10_chapter Ii.pdf

CHAPTER H

ACCOUNTING ANALYSIS AND GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP) CONTENTS Concept ofAccounting Communicating Accounting Information Users of Accounting Reports Generally Accepted Accounting Principles (GAAP) Controversies Regarding Accounting Principles Diversity in Accounting Principles

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ACCOUNTING ANALYSIS AND GENERALLY ACCEPTED ACCOUNTING PRINCIPLES.

The tired joke *old accountants never die, they just lose their balance” is as

out-dated as the image of an

accountant wearing a green eyeshade and working at a dimly lit desk.1 Although some accounting still involves the computation of balances, a large part of accounting is the communication of information for use in many important decisions. Some people think of accounting as a highly technical field, which can be understood only by professional accountants.

Actually,

nearly

eveiyone

practices

accounting in one form or another on an almost daily basis. Accounting is. the art of measuring, describing and interpreting economic activity. Whether you are preparing a household budget, balancing your chequebook, preparing your income tax return or running Reliance Industries, you are working with accounting concepts and accounting information. 2-1

Concept of Accounting

Accounting has been defined in many different ways and by combining

these definitions we can say,

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‘Accounting is the process of providing quantitative information about economic entities to aid users in making decisions concerning the allocation of economic resources Thus, it involves (1) identifying the information, (2) Measuring the information, (3) Recording the information & (4) Communicating the information. 2.2

Communicating Accounting Information

Accounting has been called the ‘language of business'. The underlying purpose of accounting is to provide financial information about an economic entity i.e. business enterprise. There are many users of accounting information. Users may be categorized into two groups: external users and internal users. a) External users are persons and groups outside the business or other economic entity who need accounting information to decide whether or not to engage in some activity with the entity. They include investors, bankers, suppliers, labour unions and local, state and federal governments. b)

Internal users are persons within a business or other economic entity who peed accounting information to make decisions concerning the operations and activities of the entity. These users include all levels of management, including departmental supervisors, sales personnel, divisional and regional managers and top management’.

The role of accounting information in the decisionmciking process is illustrated in the Diagram 2.1. It shows

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the continual nature of the accounting process that is, accounting

information

about

economic

entities

is

accumulated and communicated to both internal and external users to assist them in decision-making.

Their

decisions, in turn, have an impact on the economic entity, and

the

accounting

information

accumulation

and

communication process is repeated again.
Edition PWS-KENT

2.3

Users of Accounting Reports

An accounting system must provide information to users i.e. managers and also to a number of outsiders who have an interest in the financial activities of the business enterprise.

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The type of information that a specific user will require depends upon the kinds of decisions that person must make e.g. managers need detailed information about daily operating costs for the purpose of controlling the operations of the business and setting reasonable selling prices. Outsiders, on the other hand, need summarized information concerning resources on hand and information on operating results for the past year to use in making investment decisions, imposing income taxes, or making regulatoiy decisions. Diagram 2.2 shows the flow of accounting information to various user groups.
Flow of Accounting Information

Management

Source: Financial Accounting by Robert Meigs & Walter Meigs 6th edition, Page 7. McGrow Hill edition

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As seen in the diagram, financial statements are the main source of financial information to persons outside the business organization and also are of great importance to management. The basic purpose of financial statements is to assist decision makers in evaluating the financial strength, profitability and future prospects of a business. However, corporate annual reports are used by a variety of user groups for their own distinct need based purposes. Table 2.1 illustrates the diverse purposes of various interest groups. i

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Corporate Annual Report: Information for Relevant Public Owners/Shareholders Trends in market price, dividends, EPS, DPS, future plans, profit and sale product group-wise, source of financing, rationale for expansion and acquisition, labour relations, pattern of ownership, etc. Investors (Prospective) Trends in market price, dividend, future plans, leadership, corporate image, product leadership, government regulation, market share, etc. Public Corporate responsibility, labour relations, indigenization, employment opportunities, present and future range of products, regional development, quality of products, composition of management etc. Creditors Liquidity, profitability trends in growth and diversification, composition of capital - present and desirable sources and uses of funds, corporate image etc, Government Adherence to legislation, corporate responsibility, exports, employment and labour relations, indigenization and collaboration, pattern of ownership, providing help to small industries, etc. Employees Stock option, pension plans, future plans, corporate image adherence to legislation and recommendation of wage board etc. Consumers Product range and quality, regularity of supplies, R & D efforts, labour relations, and market share, product leadership, research studies, etc. Source:

Shankar, Tilak “Making Corporate Reporting Practices More Communicative” Economic and Political Weekly, November 1972 p.p 164-168.

