GAAP
GAAP was developed by the Financial Accounting Standards Board (FASB) to
standardize financial reporting and provide a uniform set of rules and formats to
facilitate analysis by investors and creditors. The GAAP created guidelines for item
recognition, measurement, presentation, and disclosure.
Bringing uniformity and objectivity to accounting improves the credibility and stability
of corporate financial reporting, factors that are deemed necessary for capital
markets to function optimally.
Following standardized rules allows for companies to be compared against one
another, results to be verified by reputable auditors, and investors to be assured that
the reports are reflective of a company's true standing. These principles were
established and adapted largely to protect investors from misleading or dubious
reporting.
American Institute of Certified Public Accountants (AICPA)
What Is the American Institute of Certified Public Accountants
(AICPA)?
The American Institute of Certified Public Accountants (AICPA) is a nonprofit professional
organization
representing certified
public
accountants (CPA) in the United States.
KEY TAKEAWAYS
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The American Institute of Certified Public Accountants (AICPA) is a non-profit
professional organization representing certified public accountants (CPA) in the
United States.
The AICPA was founded in 1887, under the name American Association of
Public Accountants.
The organization is integral to rule-making and standard-setting in the CPA
profession and serves as an advocate for legislative bodies and public interest
groups.
Understanding the American Institute of Certified Public
Accountants (AICPA)
The American Institute of Certified Public Accountants (AICPA) was founded in 1887,
under the name American Association of Public Accountants, to ensure
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that accountancy gained respect as a profession and was practiced by ethical,
competent professionals. The AICPA exists to provide its more than 431,000
members with the resources, information, and leadership to provide CPA services in
the highest professional manner.
From its earliest iteration in 1887 to as late as the 1970s, the AICPA was the only
body setting generally accepted technical and professional standards for CPAs in a
number of areas. In the 1970s, the Financial Accounting Standards Board (FASB)
took over responsibility for setting generally accepted accounting principles (GAAPs).
However, the AICPA still retains its standards-setting responsibilities in such areas
as professional ethics, business valuation, financial statement auditing, attest
services, and CPA firm quality control. The AICPA is integral to rule-making in the
CPA profession and serves as an advocate for legislative bodies and public interest
groups.1
Traditional Assumptions of the Accounting Model
Business Entity
Exists independently of its owner's personal holdings; The accounting records and reports are
maintained separately and contain financial information related only to the business
Going Concern or Continuity
Assumes that the entity being accounted for will remain in business for an indefinite period of
time. Disregards possibility of bankruptcy or liquidation, impacts how assets and liabilities are
measured and reported.
Time Period
Entity can be accounted for with reasonable accuracy for a particular period of time. Allows
measurement of the results of operations prior to the liquidation of a business entity's life
1)Natural
Business
Year
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2)Calendar
3)Fiscal Year
Year
Monetary Unit
An assumption that requires that only those things that can be expressed in money are included
in the accounting records.
Historical Cost
A concept that is applied when the actual amount paid for merchandise or other items bought is
recorded. Merchandise and other items bought are recorded and reported at the price agreed
upon at the time of the transaction.
Conservatism
The accountant must select the measurement with the least favorable effect on net income and
financial position in the current period.
Realization (recognition of revenue)
The accountant must determine when it is practical to recognize revenue.
Point of Sale
Is usually when revenue is recognized. However there are many other acceptable methods of
recognizing
revenue....
1)
End
of
Production
2)Receipt
of
Cash
3)During
Production
4)Cost Recovery
3
Matching (expenses with revenues)
The accountant must determine revenue first and then match the appropriate costs against this
revenue.
Consistency Concept
Requires the entity to give the same treatment to comparable transactions from period to period
which adds to the usefulness of reports while facilitating the detection of trends. If a change is
made then justification of change is disclosed and impact of the change on financial must be
explained.
Full Disclosure
The accounting reports must disclose all facts that may influence the judgement of an informed
reader using a reasonable summary of financial information.
Methods of Disclosure
1)Parenthetical
2)Supporting
3)Cross-references
4)Notes
Explanation
Schedules
Materiality
The point involved is one of relative size
"Would this item influence an informed reader
Immaterial items not subject to concepts and principles.
and importance to a firm.
of the financial statements?"
