Understanding Business Accounting For Dummies, 2nd Edition (8 page)

Accounting and Financial Reporting Standards

Experience and common sense have taught business and financial professionals that uniform financial reporting standards and methods are critical in a free-enterprise, private, capital-based economic system. A common vocabulary, uniform accounting methods, and full disclosure in financial reports are the goals. How well the accounting profession performs in achieving these goals is an open question, but few disagree that they are worthy goals to strive for.

The importance of GAAP and evolving accounting standards

The most important financial statement and financial reporting standards and rules are called
generally accepted accounting principles (GAAP)
, which describe the basic methods to measure profit and to value assets and liabilities, as well as what information should be disclosed in those financial statements released outside a business. Suppose you're reading the financial statements of a business. You're entitled to assume that the business has used GAAP in reporting its cash flows and profit and its financial condition at the end of a financial period -
unless
the business makes very clear that it has prepared its financial report on a comprehensive basis of accounting other than GAAP.

The word
comprehensive
here is very important. A financial report should be comprehensive, or all-inclusive - reflecting all the financial activities and aspects of the entity. If not, the burden is on the business to make very clear that it is presenting something less than a complete and comprehensive report on its financial activities and condition. But, even if the financial report of a business is comprehensive, its financial statements may be based on accounting methods other than GAAP.

If GAAP are not the basis for preparing its financial statements, a business should make very clear which other basis of accounting is being used and should avoid using titles for its financial statements that are associated with GAAP. For example, if a business uses a simple cash receipts and cash disbursements basis of accounting - which falls way short of GAAP - it should not use the terms
profit and loss account
and
balance sheet.
These terms are part and parcel of GAAP, and their use as titles for financial statements implies that the business is using GAAP.

In brief, GAAP constitute the gold standard for preparing financial statements of business entities - although the gold is somewhat tarnished as later chapters explain. Readers of a business's financial report are entitled to assume that GAAP (and any accounting standards that have evolved from GAAP) have been followed in preparing the financial statements unless the business makes very clear that it has not complied entirely with GAAP. If the deviations and shortfalls from GAAP are not disclosed, the business may have legal exposure to those who relied on the information in its financial report and suffered a loss attributable to the misleading nature of the information.

Why the GAAP rules are important

Business managers should know the basic features of GAAP - though certainly not all the technical details - so that they understand how profit is measured. Managers get paid to make profit, and they should be very clear on how profit is measured and what profit consists of. The amount of profit a business makes depends on how
profit
is defined and measured.

For example, a business records the purchase of products at cost, which is the amount it paid for the products.
Stock
is the name given to products being held for sale to customers. Examples include clothes in a department store, fuel in the tanks in a petrol station, food on the shelves in a supermarket, books in a bookstore, and so on. The cost of products is put in the stock asset account and kept there until the products are sold to customers. When the products are eventually sold, the cost of the products is recorded as the cost of goods sold expense, at which time a decrease is recorded in the stock asset account. The cost of products sold is deducted from the sales revenue received from the customers, which gives a first-step measure of profit. (A business has many other expenses that need to be factored in, which you can read about in later chapters.)

Now, assume that before the business sells the products to its customers, the replacement cost of many of the products being held in stock awaiting sale increases. The replacement cost value of the products is now higher than the original, actual purchase cost of the products. The company's stock is worth more, is it not? Perhaps the business could raise the sales prices that it charges its customers because of the cost increase, or perhaps not. In any case, should the increase in the replacement cost of the products be recorded as profit? The manager may think that this holding gain should be recorded as profit. But GAAP accounting standards say that no profit is earned until the products are sold to the customers.

What about the opposite movement in replacement costs of products - when replacement costs fall below the original purchase costs? Should this development be recorded as a loss, or should the business wait until the products are sold? As you'll see, the accounting rule that applies here is called
lower of cost or market
, and the loss is recorded. So the rule requires one method on the upside but another method on the downside. See why business managers and investors need to know something about the rules of the game? We should add that GAAP are not all crystal-clear, which leaves a lot of wriggle room in the interpretation and application of these accounting standards. But first a quick word about GAAP and income tax accounting.