Tk - a

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2.3(i)

Corporate Reality & Accounting for Investors.

Due to diverse information needs of different users, a general-purpose report will not be able to serve the purpose. The most effective and efficient report will be achieved when the dominant user group is singled out as the focal point of the report [Stone (1967)], Traditionally, investors (both existing and potential| are singled out as the dominant group [Lai (1985)]. The selection of investors as a largest user group is not sufficient as investors themselves are a heterogeneous group. They may differ with respect to tastes or preferences, wealth, beliefs, access to financial information and skill in interpreting financial information. Individual investors i

consider the future economic outlook of the company, the quality of management and the future economic outlook of the concerned industry to be most important factors in investment decision-making [Baker and Haslem (1973)]. On the other hand, security analysts tend to show more faith in transaction based data as opposed to data based on projected transactions [Chandra (1975)]. They consider earnings per share, the amount of revenue and the method used in its recognition and the operating income for the period to be the most important factors [Chandra (1975)]. ‘Accounting for investors as it is visualized by much of the accounting profession and the regulatory authorities is frequently not very useful as a tool for determining anything other than what the authorities think other people think is important in the stock market.............. accounting

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cannot be and should not be expected to be either realistic or to reflect fairly all the myriad situations that exist in the real world. Accounting cannot be both realistic and useful. At best it can provide diligent and serious investors with an appropriate abstract model for the construction of objective benchmarks which they can use as one tool of analysis in determining their own view of corporate reality/ (Martin •Whitman & Martin Shubik). 2.3(H) Financial Statements For Whom? One of the primaiy areas of controversy revolves around a misunderstanding as to who should be expected to use financial statements. Many people seem to be concerned with the notion that financial statements frequently are not clear and comprehensible to the ‘Man on the street^2 or the uninformed layman e.g. the current attention to ‘cash flow’ analysis seems to be directed towards protecting the financial statements’ reader who is not properly equipped to understand, interpret and use accounting data presented on the accrual basis of accounting. A serious question arises as to whether this concern for the unqualified user of financial statements is warranted. Does the average ‘man on the street’ expect to be able to read comprehend and make decisions based upon legal documents without Competent assistance ? He does not. Rather he seeks the advice of an attorney.

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Neither is the lawyer particularly concerned with simplifying legal materials so that the uninformed layman can understand and use them without professional assistance. The same analogy can be applied to the physician, the engineer or a member of any other recognized profession. Why then should the professional accountant be concerned with making his reports - the financial statements - comprehensive to the uninformed laymen? The layman should be made to recognize here that professional assistance is necessary for intelligent interpretation of reports. On the other hand, accountants certainly should strive to improve the usefulness of their statements to informed, qualified users. This view is evidenced in the results of the survey of individual investors conducted by Baker and Haslem (1973), which reveals that 62.4% of the individual investors questioned by them rated the professional investment community to be the most important source of information, while financial statements as the most important source of information was considered by only 7.9% of them. This means that individual investors rely on financial analysts for their information needs. So corporate reports should be geared towards fulfilling the needs of professional investors. The modem corporation is too complex to be represented by overly simplified financial statements understandable by average investors. In this process, too much significant information is lost (Norby and Stone 1972).

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While Sorter and Gans (1974), Me Cormick (1960), and also Trueblood Committee Report - one of the significant reports on objectives of financial

most

reporting -

recommends that the unsophisticated investor, who have limited authority, ability or resources to obtain information should be the focal point of the annual report. As against this, researchers like Mautz and Sharaf (1961), Norby and Stone (1972), Baker and Haslem (1973) and Beaver (1978) are of the view that the disclosure should be made for sophisticates. There is a growing recognition both on the part of the Securities Exchange Commission (SEC) and the accounting profession that the major users of the financial statements are relatively sophisticates and that disclosure should focus on the professional investment community (Maloo 1986). Thus the accounting profession faces an increasingly difficult problem in coming up with a suitable form of financial statement that could meet the information needs of both unsophisticated and sophisticated users. Also, the accounting profession has a concurrent duty to educate the public in the proper use of financial statements. This involves explaining the basic tenets upon which financial statements are based and indoctrinating the public in the wisdom of selecting competent professional advice and assistance when needed (Patrik Kemp).

