Discussion of terms
GAAP is a composition of rules and regulations that guide professional accountants how to prepare financial statements. The Financial Accounting and Standards Advisory Board (FASAB) set these rules and regulations. The accounting principles are updated periodically in order to make the presentation of the accounting statement more relevant to users and the company (Aubert and Grudnitski 17). The generally accepted accounting principles are important to financial statements because they contain rules that are used when preparing financial reports. These rules regulate how companies should prepare financial statements. For instance, it includes the fundamental principles of double-entry which ensures that all accounting events are recorded either as a debit or as a credit entry.
IFRS is a set of rules and regulations established by the International Accounting Standard Board (IASB). It is a guideline on how companies should prepare financial statements. Most publicly listed companies across the globe use the IFRS to prepare financial statements (Yoon and Gil Jones 356). In fact, the US Securities Exchange Commission is considering adopting the International Financial Accounting Standards because it is easy to apply. Moreover, it is universally recognized which makes it easier for investors to analyzed accounting information. IFRS ensures all companies prepare accounting statements using the same format. It also enables companies to win global contracts because of using acceptable accounting standards.
The Security and Exchange Commission protects investors and oversees corporate takeover in the US. The US government established it in order to protect the interest of investors. The commission requires all publicly listed companies in the US to disclose financial statements to the general public. It also expects investment advisers to specify the volume of all the assets under their management in order to ensure transparency and accountability.
Annual reports refer to accounting statements that are prepared by companies at the end of each financial year. Annual reports are prepared once in any accounting period. However, companies usually prepare quarterly financial statements such as 10-K, 10-Q and 8-K. Preparing financial statement help managers and investors to know how well the company is utilizing its assets to general revenues. Specifically, it helps the investors to know whether the company is making profits or losses. All publicly listed companies are required by the Security and Exchange Commission to file Form 10-K, 10-Q and 8-K. Form 10-K contains a financial breakdown of all the assets and liabilities of a company. The report is prepared in order to ensure accountability and transparency (Wang 967). It contains important information about the sources of finances of a company such as debt capital, number of shares issued and a firm’s corporate bonds.
The basic format of financial statements
There are different types of accounting statements such as a statement of financial position, statement of financial performance, statement of cash flow and statement of changes in equity. Financial statements refer to formal records prepared to show activities in a firm. They show the activities and transactions of a firm within a specified period. All the financial statements must comply with accounting principles.
Statement of financial position
A statement of financial position reflects all the assets and liabilities of a company. A statement of financial position is essential to managers and investors because it helps them to assess the financial condition of the company (Taparia 28). A balance sheet is prepared by showing all the assets, liability and equities. Assets represent something that is owned by a firm such as inventory, machinery and land. Liabilities refer to something a firm owes to someone such as bank loans and debt capital (Fridson and Alvarez 14). Equity is the difference between a company’s assets and liability. It represents the balances as at the final date of preparing financial statements. The statement of financial position is prepared similarly to the asset equation. The balance sheet must be prepared in compliance with accounting principles and full disclosure. When they are changes in accounting policies, an adjustment must be made each accounting period at the shareholder’s reserve to reflect the new change.
The statement of profit and loss shows the financial performance of a business. It shows whether a company has made profits or losses over a specified period. An income statement reflects only two items: income and expenses. Incomes refer to what the firm has earned within a given period. Expenses refer to what the business has incurred within a specified period. Expenses include rental charges, electricity and depreciation. Expenses can also refer to costs incurred to earn revenues.
A statement of cash flow shows the movement of cash in and out of a firm. A cash flow statement helps investors to know the amount of cash that circulates in and out of the business. It is an essential report that enables managers to know the amount of cash in the business so that they can be able to make decisions (Ittelson 39). It also shows the liquidity position of a company by disclosing cash in and out of the bank. The movement of cash in and out of the business is classified as operating activities, investing activities and financial activities. Cash movement in the operating activities shows the purchases and sales of assets other than stock. Cash flow from financing activities shows money spent on raising share and debt capital.
The statement of changes in equity shows the changes in owners’ equity in a financial year. A statement of changes in equity is prepared by adjusting the net profit with shares issued or paid, dividends, gains and losses and correction of accounting errors.
The accounting equation states that total assets are equal to liabilities plus shareholders’ equity.
Assets = Liabilities + Owner’s Equity
From the equation above, a firm’s assets must be equal to the liabilities and owners’ equity. Liabilities refer to a company’s obligations such as bank overdrafts, salaries, income taxes payable and a bank loan. It can be shown in the following equation:
Assets – Liabilities = Owner’s (or Stockholders’) Equity.
Both sides of the asset equation must balance in the statement of financial position. For instance, if a company issues bonds, the assets and liabilities will increase by the same amount. However, if a firm buys stocks in cash, one asset will increase while the other will decrease. To ensure the accounting equation balances, a double-entry accounting system is employed. All the assets and liabilities are recorded in the general ledger accounts. These accounts are shown in the table below.
|assets||Current liabilities||Owners’ equity|
|Deferred tax asset||Wages payable||Share capital|
|Motor vehicles||Rent payable||Retained earnings|
|Acc.Depr. motor vehicle||Taxes payable||Dividends|
|Building||Share application||General reserve|
|computers||Dividends payable account||Revaluation surplus|
Aubert, François, and Gary Grudnitski. “The Impact and Importance of Mandatory Adoption of International Financial Reporting Standards in Europe.” Journal of International Financial Management & Accounting 22.1 (2011): 1-26.Print.
Fridson, Martin S., and Fernando Alvarez. Financial statement analysis a practitioner’s guide, fourth edition. Hoboken, N.J: John Wiley & Sons, 2011. Print.
Ittelson, Thomas R. Financial statements a step-by-step guide to understanding and creating financial reports. Franklin Lakes, NJ: Career Press, 2009. Print.
Taparia, Jay. Understanding financial statements: a journalist’s guide. Oak Park, IL: Marion Street Press, 2004. Print.
Wang, Clare. “Accounting Standards Harmonization and Financial Statement Comparability: Evidence from Transnational Information Transfer.” Journal of Accounting Research 52.4 (2014): 955-992.Print.
Yoon, Sung Wook, and Christopher Gil Jones. “IFRS Knowledge, Skills, and Abilities: A Follow-Up Study of Employer Expectations for Undergraduate Accounting Majors.” Journal of Education for Business 88.6 (2013): 352-360.Print.