Does the Information influence an informed reader of the financial statements?
Yes,
No, if it is immaterial.
if
it
is
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material.
Industry PracticesPeculiarities of some industries and business concerns that cause variations
from basic accounting theory or practice. For example, agricultural companies often report crops
at fair value because it is costly to develop accurate cost figures on individual crops.
Transaction Approach
Method of income measurement that focuses on the income-related activities—revenue,
expense, gain, and loss transactions—that have occurred during the period.
Cash Basis
An accounting practice in which revenue is not recognized in the accounting records until
received and in which expenses are not recognized until paid. (usually not accepted by GAAP)
Accrual Basis
Accounting method whereby income and expense items are recognized as they are earned or
incurred, even though they may not have been received or actually paid in cash.
What Are Financial Statements?
Financial statements are written records that convey the business activities and the
financial performance of a company. Financial statements are often audited by
government agencies, accountants, firms, etc. to ensure accuracy and for tax,
financing, or investing purposes. Financial statements include the
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Balance sheet
Income statement
Cash flow statement
KEY TAKEAWAYS
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Financial statements are written records that convey the business activities
and the financial performance of a company.
The balance sheet provides an overview of assets, liabilities, and stockholders'
equity as a snapshot in time.
The income statement primarily focuses on a company’s revenues and
expenses during a particular period. Once expenses are subtracted from
revenues, the statement produces a company's profit figure called net income.
The cash flow statement (CFS) measures how well a company generates cash
to pay its debt obligations, fund its operating expenses, and fund investments.
Balance Sheet
The balance sheet provides an overview of a company's assets, liabilities, and
stockholders' equity as a snapshot in time. The date at the top of the balance sheet
tells you when the snapshot was taken, which is generally the end of the reporting
period. Below is a breakdown of the items in a balance sheet.
Assets
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Cash and cash equivalents are liquid assets, which may include Treasury
bills and certificates of deposit.
Accounts receivables are the amount of money owed to the company by its
customers for the sale of its product and service.
Inventory
Liabilities


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Debt including long-term debt
Wages payable
Dividends payable
Shareholders' Equity

Shareholders' equity is a company's total assets minus its total
liabilities. Shareholders' equity represents the amount of money that would be
returned to shareholders if all of the assets were liquidated and all of the
company's debt was paid off.
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Retained earnings are part of shareholders' equity and are the amount of net
earnings that were not paid to shareholders as dividends.
Income Statement
Unlike the balance sheet, the income statement covers a range of time, which is a
year for annual financial statements and a quarter for quarterly financial statements.
The income statement provides an overview of revenues, expenses, net income, and
earnings per share.
Revenue
Operating revenue is the revenue earned by selling a company's products or
services. The operating revenue for an auto manufacturer would be realized through
the production and sale of autos. Operating revenue is generated from the core
business activities of a company.
Non-operating revenue is the income earned from non-core business activities.
These revenues fall outside the primary function of the business. Some nonoperating revenue examples include:


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
Interest earned on cash in the bank
Rental income from a property
Income from strategic partnerships like royalty payment receipts
Income from an advertisement display located on the company's property
Other income is the revenue earned from other activities. Other income could include
gains from the sale of long-term assets such as land, vehicles, or a subsidiary.
Expenses
Primary expenses are incurred during the process of earning revenue from the
primary activity of the business. Expenses include the cost of goods
sold (COGS), selling,
general
and
administrative
expenses
(SG&A), depreciation or amortization, and research and development (R&D).
Typical expenses include employee wages, sales commissions, and utilities such as
electricity and transportation.
Expenses that are linked to secondary activities include interest paid on loans or
debt. Losses from the sale of an asset are also recorded as expenses.
The main purpose of the income statement is to convey details of profitability and the
financial results of business activities; however, it can be very effective in showing
whether sales or revenue is increasing when compared over multiple periods.
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Investors can also see how well a company's management is controlling expenses to
determine whether a company's efforts in reducing the cost of sales might boost
profits over time.
Cash Flow Statement
The cash flow statement (CFS) measures how well a company generates cash to
pay its debt obligations, fund its operating expenses, and fund investments. The
cash flow statement complements the balance sheet and income statement.