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2.4

Generally Accepted Accounting Principles (GAAP}

Accounting is a dynamic and growing field, keeping pace with the rapidly changing business and economic environment. Over the years, because of the activities of several professional accounting organizations, a set of guidelines for financial accounting has evolved. These guidelines are referred to as Generally Accepted Accounting Principles (GAAP), To understand financial statements, one must first understand these Generally Accepted Accounting Principles. These are the ‘ground rules’ developed over a long span of years by the accounting profession. The purpose of these broad basic rules is to guide accountants in measuring and reporting the financial events that make up the life of a business. Briefly stated, generally accepted accounting principles are the accounting standards and concepts used in the measurement of financial activities and preparation of financial statements. In Accounting Principles Board (APB)’s statement No.4 it is stated : *Generally accepted accounting principles encompass the conventions, rules and procedures necessary to define accepted accounting practice at a particular time.” There are two broad categories of accounting principles, measurement and disclosure. Measurement principles determine the timing and basis of items, which enter the accounting cycle and effect the financial statements. Disclosure principles deal with qualitative features that are essential ingredients of a full set of

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financial statements. Their absence would make the financial statements created by measurement principles misleading by themselves. Disclosure principles complement measurement standards by explaining these standards and giving other information on accounting policies, contingencies, uncertainties etc. which are essential ingredients in the analytical process of accounting [Delaney (1995)). In general, when managers prepare reports for use by outsiders such as lenders, investors, regulatory authorities or other interested groups, they must choose among accounting conventions, practices and principles, which become basis for making the measurement necessary to prepare financial reports. Once a choice is made, the concept of consistency demands that similar conventions and practices be used in subsequent periods unless there is a reason that an alternative method would be preferred. Accounting principles are not fundamental truths or even necessarily rules of conduct. They are methods used in observing, measuring and reporting which are widely used or which have substantial, authoritative support. A generally accepted accounting principle is created whenever a method practice, concept or convention is widely used by those who prepare reports, or whenever an official pronouncement is made by a group such as the Financial Accounting Standards Board in the United States, Institute of Chartered Accountants of India (ICAI) in India or the International Accounting

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Standards Committee, by a change to a Company’s Act, or by a regulator with authority to influence reporting and securities trading. The fact that wide use leads to general acceptance in accounting principles makes it critical to understand the accounting process and the way in which it operates. In preparing and distributing their accountants

their reports, managers and

participate

in the

development

of

accounting principles. Through the criteria, its managers adopt in deciding which measurements should be made and reported, an organization supports and advances the development of principles that may be used even more widely in the future. The idea of a set of generally accepted accounting principles is very important historically. When there were fewer constraints on the accounting practices that could be employed by managers in preparing reports, unscrupulous entrepreneurs often took advantage of investors, creditors and other interested groups by rendering misleading reports about income and financial position. In an effort to avert such

practices,

professional

accountants,

regulators,

independent authorities and government agencies in most countries have sought to limit all kinds of practices that fall within the guidelines that generally accepted accounting practices provide.

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2.5

Controversies Regarding Accounting Principles

I.

Why do we need Postulates and Principles ?

There is natural tendency either to overrate or to underrate what can be done by way of a set of postulates and principles. On the one hand no set of accounting postulates and principles will ever solve all accounting problems any more than the Ten Commandments can answer all questions of right and wrong, or the constitution resolve all problem of legality or illegality or the Haws’ of physics build a bridge; launch a rocket or dam a river.3 Thus, we have so many accountants questioning the need for accounting postulates. On the other hand, the formulation of postulates and principles will give accounting the frame of reference, the integrating structure it needs to give more than passing meaning to its specific procedures. It will provide *experience’ with the aid it needs from logic’ to explain why it is that some procedures are appropriate and others are not (Maurice Moonitz). There was a lurking fear in the minds of some accountants that the formation of a set of postulates and principles will lead to rigidity in practice or that their formulation will; make ‘judgment’ unnecessary. It is usually the primitive society that has the largest number of rigid rules controlling every action the individual takes. Sophisticated societies allow much more freedom at the level of individual practice, but still within the limits of a fairly clearly defined set of ‘principles’ e.g. in case of

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inventories. The principle is well established that unsold goods on hand, including materials and work-in-process should be carried forward at cost. Under this principle, the use of simple moving average, weighted average, FIFO, LIFO, etc. are acceptable provided they are properly calculated and consistently used because they comply with the Inventory principle’. ‘Judgment’ is probably most frequently used by accountants as a

synonym for ‘making a decision’.

