Part I.
It goes without saying that reliable and objective financial reporting is vital for any business entity. Adequate financial reporting is important in order to be able to track, analyze and implement changes in business operations. In addition, financial reporting gives managers the opportunity to take appropriate measures if financial performance of a company does not meet the expectations. Most of the financial reporting in the world is conducted according to one of the two standards - United States Generally Accepted Accounting Principles (US GAAP) and International Financial Reporting Standards (IFRS). Understanding both approaches is extremely important in international business and M&A deals and, as different countries may use different standards for reporting.
According to American Institute of Certified Public Accountants, US GAAP were created as a response to Great Depression in 1930. US Security and Exchange Commission (SEC) realized that some generally accepted principles of accounting should be introduced in order to provide people the ability to compare financial information of different companies more easily. Several regulatory bodies contributed to the development of US GAAP, besides SEC. In particular, American Institute of Certified Public Accountants and Financial Accounting Standards Board. As noted by Hermanson (2007), US GAAP is based on the following major principles: Cost principle, revenue recognition principle, matching principle, gain and loss recognition principle and full disclosure principle. According to SEC, GAAP is being used in more than 100 countries around the world. However, in recent years FASB is trying to converge US GAAP with IFRS, in order to develop a single set of standards, which would be acceptable worldwide. Accountants claim that common and unique set of accounting standards will contribute to the economic growth, surge foreign investment and improve regulatory environment.
Gangwar (2009) notes that IFRS are considered to be "principle based" standards, while U.S. GAAP are considered to be "rules based" standards. For this reason, IFRS are believed to provide a better and more reliable capture of economic transactions than US GAAP. For example, under IFRS the LIFO (last-in-first-out) inventory accounting method is not allowed, while both FIFO and LIFO may be used under US GAAP. The principle which stands behind this approach is that LIFO may be used by entities to decrease tax expenditure if economy is suffering from high inflation. In addition, LIFO method may bring imbalances to financial statements, as old inventories might be kept on balance sheets for too long to present a relevant value. This example illustrates that principle based standards are more informative and constructive than the rule based standards.
Security and Exchange Commission (SEC) is a government agency that administers trade of securities, such as stocks and bonds. It was established in 1934 by the Securities Exchange Act (1934). In other words, SEC is a regulatory authority which controls and reviews the accounting and financial reporting of US Corporations. SEC and FASB together contribute to the development of efficient accounting standards.
Forms 10-K, 10-Q and 8-K are the most essential reports required by SEC. Form 10-K represents company’s annual report where it discusses its annual performance, financial statements, and provides a detailed analysis of the operational activities. Form 10-Q stands for a quarterly report, which is filed with SEC within 35 days before the end of the quarter. Form 8-K stands for Special Events Report, which presents unscheduled material events that are important to shareholders (Gangwar, 2009). These events include, CEO resignation, opening a new business line, bankruptcy, M&A deals, etc.
Part II
Income statement, balance sheet, statement of cash flows, and statement for retained earnings are most important financial statements which describe the financial soundness of the business entity. All of them are listed in the annual report (Form 10-K).
Income statement describes company’s profits in a given period. Basically, income statements compares revenues and expenditures of the company, the difference between the two is a net income or net loss (if profits are negative). Income statement is useful for analyzing company’s profitability by looking at gross and net profit margins and expenditure structure.
While income statement provides us with information on company’s profits in a given period, balance sheet demonstrates company’s financial position in a given point in time. Balance sheet consists of company’s assets, liabilities and stockholder’s equity. Assets entries describe the value of the things owned by a company. Liabilities demonstrate company’s debts and obligations. Stockholder’s equity captures the amount of capital received from investors in exchange for the stock of a company. In other words, Stockholder’s equity describes the book value of a company.
Statement of Cash Flows describes the financial inflows and outflows in a company for a given period. It consists of CFO (Cash flow from operating activities), CFF (Cash flow from financial activities) and CFI (cash flow from investing activities). CFO captures the transactions which affect net income, CFF captures transactions related to borrowing and lending, while CFI concentrates on inflows and outflows of funds related with investments into long-term assets.
Statement of retained earnings differentiates between the income which is saved for future operational activities and income distributed to shareholders in terms of dividends. This statement depicts changes in the retained earnings in a given period. In general, the balance of this statement shows how much of net income was accumulated by a company and was not distributed to shareholders.
Part III.
General accounting equation has the following form:
Assets = Liabilities + Shareholder’s Equity.
List of accounts for each of the component of the abovementioned equation is listed below:
References
Brealey, R. A., Myers, S. C., & Marcus, A. J. (2001). Fundamentals of Corporate Finance. Third Edition. The McGraw-Hill.
Benedicto, M.S. (2008) Introduction to Financial Accounting. IE Business School. A multimedia presentation. Retrieved from http://openmultimedia.ie.edu/openproducts/financial_accounting/financial_accounting/frames.html
Edwards, J.D. & Hermanson, R.H. (2007) Accounting Principles: A Business Perspective. First Global Text Edition, Volume 1.
Gibson, C. H., (2012) .Financial Reporting and Analysis, 13th edition. Cengage Learning.
Gangwar, Sharda & Gangwar, D.K. (2009). Fundamental Principles of Accounting, Global Media.
Ross, S. A., et al. 2002. Fundamentals of corporate finance. Sixth Edition. McGraw Hill.
Ramagopal, C. (2009). Accounting for Managers, New Age International 2009 (read chapter 11), from Trident online library.