Income tax and accounting rules

Generally speaking (and we're being very general when we say the following), HM Revenue & Customs' income tax accounting rules for determining the annual taxable income of a business are in agreement with GAAP. In other words, the accounting methods used for figuring taxable income and for figuring business profit before income tax are in general agreement. Having said this, we should point out that several differences do exist. A business may use one accounting method for filing its annual income tax returns and a different method for measuring its profit, both for management reporting purposes and for preparing its external financial statements to outsiders.

Flexibility in accounting standards

An often-repeated accounting story concerns three accountants being interviewed for an important position. The accountants are asked one key question: ‘What's 2 plus 2?' The first candidate answers, ‘It's 4', and is told, ‘Don't call us, we'll call you.' The second candidate answers, ‘Well, most of the time the answer is 4, but sometimes it's 3 and sometimes it's 5.' The third candidate answers: ‘What do you want the answer to be?' Guess who got the job?

The point is that GAAP are not entirely airtight or cut-and-dried, and are being updated. Many accounting standards leave a lot of room for interpretation.
Guidelines
would be a better word to describe some accounting rules. Deciding how to account for certain transactions and situations requires flexibility, seasoned judgement, and careful interpretation of the rules. Furthermore, many estimates have to be made.

Sometimes, businesses use what's called
creative accounting
to make profit for the period look better. Like lawyers who know where to find legal loopholes, accountants sometimes come up with inventive solutions but still stay within the guidelines of GAAP. We warn you about these creative accounting techniques - also called
massaging the numbers
- at various points in this book. Articles in financial newspapers and magazines regularly focus on such accounting abuses.

Enforcing Accounting Rules

As we mentioned in the preceding sections, when preparing financial statements a business must follow generally accepted accounting principles (GAAP) - the authoritative ground rules for measuring profit and for reporting values of assets and liabilities. Everyone reading a financial report is entitled to assume that GAAP have been followed (unless the business clearly discloses that it is using another so-called comprehensive basis of accounting).

The basic idea behind GAAP is to measure profit and to value assets and liabilities
consistently
from business to business - to establish broad-scale uniformity in accounting methods for all businesses. The idea is to make sure that all accountants are singing the same tune from the same hymnbook. The purpose is also to establish realistic and objective methods for measuring profit and putting values on assets and liabilities. The authoritative bodies write the tunes that accountants have to sing.

GAAP also include minimum requirements for
disclosure,
which refers to how information is classified and presented in financial statements and to the types of information that have to be added to the financial statements in the form of footnotes. Chapter 8 explains these disclosures that are required in addition to the three primary financial statements of a business (the profit and loss account, balance sheet, and cash flow statement).

The Accounting Standards Board, the body responsible for setting accounting standards in the UK, is undertaking a programme of gradually ripping up UK GAAP and replacing it with international financial reporting standards. Today, companies with outside shareholders in the UK and across Europe have bitten the bullet and are adopting international accounting standards, known as International Financial Reporting Standards (IFRS). International standards sound like a great idea - especially with the introduction of a single European currency and the emergence of pan-European equity markets. In fact most financial directors of public companies want to be able to adopt IFRS ahead of time. The UK's Accounting Standards Board is pressing ahead with a programme to ‘converge' UK accounting standards so that they match the international standards - almost. You can keep track of changes in company reporting rules on the Institute of Chartered Accountants' Web site at
www.icaew.com
(click on Accounting and corporate reporting and then on UK GAAP).

You could ask if the move to IFRS is such a big deal? In reality, this programme is not an accounting revolution, but a journey from one comprehensive basis of GAAP to another. GAAP remains the preferred option for the majority of the 1.4 million private companies and 3 million partnerships and sole traders in the UK. Only the 3,500 or so companies listed on UK stock markets are changing to IFRS.