The CFS allows investors to understand how a company's operations are running,
where its money is coming from, and how money is being spent. The CFS also
provides insight as to whether a company is on a solid financial footing.
There is no formula, per se, for calculating a cash flow statement. Instead, it contains
three sections that report cash flow for the various activities for which a company
uses its cash. Those three components of the CFS are listed below.
Operating Activities
The operating activities on the CFS include any sources and uses of cash from
running the business and selling its products or services. Cash from operations
includes any changes made in cash, accounts receivable, depreciation, inventory,
and accounts payable. These transactions also include wages, income tax
payments, interest payments, rent, and cash receipts from the sale of a product or
service.
Investing Activities
Investing activities include any sources and uses of cash from a company's
investments into the long-term future of the company. A purchase or sale of an
asset, loans made to vendors or received from customers, or any payments related
to a merger or acquisition is included in this category.
Also, purchases of fixed assets such as property, plant, and equipment (PPE) are
included in this section. In short, changes in equipment, assets, or investments relate
to cash from investing.
Financing Activities
Cash from financing activities includes the sources of cash from investors or banks,
as well as the uses of cash paid to shareholders. Financing activities include debt
issuance, equity issuance, stock repurchases, loans, dividends paid, and repayments
of debt.
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The cash flow statement reconciles the income statement with the balance sheet in
three major business activities.
Meaning, Nature and Objectives of Financial Statements
The financial statements of a company reflect a true picture of its financial
performances. They depict not only profits and losses, but also assets and
liabilities. It is only at the end of all accounting processes that we can generate
these statements. Let’s take a look at the objectives of financial statements
along with their features.
Meaning of Financial Statements
Financial statements are basically reports that depict financial and accounting
information relating to businesses. A company’s management uses it to
communicate with external stakeholders. These include shareholders, tax
authorities, regulatory bodies, investors, creditors, etc.
These statements basically include the following reports:
1.
2.
3.
4.
Balance sheet
Profit and Loss statement
Statement of cash flow
Income sheet
Nature of Financial Statements
Financial statements are prepared using facts relating to events, which are
recorded chronologically. Thus, we have to first record all these facts
in monetary terms. Then, we have to process them using all applicable rules
and procedures. Finally, we can now use all this data to generate financial
statements.
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Based on this understanding, the nature of financial statements depends on the
following points:
1. Recorded facts: We need to first record facts in monetary form to create
the statements. For this, we need to account for figures of accounts like
fixed assets, cash, trade receivables, etc.
2. Accounting conventions: Accounting Standards prescribe certain
conventions applicable in the process of accounting. We have to apply
these conventions while preparing these statements. For example, the
valuation of inventory at cost price or market price, depending on
whichever is lower.
3. Postulates: Apart from conventions, even postulates play a big role in
the preparation of these statements. Postulates are basically presumptions
that we must make in accounting. For example, the going concern postulate
presumes a business will exist for a long time. Hence, we have to treat
assets on a historical cost basis.
4. Personal judgments: Even personal opinions and judgments play a big role
in the preparation of these statements. Thus, we have to rely on our own
estimates while calculating things like depreciation.
Now that we understand the meaning and nature of financial statements, a
glance at their objectives would be appreciable.
Objectives of Financial Statements
Stakeholders of a company heavily rely on financial statements to understand
its functioning. They portray the true state of affairs of the company. Here are
some objectives of financial statements:


These statements show an accurate state of a company’s economic assets
and liabilities. External stakeholders like investors and authorities generally
do not possess this information otherwise.
They help in predicting the extent of a company’s capacity to earn profits.
Shareholders and investors can use this data to make their financial
decisions.
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These statements depict the effectiveness of a company’s management.
How well a company is performing depends on its profitability, which these
statements show.
They even help readers of these statements know the accounting
policies used in them. This helps in understanding statements more
comprehensively.
These statements also provide information relating to the company’s cash
flows. Investors and creditors can use this data to predict the company’s
liquidity and cash requirements.
Finally, they explain the social impact of businesses. This is because it shows
how the company’s external factors affect its functioning.
Limitations of Financial Statements
1. Not a reflection of the present Financial Position
Firstly, financial statements do not show how well a company is performing in
the present times. This is because they are made at the end of every financial
year. Hence, they only depict performances of the previous twelve months.