Judgment is necessary and cannot be replaced by any other known means, whenever decisions have to be made about unknown factors or variables. ‘Judgment’ however has one defect. It is completely subjective. It cannot be tested, it can only be overruled by another superior judgment or by revised judgment taking ‘objective evidence’ into account. In the interests of efficiency and accuracy then, its use should be limited to cases where the probable benefits outweigh the handicap of its subjectivity (Maurice Moonitz) II.

Uniformity v/s Flexibility

The biggest area of misunderstanding seems to lie in determining just what proportions of accounting theory and practice should be uniform and which should be flexible. It wduld be difficult to find an intelligent, thinking professional accountant who would advocate that all accounting be reduced to set of hard and fast rules - a ‘cook book’4 which any person of reasonable intelligence could follow - for this would reduce accountants to the status of mere clerks. On

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the other hand, it would be equally difficult to find an intelligent, thinking professional accountant who would support the idea of allowing each accountant to simply select any methodology, which happens to suit his fancy. Obviously, a middle ground must be found. The familiar Generally Accepted Accounting Principles/Condepts like going concern, objectivity, consistency, full disclosure, cost as the primaiy measure of value, the matching of cost and revenue realization etc. form a basis for accounting theory and practice. Substantial general acceptance is existent in this area though there can be disagreement on the name by which they can be called like principles, conventions, doctrines, standards, etc. As we move away from the area of basic accounting principles to ‘accounting procedures' - the means of implementing the principles, we encounter the major area of controversy. The proponents of ‘uniformity' deplore the variety of 'acceptable' procedures and methods available to accountants in several areas like inventory valuation, depreciation methods etc. They speak of these various i

I

procedures as alternatives implying that any one is equally acceptable to any other in a given situation. This concern is unwarranted if it is recognized that the various procedures and methods available to implement the accounting principles are not alternatives but constitute varying methodology which is necessary to reflect varying set of facts e.g. two companies which buy on the same day identical assets paying the same price. Assets are to be put

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to exactly the same use. There is little question that these assets represent unexpired costs and must be recorded at acquisition price (The Cost Principle). NorJ±Lere_is_aijy-4eubt that the costs of these assets should be allocated to the accounting periods constituting the useful lives of the assets (Matching Costs with Revenue Principle). The question is ‘by what means' the costs be allocated ? Many depreciation methods are available, but these are not alternative methods. The correct method is that one I which most nearly accurately describes the using up of the service potential embodied in each asset. The same reasoning applies to inventory valuation and to any other area in which varying accounting procedures or methods are available.

The various methods do not

represent equally acceptable alternatives, only one is acceptable for a given set of circumstances.

The answer

does not lie in a uniform set of accounting procedures but in a realization by practicing accountants that they are charged with a responsibility to see that the proper method is selected. A high degree of ‘uniformity’ in

regard

general acceptance and hence to

accounting

postulates

and

principles seem clearly desirable. The financial statements should reflect as nearly accurately as possible, the financial facts concerning a business entity. To be sure, accountants need a generally accepted or *uniform” set of broad principles and postulates to guide them in the recording, assembling and classification of financial data.

