Understanding Financial Statements: GAAP and FASB

Accounting Overview and Purpose:

Financial statements are standardized formal records that detail and explain the financial activities such as, revenue and expenses for a business or an individual, and are one of the most fundamental aspects of Accounting. In business people will discuss earnings, net income, equity, liabilities, and other business terms in order to understand the operations and financial status of a company. In order to communicate in a precise and ordered manner that is repeatable and understandable for anyone to interpret, a language has been developed specially for business. The best way to understand accounting is to think of it as a language. Accounting is the language of business and it allows people to communicate with the operations and transactions of a business or even an entire industry.

Accounting began hundreds of years ago and first showed up in a mathematics textbook published in the 1490's by an Italian mathematician named Luca Pacioli. The mathematical expressions and ideas published by Pacioli were the framework for what is now known as double-entry accounting or double-entry bookkeeping as it was referred to at the time. The concept of Pacioli's double-entry bookkeeping was that, "for every credit there must be a debit". A more modernized definition would be that for every financial entry made to an account there must have a subsequently different and corresponding account with the opposite entry made to it. Pacioli also wrote that there should be a separation of five different types of accounts that are still used in the present day. These accounts are the income account, the assets, the liabilities, the capital account, and the expense account.

Key Definitions:

Assets- Assets are defined as items that are considered to be of value and owned or controlled by a business. These items can include cash, inventory, property, and vehicles.

Liabilities- Liabilities are the amounts of money that are owed to people or other companies outside of your business. Examples of these would be amounts owed for car payments, or bank loans.

Equity- Equity is what someone owns the business and is represented by the assets of the business minus the liabilities of the business.

Revenue- The revenues for a business are the earnings or income. These can be things like the sales of goods or services as well as selling stock or property.

Expenses- Expenses are defined as monetary cash outflows of a business. Examples of this would be payments that are made to employees for wages or salaries, the purchasing of raw materials or goods, the purchase of advertising, etc.

 Learning Objectives • You should gain knowledge of the types of forms that are required by United States Securities and Exchange Commission to be filed for publicly traded companies. • You should be able to recognize the four main types of financial statements that a business will use during a normal reporting period. • You should be able to recognize and understand how the financial statements are inter-linked to each other and how the information in one financial statement will have an impact on all of the others.

The purpose of this article is explain the purpose and structure of the financial statements that are used to by accountants, business managers, and investors to interpret and analyze the current financial position of a company as well as any past trends in order to forecast where the company is headed in the future.

Companies will present their financial records with four basic financial statements:

1.) Balance Sheet

2.) Income Statement

3.) Statement of Stockholders' Equity

4.) Statement of Cash Flows

Balance Sheet:

The balance sheet answers the question of "What does the business own and who has monetary claims against the business?" The balance sheet will provide a snapshot or overview of the financial position of a company for a point in time. The balance sheet reports assets, which are items that have a value such as equipment, buildings, and inventory. The balance sheet also reports liabilities, which are the debts of the business. Additionally the balance sheet reports the stockholders' equity, which are the owners' shares of the business.

 Balance Sheet Assets Liabilities Stockholders' Equity

Income Statement:

The income statement answers the question of "How profitable is the business?" The income statement shows the profitability for a business during a given accounting period. It will report the revenues of the business that come from products or services that have been sold. It will also report the expenses for the business, which are all the costs that have been incurred in order to produce revenues. The difference between the revenues and the expenses is called the net income, which is also reported.

 Income Statement Revenues Interested in learning more? Why not take an online class in Understanding Financial Statements? (Expenses) Net Income

Statement of Stockholders' Equity:

The statement of stockholders' equity answers the question of "Who owns the company?" The statement of stockholders' equity reports if the net income for a given accounting period has been paid out to shareholders in the form of dividends, or if the net income has been retained in the form of retained earnings.

 Statement of Stockholders' Equity Retained Earnings, Beginning Contributed Capital, Beginning Net Income Issuance of Shares (Dividends) (Repurchase and Retire Shares) Retained Earnings, Ending Contributed Capital, Ending

Statement of Cash Flows:

The statement of cash flows answers the question of "Where is the money coming from and where is it paid out?" The statement of cash flows will report on the cash in-flows as well as the cash out-flows for a business over a given period.