Even the value of assets and liabilities change as money’s purchasing power
fluctuates.
2. Possibility of Bias
Financial statements might not always be an accurate representation of a
company. This happens because they are based on several personal judgments,
conventions and internal policies of accountants.
3. The Absence of Vital Information
Accountants might skip a lot of vital information while making financial
statements. For example, the nature of agreements signed by the company is
important information, but it is never mentioned in annual statements.
4. Lack of Qualitative Information
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Although companies portray their numbers and finances in annual statements,
a lot of qualitative data is skipped. Hence, details of the company’s industrial
relations, employees’ productivity, etc. are generally missing from these
statements.
5. Lack of Details
Financial statements might state the total value of assets, but they do not
disclose the nature of these assets. Similarly, a lot of minute details like these
do not find mention.
Uses of Financial Statements
1. Bridging the Gap in Management
Financial statements basically reflect a company’s financial performances.
They show profits and liabilities of the business. They show how successful a
company’s decisions have been. Since shareholders have access to these
statements, they can gauge their company’s performance. This further helps in
bridging the gap between lapses in management and expectations of owners.
2. Availing Credit from Lenders
Every business needs to borrow funds for functioning. They have to rely on
lenders like banks and financial institutions for this purpose. Financial
statements play a huge role in this purpose. Since they show a company’s
liabilities, debts and profits, investors can use them to make informed
decisions.
3. Use for Investors
Investors also extensively use a company’s financial statements to asses
its finances. That helps them figure out how the company’s solvency will be in
the longer term. Thus, the better a company’s financial position is, the greater
the investment it will receive.
4. Use for Government
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Governmental policies pertaining to corporates depend heavily on financial
statements. This is because these statements depict how companies are
functioning in general. The government can use this information to decide
taxation and regulatory policies.
5. Use for Stock Exchanges
Regulatory bodies like SEBI and stock exchanges like BSE and NSE also use
financial statements for many reasons. SEBI can assess a company’s internal
matters using them to ensure the protection of investors. Even stock advisers
require them to frame their quotes. They are also a great source of information
for stock traders and investors.
6. Information on Investments
The shareholders of a company rely on these statements to understand how
their investments are paying off. If a company is earning profits, they might
decide to invest even more money. On the contrary, stagnant profits or even
losses will prompt them to pull out. Despite all these uses of financial
statements, there are some limitations to them as well.
What Are Consolidated Financial Statements?
Consolidated financial statements are financial statements of an entity
with multiple divisions or subsidiaries. Companies can often use the word
consolidated loosely in financial statement reporting to refer to the
aggregated reporting of their entire business collectively. However, the
Financial Accounting Standards Board defines consolidated financial
statement reporting as reporting of an entity structured with a parent
company and subsidiaries.
Private companies have very few requirements for financial statement
reporting but public companies must report financials in line with the
Financial Accounting Standards Board’s Generally Accepted Accounting
Principles (GAAP). If a company reports internationally it must also work
within the guidelines laid out by the International Accounting Standards
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Board’s International Financial Reporting Standards (IFRS). Both GAAP
and IFRS have some specific guidelines for companies who choose to
report consolidated financial statements with subsidiaries.
What are Consolidated Financial Statements?
Consolidated financial statements are the financial statements of a group of entities
that are presented as being those of a single economic entity. These statements are
useful for reviewing the financial position and results of an entire group of
commonly-owned businesses. Otherwise, reviewing the results of individual
businesses within the group does not give an indication of the financial health of the
group as a whole. The key entities used in the construction of consolidated
statements are:

A group is a parent entity and all of its subsidiaries

A subsidiary is an entity that is controlled by a parent company
Thus, consolidated financial statements are the combined financials for a parent
company and its subsidiaries. It is also possible to have consolidated financial
statements for a portion of a group of companies, such as for a subsidiary and those
other entities owned by the subsidiary.
The Decision to Consolidate
A parent company may have investments in many other entities, not all of which will be included in its
consolidated statements. The main decision point when deciding whether to include a subsidiary’s
financial statements is whether the parent has more than a 50% ownership interest in the subsidiary. If so,
then its results are included in the consolidated statements. Also, if the parent company ha s decisionmaking influence over another business, despite owning a smaller share of the business, then it may also
choose to consolidate. When a parent has no decision-making influence and owns less than a 50%
interest in another business, then it will not consolidate; instead, it will use either the cost method or the
equity method to record its ownership interest.