Equally

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surely, however, these financial data vary from one company to another and even within a given company. Tiius, the procedures and methods by which the accounting principles are implemented should not be uniform, - indeed, they cannot be. The duty of the public accountant as the guardian of the public interest must always be to ensure that accounting methods and procedures are not chosen at the whim of management but that the best available method is selected to present a given set of facts. The goal must always be to reflect in the financial statements the financial facts of a business enterprise as nearly accurately as possible. Ill

To be Or Not To Be - ‘ Fair*

It is certainly possible to have conformity with generally accepted accounting principles without fairness in presentation e.g. the straight-line method of depreciation conforms to generally accepted accounting principles, the primaiy principle involved being the matching of costs and revenues. But if the predictable expiration of service value of the asset in question is related to, the number of miles it is driven rather than a number of time periods, then straight-line depreciation must result in an unfair presentation simply because it does not present the facts in so far as they can be determined. Thus in this situation, the public accountant must reject straight-line depreciation as an acceptable method. “generally

accepted

There is no such thing as a

accounting

method/procedure.”5

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Accounting methods can be acceptable only if they both fit the facts and implement generally accepted accounting principles. “The first law of accountants was not compliance with generally accepted accounting principles, but rather, full and fair disclosure, fair presentation and if principles did not produce this brand of disclosure, accountants could not hide behind the principles but had to go behind them and make whatever disclosures were necessaiy for full disclosure. In other words, ‘present fairly’ was a concept separate from ‘generally accepted accounting principles’ and the latter did not necessarily result in the former.” When U.S. Judge Hemy J. Friendly wrote these words in his landmark Continental Vending decision in 19696, he set off shock waves that are still shaking the accounting profession. The message comes through loud and clear: “Merely sticking to the rules will not keep the accountant or his client out of trouble. ” This dilemma of choosing between being fair’ or sticking to generally acceptable accounting principles goes to the heart of the public accountant’s problem. He makes his report to the management of the corporate client that hires him, but the statement that he attests to is relied on by others whose interests may be directly opposed to the corporate management - creditors, investors, government, policy makers etc. What management considers fair’ presentation may be outright deceit from the standpoint of a

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potential lender or a disgruntled stockholder.

From the

accountant’s standpoint, he cannot win. This is why the fair disclosure doctrine has thrown the accounting profession into a state of confusion, confrontation and crisis. Accounting is not a precise body of rules covering every case that comes up. It is a set of general principles - some of them going back to Middle Ages and the invention of double entry bookkeeping applied in the manner that the accountant on a particular job thinks appropriate. The problem is complicated by the enormous complexity of modem business. Companies can operate in a dozen different countries and two dozen different industries. To reduce such complex operations to a simple balance sheet and consolidated income statement even with supporting tables and pages of detailed footnotes - calls for sweeping simplifications. It also calls for a high degree of faith in the company’s own system of financial reporting and controls. IV.

‘Comparability’ in ‘Diversity’

The idea that financial statements of two companies should be comparable is based upon the assumption that the companies themselves are comparable, which might or might not be true. It is perfectly, reasonable to expect that the statements of both companies be based on the same generally accepted accounting principles but unreasonable to expect that the same accounting methods be employed by

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both e.g, the users of financial statements have every right to expect that the statement of Company A and Company B use cost as the measure of asset valuation. But there is no reason to expect that the same method be used to record the expiration of asset costs unless, in fact, the assets in question expire in exactly the same manner. Suppose that Company X uses UFO method of inventory valuation and company Y uses the FIFO method. Each of these companies is using the best available method to reflect the facts of its operation.

If the statements of

Company X are adjusted to a FIFO basis in order to make them comparable

with

Company Y

the

two

sets of

statements would be comparable i.e. mechanically, but the comparison wduld be fallacious because the revised statements for Company X would simply be wrong. Attempts to force comparability where none exists can result only in distortion. The users of financial statements must be made to recognize that those statements can be expected to be comparable only

if

the

companies

represented thereby are comparable. Forced comparability is necessarily misleading. The primary objective of comparability should be to facilitate the making a financial decisions by investors and thus assist in the proper functioning of the investment markets and to provide an adequate means whereby stockholders can judge the results of the activities of the management of their firm.

Comparability may also be

desirable to obtain useful economic data for industries,

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regions or for the country as a whole and as a basis for enforcing laws or providing a sound basis for government regulations. In comparing the financial data of two or more firms, the characteristics affecting comparability may be classified as a)

Similarities or differences in the type of business, the nature of the markets and the competitive nature of the industry and

b)

Similarities or differences in the profitability, efficiency, growth trends and stability.

The former characteristics must be taken into account by investors and financial analysts for accounting cannot compensate entirely for these differences. The uncertainty of an investment in a firm with considerable foreign operations cannot be made comparable with an investment in a domestic public utility firm.