 Statement of Cash Flows Cash Inflows (Cash Out-Flows) Change in the Cash Account

FASB and IFRS:

In the field of accounting there two main regulatory boards which oversee the development of accounting standards for many countries across the world including the United States and the European Union. One of the main standards agencies is known as The International Accounting Standards Board (IASB). The IASB works to develop standards and accounting procedures for more than 100 countries including the United States. The IASB also help to develop regulatory policies and accounting principles for countries that require the use of International Financial Reporting Standards (IFRS). In previous decades, the United States based Financial Accounting Standards Board (FASB) and the IASB operated independently from each other. However in early 2000's there was international pressure from the accounting industry to two regulatory boards work in collaboration with one another and create a set of acceptable standards that were internationally applicable to accounting. In 2002 to the FASB as well as the IASB begin the development process to create interchangeable accounting standards that would apply to both domestic as well as international financial reporting.

Originally the two boards wanted to create one set of principles and standards that would be used by businesses across the world, however there was a great deal of blowbacks from companies in the United States as well as legislators and investors that stifled progress. As a compromise a new approach was developed that has support of the Securities and Exchange Commission. This new method which is called the endorsement method set in place a framework where the FASB would continue to remain the standard-setting board for the United States and additionally endorse new IFRS into the United States financial reporting system. The FASB is a nonprofit private organization that has been designated by the securities and exchange commission SEC to be responsible for organizing and the development and implementation of accounting standards for public companies in the United States. In 1973, the FASB became the successor to the accounting principles board that was developed by the American Institute of Certified Public Accountants.

What is meant by "Principles of Accounting"?

Generally there are two meetings that come to mind when discussing the principles of accounting.

1.) Principles of accounting can refer to the fundamental building blocks of accounting such as, cost principles, matching principles, materiality principles, going concern principles, etc. This context refers to the principles of accounting as co-integrated building blocks that support the underlying concepts that accountants use when preparing financial statements.

2.) Principles of accounting can also refer to the generally accepted accounting principles (GAAP). When the Principles of accounting are referred to in this context, it is meant to describe both the underlying basic accounting constables as well as the official accounting pronouncements that are issued by the Financial Accounting Standards Board (FASB), and any predecessor organizations. These official pronouncements that are issued by the FASB are detailed rules or standards for specific and specialized topics.

Understanding GAAP:

There are a set of standards and common procedures that have been adopted by the accounting profession. These common standards are better known as GAAP. The term GAAP stands for Generally Accepted Accounting Principles; which are the guiding rules and standards that have been set by the Financial Accounting Standards Board (FASB), and adopted by the United States accounting profession as a whole. The accounting principles and standards were historically set by the American Institute of Certified Public Accountants in accordance with United States regulations that were enforced by the securities and exchange commission. In the early 1970s the financial accounting standards Board FASB was created with guidance from the financial accounting standards advisory Council and the financial accounting foundation.

These accounting principles are used in the preparation and standardization of the financial statements like the balance sheet, the income statement, as well as the statement of cash flow. GAAP based financial statements are used by publicly traded companies that are regulated by the United States Securities and Exchange Commission (SEC), as well as being used in privately owned companies and small businesses in the United States.

Organizations Involved with the Development and Implementation of GAAP:

GAAP Principles:

There are 12 main GAAP principles that accountants rely upon basic assumptions and rules when developing financial statements. This set of rules and assumptions allow accountants to dictate what items to quantify as well as how to quantify them and when. Overall there are 12 points that are fundamental to GAAP. The GAAP basic framework can be broken into three subsections. The first subsection is known as Accounting Assumptions.

1.) Business Entity- The business or accounting entity is the business unit for which the financial statements are being prepared. This applies regardless of the legal Business structure. This principle states that there is a "Business entity" that is separate from its owners. The idea behind this is that revenue and expenses for the business, should be kept separate from personal expenses.

