Accounting

The Generally Accepted Accounting Principles (G.A.A.P.) are the conventions, traditions, assumptions and rules that the accountants are required to use when recording the transactions as well as when preparing the final financial statements. These principles are adopted to ensure that the financial statements are objective and free from any material misstatements, whether intentional or accidental. However, in the United States, these GAAP are not written in law.
The Financial Accounting Standards Board (FASB) is the body that is entrusted with the work of coming up with the generally accepted accounting principles, while the United States Securities and Exchange Commission (SEC) ensures that the public companies adopt these principles when reporting their financial accounts. These principles must have some characteristics that make them regulate the manner in which the financial statements are presented. The principles themselves must be acceptable by the reporting entities, allow for objective reporting, and must be simple to comprehend.
The United States generally accepted accounting principles are categorized into four basic assumptions, four principles and four constrains. The four basic assumptions are: business entity, the going concern, money unit principle and time period principle. The business entity assumption proposes that the business enterprise should be treated as a different entity from its owners and the revenues and expenses of the business should be accounted for separately from those of the owners. The going concern assumes that the enterprise will continue with operations in the foreseeable future while the money unit principle assumes that the US dollar will be the currency used. The time period principle supposes that the accounting periods can be divided into periods like one year or half a year and present financial statements that relate to that specific period.
The principles are: historical cost principle, the revenue realization principle, the matching principle and the disclosure principle. The historical cost principle requires that items should be accounted for based on their historical cost and not the market values. The revenue recognition principle requires that revenues should be recognized when earned and not when cash is received. This principle forms the basis of the accrual accounting system. (Nikolai, Loren A., John D. Bazley, and Jefferson Jones, 2007).
 The matching principle requires that the revenues be matched with the expenses so long as it is possible to do so. The disclosure principle requires that the information provided to the third parties should be just enough to allow for decision making. If necessary, supplementary notes should be attached.
The four constrains are: objectivity principle, materiality principle, consistency principle and prudence principle. The objectivity principle calls for the information contained in the financial statements to be gathered objectively. Materiality principle holds that significant items should be reported whereas the trivial items should be ignored. Consistency principle requires that the same accounting methods should be applied from period to period. However, this does not mean that a company should be rigid. Prudence principle means that profits should not be overstated and provisions should be made for losses.
Due to these detailed requirements, companies are now subverting the generally accepted accounting principles and presenting, to third parties, financial statements that are not in line with the principles. There are limited situations in which departure from the generally accepted accounting principles is allowed. These are situations in which it is evident that following the principles would make the financial statements become misleading. For instance, where it has been noted that the useful life of an asset is shorter than initially expected, a company may be forced to change its depreciation policy to reflect that fact. Continued use of the current depreciation policy would lead to material misstatements and therefore it is imperative to deviate from the consistency principle and adopt a new policy.
Another instance where deviation from the GAAP is called for is where a company has ceases to be a going concern. In other words, in a case were the company’s future is very uncertain. In such a case, the company would be compelled to show cognizance of this fact by stating the balance sheet items at their net book values as well as at their net realizable values. The net book values are the historical costs less the accumulated depreciation while the net realizable values are the estimated current market value of an item.
However, companies are also deviating from the principles for other reasons and through other ways. The companies may, at some instances, present revenues and costs that belong to the owners so that they appear as if they are making huge profits whereas they are not. This is subversion of the business entity assumption.
Subversion of the time period principle occurs when a company, includes in its financial statements, some information that does not relate to the period under consideration. Similarly, a company may fail to capture all the information that relates to the period being reviewed. This misapplication of the principles is an intentional act that is meant to distort the financial statements or to defraud the owners of the company. It is a requirement that the statement of comprehensive income should only contain revenues and expenses items that strictly relates to the period being reported.
Corporations that are faced with liquidity problems will always try to conceal this fact to the third parties. For this reason, such companies usually ignore the revenue recognition principle and record, as if earned, revenues that have not yet been earned. The revenue recognition principle requires that mere promises to purchase should not be recorded but the companies are recording promises as debts. These mere promises are reported as being part of current assets.