Similarities and

differences of the second type should be disclosed rather than concealed by the choice of accounting procedures. Comparability would be inappropriate if it led directly to a conclusion contrary to the facts as interpreted by a completely independent observer fully informed of all financial data relating to each of the two firms. Uniform accounting procedures do not necessary result in an increase in the comparability of financial statements. However neither does diversity nor flexibility in the free choice of procedures lead to comparability. Greater i

comparability can be achieved only by the establishment of

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sound accounting principles that can be used as a guide in the selection of appropriate accounting procedure. As stated by John L. Carey, “rather than uniform accounting what may be needed are refined criteria as a basis forjudging when one principle or practice is preferable to another.”7 Thus, though there is no justification for alternatives for basic accounting principles, there are few justifications for

alternatives

in

their

application

to

different

circumstances. 2.6

Diversity in accounting principles

If you ask an accountant for a definitive list of practices and principles that are “generally accepted”, he is most likely to answer that it is much easier to find lists of regulations or methods or practices that are not generally accepted.

This means that in spite of all the efforts to

reduce diversity in reporting practices, great diversity still remains and anyone who seeks to use financial reports has to pay close attention to the methods used by the managers and aceouhtants who prepare them. Unfortunately,

diversity

in

accounting

principles

presents an important problem to anyone who wants to compare the economic performance or financial position of an organizatiori at two points in time or with that of another organization, or to some normative standard or model.

To

merely look at the numbers that are reported without considering the methods that lie behind them creates the risk of faulty conclusions or errors in judgment.8

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Financial reports are a showcase through which managers can fulfill their obligations to provide information to shareholders and other interested parties. The fact that periodic financial reporting is required shows how important the economic community and society think reporting by managers is, in facilitating the free flow of capital and preventing one group from taking advantage of another because of the information available to it. It is difficult to imagine how a modem free enterprise economy could function without a financial reporting system that is effective. The diversity in accounting principles is so great that it would be impossible to summarize in brief, all of the concepts, methods and procedures that are at the present time acceptable in accounting practice. It is important at least to realize how many diverse practices are acceptable and the way in which the possibilities are multiplied if combinations of different principles and practices relating to assets, liabilities, shareholders equity, revenues and expenses are considered. Table 2.2 lists some selected examples of diverse generally accepted accounting principles for presentation of financial information about important classifications. The role that financial reporting plays in a modem economy requires that managers should be trying to report about the operations and financial conditions of their organizations as accurately and informatively as possible. It would be helpful if there were some normative

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standard against which diverse practices and their effect on financial reports might be compared. By estimating the differences between a report in hand and one based on the normative standard, a financial report reader could make a judgment about the quality of information available in the financial report. In the absence of a standard, each person who seeks to use accounting information needs to create his or her own reference point. This is harder to do than it appears at first glance.9. Anyone who attempts to compare financial statements from two or more entities is faced with the task of identifying the accounting methods used. Then the impact that.particular methods might have had on the reports must be estimated before any comparison of the two organizations can be made. Even when examining the financial statements of a single company through time, attention must be given to possible changes in accounting principles and the impact these changes may have had before information contained in the financial reports can be used for many purposes. This is the precise reason why in recent years so many articles in such publications as Forbes, Business Week, Fortune, The New York Times and the Wall Street Journal have complained of too much diversity in the accounting practices used by corporations in their published financial reports. They have wondered why the profession has taken so long to take positive decisive action in making “like things i

..55.. look alike and unlike things look different” in corporate financial statements.

fZa6/g 2.2 Selected Examples of Diversity in Generally Accepted Accounting Principles

Cash 1. 2.

Include all cash on hand and in banks as one item. Use separate captions for cash on hand, and/or cash in banks, and/or cash in banks that cannot be easily withdrawn, and/or separate currencies.

Receivables 1. 2. 3. 4.

Show receivables at gross amount. Show receivables at gross amount less allowances for unearned interest and doubtful accounts. Show receivables classified by type (accounts, notes, etc.) and/or by time, and/or by source (customers, employees, government, etc.). Exclude receivables unless earned and due, as in lease payments receivable.

Marketable securities ttemporary investments! 1. 2. 3. 4.