2.) Going Concern- The going concern makes the general assumption with the business will continue operations indefinitely. Clearly this assumption cannot be verified with certainty and is hardly ever true, but the use of this assumption greatly simplifies how the financial position of the firm is presented as well aiding in the preparation of financial statements. The principle of going concern validates the usage of asset capitalization as well as depreciation and amortization. When an accountant is performing a review of a corporation's books, and has reason to believe that the company might go bankrupt based off of the corporations financial state, viewer she must issue a qualified opinion that states the potential of the corporation going bankrupt.

3.) Measurement Principle- The measurement principle in accounting this with things that can be "quantified" resources and obligation for which an agreed-upon value exists. The measurement principle or assumption can potentially weed out valuable company assets. An example of this would be loyal customers, while they are a necessary component for success of the company, they still cannot be quantified and given an accurate value and therefore not stated in the books.

4.) Periodicity Principle-

The periodicity principle is also known as the time period principle. This principle allows accountants to assume that the economic activities of an enterprise can be divided into artificial time periods in which profits and losses can be reported. These artificial time periods are usually segmented as monthly, quarterly, or yearly. The reason for dividing the time periods up by month, quarter, or year is a matter of convenience. These time frames are generally short enough so that management can remember what has happened and long enough to have meaning beyond random fluctuations in the business. His periods are also referred to as "fiscal" periods. An example of this would be a company that has a "fiscal year" from November 1st extending until October 31st of the next year. Another example could be a corporation that has a "fiscal year" that also matches the calendar year starting on January 1 and extending through until December 31st of the same year.

5.) Historical Cost-

The historical cost principle requires businesses to account and report for both assets and liabilities active at their original purchase, also known as the historical price. There commonly two types of pricing structure, that are known as:

•The Historical Price or

•The Fair Market Value (FMV).

The historical price is the original value of the asset or liability without adjustment for inflation. The fair market value is the price of an asset or real property, that a seller could perceive in the marketplace subject to two conditions. The first condition is that the perspective buyers and sellers have some knowledge about the asset or property; and they're acting in their own best interests free of coercive pressure. The second condition is that a reasonable time frame or period of time is given for the transaction to which completion.

By accountants using that is the cost principle, this means that a company can own a building valued at \$100 million yet carry it on the company books at its original \$10 million purchase price (minus without depreciation).

Historical cost principle has the potential to greatly understate the value of assets that were purchased in the past and then subsequently depreciated to a very low amount on the company's books. Many accountants like using historical costs because it allows assets to be understated which means that they do not have to be appraised and continuously reappraise. Council select key is indispensable because it provides information that is statistically more reliable, this is because

6.) Materiality Principle-

The principle of materiality generally refers to the relative importance of the various financial information. This means that accountants decide whether or not to apply accounting principles to financial information based upon its impact on the company. Accountants are concerned with transactions the must be reported if they would materially affect the financial condition of a company, either positively or negatively. An example of something that is immaterial would be an accountant tracking individual pieces of paper that are used by a company. This would be very time-consuming and a very inefficient use of the accountant's time. An example something that is material to the company would be a large sales order where there will be an inflow of revenue to the company in the near-term future; or a large purchase made by the company where there will be an outflow of money in the near future. It is important to remember the what is material for one company is not necessarily material for another company. A small corner pharmacy my view a transaction of \$500 as material to the business, while large multibillion-dollar corporations such as Microsoft and IBM might consider a \$500 transaction as immaterial.

7.) Units of Measure-

The units of measurement and value that are reported in the financial statements of a business that is domiciled in the United States are reported in U.S. dollars. The results of any foreign subsidiary companies must be translated back into U.S. dollars and then consolidated and integrated into the financial reports. This means that business and accountants must always be conscious of the changes that occur in the exchange rates of the international currency markets.

8.) Estimates and Judgments-

In accounting there will always be elements of complexity and an uncertainty, which will have an effect on making any precise measurements. There are many times when judgments and estimates must be made for financial statements and financial reporting. The acceptable standards say that it is ok to make an educated estimate if: 1.) The information available to you at the time of the estimate is the best that you can do, and 2.) The error that you might expect from making an estimate would not make a material difference to the accounts and financial reports of a business. If you must make an estimate then it is important to use the same method of estimation across each reporting period.