It is a requirement by the generally accepted accounting principles that the information disclosed should be enough to enable a third party to make informed decisions based on the financial reports. The disclosure principle requires that supplementary notes be provided to support the figures in the financial statements or to expound the statements. Some companies ignore this requirement when presenting their repots. For instance, since a pending litigation against the corporation cannot be recorded in terms of figures in the financial reports, they should be disclosed by way of notes. This is because the outcome of the lawsuit could negatively impact on the financial strength of the company.
The materiality principle was established to guide the companies on the items to include in the financial statements and the items to leave out. What is material to one company may be immaterial to another.  Materiality depends on the sensitivity of the item and the amounts involved. It is left to the discretion of the companies to decide what items is material to them. However, companies subvert this principle by failure to disclose certain items, which if disclosed, would affect the decisions made by the third parties.
The prudence principle requires that profits should not be overstated when reporting while there should be provision for losses. This principle requires that provisions should be made for bad and doubtful debts, provision for loss in inventory values, and any other provision that the company may find fit to make. For instance, if a debtor is declared bankrupt, the company should make sufficient provisions to cater for the loss.
The value of the debtors in the balance sheet should be adjusted accordingly so as to show only the valid debtors. This principle notwithstanding, corporations continue to present their financial reports without making the necessary adjustments to reflect a probable loss. (Bragg, Steven M., 2004).
The United States Securities and Exchange Commission (SEC) has been charged with the responsibility of ensuring that the investors are protected against fraudulent companies. The SEC does so by ensuring the GAAP are properly followed. The commission takes necessary action against the companies that fail to comply with these principles and the action may even involve lawsuits against those companies.
For instance, in 2007, the commission instituted a lawsuit against Ernst & Young Chartered Accountants and Denis O’ Hogan who carried out an audit on SmartForce PLC and wrote an unqualified audit report, despite the fact that SmartForce PLC had not complied with the requirements of GAAP. “SmartForce’s financial statements, which the company included in its annual and quarterly reports during the Restatement period, were materially false and misleading in that they overstated net income and revenue in some periods and understated net income and revenue in other periods by failing to comply with the GAAP”.(Administrative proceeding, File No. 3-12703).
In some cases, the commission may require the companies to restate their prior years’ profits and the chief executives may be compelled to refund compensation paid to them by these fraudulent companies. The commission issues a Wells notice to the Chief Executives of such companies informing them that its staff wishes to recommend an action against the company or the individuals. “In doing so, the SEC is relying on a provision of the Sarbanes-Oxley Act that lets the government try to recover incentive-based compensation from senior executives when their company is accused of reporting inaccurate financial data” (Otapka, Dawn W., & Maremont, Mark, 2009).
The US GAAP and the International Financial Reporting Standards share some similarities as well as differences. The generally accepted accounting principles are established by the Financial Accounting Standards Board (FASB) while the International Accounting Standards Board (IASB) establishes the International Financial Reporting Standards (IFRS). Some differences have come up as a result of different interpretations of the standards.
The similarities between the two relates to the presentation of the final accounts. The two frameworks requires that the final financial statements be comprised of the statement of balances of assets and liabilities (the balance Sheet), income statement, cash flow statement and a set of notes to the accounts. The two regulations also require that the accrual system of accounting should be adopted except when preparing the cash flow statement. The two frameworks also emphasize on the need to observe consistency as well as materiality principles when reporting. (Epstein, Barry J. & Eva K. Jermakowicz, 2008)
One of the notable differences between the two frameworks is on the layout of the financial statements. Under the US GAAP, there is no specific layout of the balance sheet or the income statement, but the public companies must follow requirements of Regulation S-X. Under the IFRS, there is no standard layout but there are minimum items that must be disclosed. When presenting the balance sheet under the US GAAP, the previous periods may be shown or a single year may be shown in certain circumstances. The IFRS requires that comparative figures for all items of the previous period must be presented.
Regarding the disclosure of deferred taxes, the US GAAP requires that they be presented as current or non current. However, the IFRS strictly requires them to be shown as non current asset or liability. The expenses in the income statement are classified according to their function under US GAAP while under the IFRS the expenses are classified according to their function or their nature. However, notes on the nature of the expenses must be attached if the function category is chosen. (Ernst & Young, 2009)
In conclusion, it can be pointed out that the principles as well as the international standards are very important when preparing the financial statements because they ensure uniformity and understandability of the financial statements.