Show securities at cost. Show securities at market value when below cost. Show securities at cost plus interest earned but not yet paid. Show securities at approximate market value.

Inventories 1. 2. 3. 4. 5.

Show inventories at gross cost and/or by classes (supplies, raw materials, work in process, finished goods ready for sale). Show inventories at cost or market, whichever is lower. Show inventories at market or selling price. Determine “cost” or “price” by assuming average costs or standard costs. Report flow of costs and value of goods remaining by assuming last-in-first-out, or first-in first-out, or

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Land, plant, and equipment 1. 2. 3.

4. 5.

Show land, plant, and equipment at original cost, and/or adjusted original cost, and/or cost or market value, whichever is lower. Show plant and equipment at current value. Show plant and equipment at cost less accumulated depreciation calculated by assuming straight-line allocation of cost to periods, or by an accelerated or decelerated rate of depreciation. Charge all purchases of plant and equipment as expense in period purchased. Show land at original cost less depletion caused by mining, harvesting, or extraction of gases or fluids.

Investments 1. 2. 3. 4.

Show investments in other companies at cost. Show investments in other companies at cost or market value whichever is lower. Show investments in other companies at cost plus any proportional share of earnings on investment not received. Show investments at market value.

Intangible assets 1. 2. 3. 4. 5. 6.

1.

Exclude intangible assets, charging all costs related thereto as expense in the period of expenditure. Show all intangible assets at cost. Show intangible assets at cost but allocate costs over a few periods until only a nominal value remains. Show intangible assets at cost but allocate cost to all periods of expected value. Show intangible assets at cost but do not charge costs to periods unless value has clearly fallen. Show intangible assets at estimated value at a time of acquisition, adjusted for subsequent charges.

Current liabilities

Show liabilities at face amount.

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2.

1. 2. 3.

1. 2. 3.

4.

Show liabilities at amount at which obligations could be satisfied plus any costs of doing so. Long-term liabilities Show long-term liabilities at face amount. Show long-term liabilities at face amount adjusted for discounts or premiums given at acceptance and amortized over period of the liability. Show liabilities, including commitments on leases, pensions, and other contractual agreements, at face amount or adjusted for effects of interest. Owners’ equity Show owners’ equity as the amount of assets less the amount of liabilities. Show owners’ equity classified to show original source. Show owners’ equity classified by original source but modified by transactions between the entity and shareholders, and/or extraordinary reclassifications or adjustments. Within owners’ equity, segregate earnings retained by implied use of resources earned. i

1. 2. 3.

1. 2. 3.

Revenues Recognize revenue in period when products or services are delivered. Recognize revenue in period when product is ready for delivery (as in case of precious gems or metals). Recognize revenue in period when payment is received from customer or client. Cost of goods sold Recognize expense in the period and at purchase of product delivered. Recognize expense in the period and at purchase cost of some assumed unit of product delivered. Recognize expense in the period and at cost of replacement of the product delivered (Also see Inventories above).

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Expenses 1. 2.

3.

Recognize as expenses of the period, all or selected cash payments. Recognize as expenses of the period, all expenditures related to products or services sold in the period. All expenditures are assets or in satisfaction of obligations. Recognize, as expenses in the period, all estimated declines in asset values and estimated increases in obligations not related to cost of goods sold.

Net Income 1. 2.

Show all increase or decreases in net value of owners’ equity as net income, regardless of source. Exclude from net income all adjustments relating to prior period reports, and/or extraordinary events.

Source : Adopted from Financial Reporting, Analysis & Valuation Reading by Ramesh Gupta - EMA !

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References: 1 Accountants Turned Tougher, Business Week, October 18,1969 PP 124-130 2 Financial Accounting Theory II, Issues & Controversies edited by Thomson Keller & Stephen Zeff 3 Maurice $ Moonitz, Financial Accounting Theoiy-II Issues & Controversies, edited by Keller and Zeff 4 Patrick Kemp, Controversies on the construction of Financial Statements 5 Ibid 6 Business Week, April 22,1972 PP 55-60 7 E ldon S. Hendriksen, towards greater comparability through uniformity of Accounting Principles 8 Stephen H. Penman, Financial Statement Analysis & Security valuation, Me. Graw Hill, International edition 2001, Chapter I- III 9 Ibid