9.) Consistency-

Consistency, and consistent financial reporting is one of the most important concepts in accounting. One reason to emphasize consistent reporting of financial information is because sometimes it is possible for identical transactions to be accounted for differently. The value of consistency is that it allows information to be prepared with the exact same methods time after time. This allows accountants to make more accurate and meaningful comparisons of financial data, that help allow the business to make the best strategic decisions for the future.

10.) Conservatism-

The principle of conservatism refers to the fact that many accountants have a bias towards downward measurement. This means a many accounts prefer an understatement rather than and overvaluation. An example would be if losses are recorded when the accountant feels that there is a statistical probability of them occurring, rather than later, and in fact they actually do happen. It is important to note that the converse of this would be if the recording of a gain were postponed until it actually occurs not just when it is expected to occur.

11.) Substance Over Form-

Accountants will report and list the economic substance of a transaction as opposed to just its form. An example of this would be construction equipment that is actually purchased that has been masked, is booked as a purchase and not as a lease on the financial statements. Think about it like this…"If it is a skunk you must report it as a skunk."

12.) Accrual Basis Accounting for Presentation-

The accrual basis concept is very important concept to understand and accounting. Accountants like to translate financial data for a period into dollars of profit or loss, and all the money generating (or losing) activities that take place during the fiscal period. Generally an accrual accounting if a business transaction generates revenue in a period then all of the associated costs and business expenses should be reported in that same period. In the framework of acrylic counting this documentation is completed by matching for presentation:

1.) The revenue cash flows that are received by selling a product and

2.) The costs that are associated with making the specific product that is sold.

The expenses in the fiscal period such as selling, administrative, legal, etc. are then subtracted. Generally accounts agree that the key to accrual accounting is determining:

1.) When you're allowed to report the sale of the financial statements.

2.) The matching and then reporting of the appropriate costs of products sold, as well as…

3.) The use of a systematic and rational method for allocating all of the other co associated with being in business sts being in business for that particular.

For many people the concept of accrual basis accounting can seem abstract when I first begin learning how accrual accounting works. That's why for this site we will segment the components of accrual-based accounting into three components with further explanation. These components are revenue recognition, matching principle, an allocation.

Revenue Recognition- The accrual accounting a sale is recognized and recorded after the completion of the necessary activities that are required to provide the good or service have taken place regardless of when money changes hands. Revenue is also recorded after the product has been shipped.

Matching Principle- The matching principle and accrual accounting says that expenses must be matched with revenues as long as it is reasonable to do so. The costs that are associated with making or providing a good or service, also known as the Cost of Goods Sold (COGS), and are recorded as soon as the matching revenue is recorded.

Allocation- The concept of allocation states that there are many costs which are not specifically associated with the product or service, and that these costs must be assigned to fiscal periods in a reasonable and rational manner. An example of allocation would be if a business purchases an insurance policy at the beginning of the year and pays for the policy in full, each month during the year can be charged with 1/12 of the general costs for the insurance policy. It's important to note that all businesses with inventories must use the accrual basis of accounting. Many other businesses may use a "cash basis" if they desire to do so. The accounting for cash basis financial statements are exactly like the cash flow statement. They can also be compared accurately to a simple checkbook.

 KEY POINTS REVIEW Accounting is a system of recording financial data for a business that can be thought of like a language. There is a systematic and direct linkage between the disciplines of accounting and finance. Accounting is the language of finance and the methods and systems that are used in accounting will provide the information and the analysis that are used by financial markets and financial investors to make strategic decisions. Accounting information exists in order to meet the needs of the users such as business owners, investors, the IRS, and other regulatory agencies. The Generally Accepted Accounting Principles are continuously evolving and are influenced by multiple groups such as the Financial Accounting Standards Board (FASB), and the American Institute of Certified Public Accountants (AICPA), as well as the United States Securities and Exchange Commission (SEC). The GAAP principles and concepts are the framework that financial statements and financial reporting are built upon. There are limitations to accounting and sometimes estimations must be made because of inadequate or inaccurate data limitations.