Intercompany Transactions
Consolidated statements require considerable effort to construct, since they must exclude the impact of
any transactions between the entities being reported on. Thus, if there is a sale of goods between the
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subsidiaries of a parent company, this intercompany sale must be eliminated from the consolidated
financial statements. Another common intercompany elimination is when the parent company pays
interest income to the subsidiaries whose cash it is using to make investments; this interest income must
be eliminated from the consolidated financial statements.
Best Practices for Consolidated Financial Statements
To reduce the time requirements and errors associated with the production of consolidated financial
statements, put all subsidiaries on the same centralized accounting system. Once this system is installed,
flag all inter-company transactions within it, so that the system can automatically remove them when
creating consolidated financial statements. Another best practice is to mandate the use of a consist entlyapplied set of accounting policies and procedures across all reporting entities, so that accounting
transactions are dealt with in a consistent manner in all locations.
What Is an Auditor's Report?
An auditor's report is a written letter from the auditor containing their opinion on
whether a company's financial statements comply with generally accepted
accounting principles (GAAP) and are free from material misstatement.
The independent and external audit report is typically published with the
company's annual report. The auditor's report is important because banks and
creditors require an audit of a company's financial statements before lending to
them.1
KEY TAKEAWAYS
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The auditor's report is a document containing the auditor's opinion on whether
a company's financial statements comply with GAAP and are free from material
misstatement.
The audit report is important because banks, creditors, and regulators require
an audit of a company's financial statements.1
A clean audit report means a company followed accounting standards while an
unqualified report means there might be errors.1
An adverse report means that the financial statements might have had
discrepancies, misrepresentations, and didn't adhere to GAAP. 2
What Is Financial Statement Analysis?
Financial statement analysis is the process of analyzing a company's financial
statements for decision-making purposes. External stakeholders use it to understand
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the overall health of an organization as well as to evaluate financial performance and
business value. Internal constituents use it as a monitoring tool for managing the
finances.
KEY TAKEAWAYS
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
Financial statement analysis is used by internal and external stakeholders to
evaluate business performance and value.
Financial accounting calls for all companies to create a balance sheet, income
statement, and cash flow statement which form the basis for financial
statement analysis.
Horizontal, vertical, and ratio analysis are three techniques analysts use when
analyzing financial statements.
FINANCIAL STATEMENT ANALYSIS
Financial Statement Analysis (FSA) can also be defined as the process of identifying financial strengths and
weaknesses of the firm by properly establishing relationship between the items of the balance sheet and the profit
and loss account.
Financial Ratios and Financial Statement Analysis emphasizes on the influence of financial analysis in business.
The important figures in a financial statement are intertwined by many a relationship. It helps the analyst in
comprehending these relationships and how each one plays its vital role in understanding a business’s growth,
performance, scalability and other zones of it.
Advantages Of Financial Statement Analysis
1. Evaluation Of Past Performance
Financial statement analysis evaluates the past performance of business such
as sales, cash flows, income, return on investment etc. by using different
techniques like trend analysis, vertical analysis, ratio analysis etc.
2. Indication Of Current Position
Financial statement analysis indicates the current financial position of the business in terms of
profitability and operational efficiency.
3. Prediction Of Future Performance
Financial analysis provides the data of past and current financial position of the business
. These data and information are the bases to predict future earnings and growth rate of the
business.
4. Planning And Decision Making
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Financial statement analysis evaluates and compares the past and present performance of the
business. It helps the management in planning and decision making process.
5. Tax Determination
Financial statement analysis shows accurate financial position and profitability of the business.
So, it helps to determine tax liabilities of the company.
6. Credit Decision
Financial statement analysis helps the bankers to make credit decision by providing up-to-date
information regarding profitability, solvency, liquidity and efficiency of the business firm.
Disadvantages Of Financial Statement Analysis
1. Ignores Qualitative Aspect
Financial statement analysis checks only quantitative or monetary aspect of the business. It
totally ignores qualitative aspect.
2. Historical Data
Financial statement analysis is done with the help of historical financial data provided by
financial statements. So, it may not be a base or indicator for future estimation, planning,
forecasting and decision making.
