a relevant figure. Also, current market value is somewhat subjective, while original cost is easily verifiable.

Part II. Locate the Balance Sheet, Income Statement and Statement of Cash Flows for Ford, ExxonMobil and Microsoft. Which is more useful for each, net income or cash from operating activities? Most useful for all three companies' reports, in my view, is the use of "cash from operating activities"; I believe that this gauge is more helpful in determining the current health of a company. From a snapshot of "how is the company doing today?" A close look at the cash from operating activities report gives an honest look at today's reality; meanwhile, a net income report will give a better look at the long-term investment possibilities.

One prediction about each company: EXXONMOBIL: All three companies had monster years and all three improved over the previous year's earnings, but it would seem that in terms of "most vulnerable" to market conditions and economic ups and downs - or "least predictable" in terms of investor confidence - ExxonMobil is perhaps the company with the most potential cash flow problems. Why? Because American in bogged down in a war that has a lot to do with oil; the war itself can cause economic conditions to change for companies, but in a conflict of this nature, with insurgents blowing themselves up in order to blow up Americans, in order to blow pipelines, and destroy any facility connected with Iraq's oil production, a huge oil company like ExxonMobil can be affected as the price of a barrel of oil fluctuates on the world market.

FORD MOTOR COMPANY: Like the other two companies, Ford had record net income and cash from operating activities reports; their auto sales are… [END OF PREVIEW]

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