3. Biasness
Financial statement analysis may suffer from the biasness of the analysts. This may mislead
the users.
4. Does Not Provide Solution
Financial statement analysis only identifies the finance related problems of the company. It
fails to suggest the solutions.
5. Difficult To Compare
Different companies may follow different accounting principles (like different depreciation
methods, LIFO method, FIFO method etc). In this situation it is impossible to compare
different financial statement accurately.
6. Price Level Change
Effect of price level change cannot be adjusted in financial statement analysis
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or
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LIMITATION OF FINANCIAL STATEMENTS ANALYSIS
1. Comparing companies with different fiscal year end can be difficult.
2. Comparing companies with different accounting methods (for example
Inventory LIFO vs. FIFO, depreciation method) can be difficult.
4. Takes into account only quantitative factors and ignore qualitative factors
such as efficiency, loyalty and honesty of the human resource.
5. Explanation of the results of the analysis involves human decision.
6. Data based on historical events which may not hold in future.
Relation Between Financial Statement And Financial
Statement Analysis
What is Financial Statement Analysis?
Financial Statement Analysis (FSA) is the diagnostic and investigative study of
Financial Statements in order to take logical business decisions. Financial Statement
Analysis takes the raw financial information from the financial statements and turns
it into usable information the can be used to make decisions. The three types of
analysis are horizontal analysis, vertical analysis, and ratio analysis. Each one of these
tools gives decision makers a little more insight into how well the company is
performing.
To understand Financial Statement Analysis or FSA we must first learn about the
Financial Statements.
FINANCIAL STATEMENTS
Financial statement is a report which describes the financial health of a company.
Financial statements are usually compiled on a quarterly and annual basis and
provide useful financial information to the user of financial statement. Financial
statements are often audited by government agencies, accountants, firms, etc.
Sources of Information for Financial Statement Analysis
The main sources of information about publicly held corporations are company
published reports, such as annual reports and interim financial statements, SEC
reports, business periodicals, and credit and investment advisory services.
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Sources of Financial Statement Analysis
Annual reports are the major source for financial statement analysis. They provide much of the
information users need to make economic decisions about businesses. Besides these the stock
exchange reports, business periodicals and reports by credit and investment advisory services are
also major sources for financial statement analysis. Let us discuss about the different sources of
information for analysis.
Reports Published by the Company
Nowadays the annual reports of the companies are very comprehensive. So, naturally annual
reports are the major source for financial analysis. Already we know that the main parts of the
annual reports are: (a) Financial Statements, (b) Auditor's Reports, (c) Management's analysis of
past year's operations (i.e., management and discussion analysis), (d) Notes to the Financial
Statements, and (e) a summary of operations of five or ten year period. Now companies are
publishing interim financial reports. These are unaudited reports. So care should be taken while
using these statements for analysis. These statements give the signals about the significant changes
in company's earnings trend.
Stock Exchange Reports
All public companies must file their annual, quarterly and current reports to the stock exchange
authorities. These statements are available to the general public for a small charge. Generally, the
companies submit their forms in a specified format. More information about the financial statements
is available in these reports than in the published annual reports. Quarterly reports and interim
reports submitted to the stock exchanges give valuable information. For example, in the US the
companies must submit current report (Form 8-K) within a few days from the date of the occurrence
of a certain significant event. These reports are very important because these are the first indicators
of important changes that may affect the company's financial performance in the future. Now, all the
reports are available in the stock exchange websites.
Business Periodicals and Credit and Investment Advisory Services
Financial analysts must keep in touch with the events in the financial world. The best sources of
financial news are the magazines or newspapers published by the stock exchanges. They give
information about day-to-day changes in the business environment. Periodicals like - Business
Week, ICFAI's Analyst magazine, Forbes and Fortune are very helpful magazines for financial
information. For further financial information about the companies, the publications brought out by
Standard & Poor's and Reuters are useful. Data on industry norms, average ratios and relationships
and credit ratings are available from credit rating agencies like CRISIL, ICRA, CARE and ONICRA.
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These agencies' reports and studies provide a lot of information to the financial analysts. Some
agencies provide financial information in a summarized form, which will help for analyzing and
calculating various ratios.
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