Generally Accepted Accounting Principles (GAAP)
Financial Statement AnalysisThese are ‘Ground rules’ i.e. Principles for preparing financial statements. These are constantly evolving. These embody accounting concepts, measurement techniques and standards of presentation of financial statements. These Accounting Principles enable comparability between various enterprises and of the operational performance of the same enterprise over many years. These give reliability to Financial Statements.
Following are some of the Generally Accepted Accounting Principles:
i) Entity principle: specific business entity separate from personal affairs of the owner(s).
ii) Cost principle: valuation and recording of assets at cost.
iii) Going-concern assumption: connected with cost principle, assets acquired for use and not for resale.
iv) Objectivity principle: definite, factual basis for assets valuation; measuring transactions objectively.
v) Stable currency principle. The currency remains more or less stable and rate of inflation is almost zero.
vi) Adequate disclosure concept: facts necessary for proper interpretation of statements; “subsequent events”, lawsuits against the business, assets pledged as securities/collaterals, contingent liabilities etc; reflected in Notes.
ACCOUNTING EQUATION
ASSETS = LIABILITIES + OWNER’S EQUITY
Balance Sheet is based on Accounting Equation. It is in fact, a detailed statement of the Equation. The Equation in a way shows, utilization of Funds and Sources of Funds. In other words, it shows what a business OWNS and what it OWES. Alternately, the Accounting Equation or Balance Sheet is a description of Total Assets of a business against the claimants of these Assets. Therefore, this Equation shows financial position on a specific date. The three titles in the Equation are Elements of Balance Sheet. Similarly Elements of Income Statement would be Revenues & Expenses and their net affects Owner’s equity.
Within the Elements, there would be sub-elements, for example, the Element or Account “Assets” would consist of cash, Accounts Receivable, Land, and Building etc. Each financial transaction affects two or more elements or sub-elements of the Accounting Equation. Therefore, we can say that each financial transaction affects Balance Sheet i.e. financial position of the business. This would be clear from the following illustration.
Khizr property dealer:
The proprietor starts business with deposit of Rs.180, 000. On July 1, 2006
Financial Position as on July 1, 2006
| Assets (Rs) | Owner’s equity (Rs) | ||
| i) | Deposit in business by proprietor/ owner. | Cash 180,000 | Khizr, Capital 180,000 |
Jul 3, 06 Land Valuing Rs. 141, 000 is purchased for cash on July 3. Financial Position on that date would be
| II) | Purchase of land for cash (Rs.141,000) | Cash 39,000 Land 141,000 Total assets 180,000 (Cash is reduced by Rs.141, 000, but correspondingly a new asset land has come up) | Khizr, Capital Total owner’s equity | 180, 000 180,000 |
|---|
Jul 5, 06
| III) | Purchase of building for (Rs.36,000) partly on cash Rs.15,000) and partly on credit (Rs.21,000) | Cash Land Building Total assets | 24,000 141,000 36,000 2,01,000 | Liabilities & Owner’s equityAccounts/Notespayable21,000 Owner’s equity 180,000 Total 201,000 |
|---|
Rs.15, 000 is paid in cash for the building which further reduces cash from Rs.39, 000 to Rs.24, 000. For remaining amount of Rs.21, 000, a liability in the form of accounts or notes payable involve interest, where as accounts payable are without interest.
July 10, 2006: A part of land valuing Rs.11, 000 was sold on credit. A new asset “Accounts Receivable” has been introduced.
The new financial position as a result of this transaction would be:
| iv) | Sale of part of | Cash | 24,000 | Accounts Payable | 21,000 |
| land on credit for | Accounts Receivable | 11,000 | Owner’s equity | 180,000 | |
| Rs.11,000 | Land | 130,000 | |||
| Building Total | 36,000 201,000 | _______ 201,000 |
July 14, 2006: Office equipment for Rs.5400/- was purchased on credit. A new liability of Rs.5400 has accrued, raising Accounts Payable from Rs.21, 000 to Rs.26, 400.
| v) | Purchase of Office | Cash | 24,000 | A/C Payable | 26,400 |
| Equipment for Rs.5400 on credit. | A/Cs Receivable Land | 11,000 130,000 | Owner’s equity | 180,000 | |
| Building Office equipment Total | 36,000 5,400 206,400 | 206,400 |
July 20, 2006. Accounts receivable which were Rs.11, 000 on July 14, have been converted into cash to the extent of Rs.1, 500. Cash has therefore increased from Rs.24, 000 to Rs.25, 500 and accounts receivable have correspondingly decreased to Rs.9, 500
| (VI) | Partial collection of | Cash 25,500 | A/Cs payable | 26,400 |
| Accounts (Rs.15,00) | A/C receivable 9,500 | owner’s equity | 180,000 | |
| Land 130,000 | ||||
| Building 36,000 | ||||
| Office equipment 5,400 | ||||
| Total 206,400 | Total | 206400 |
July 31, 2006
| (VII) | Payment of liability | Cash | 22,500 | A/Cs payable | 23,400 |
| (A/C payable) Rs.3,000 | A/C receivable | 9,500 | owner’s equity | 180,000 | |
| Land | 130,000 | ||||
| Building | 36,000 | ||||
| Office equipment | 5,400 | ||||
| Total | 203,400 | Total | 2,03,400 |
It is thus clear from the above illustration that each financial transaction affects financial position, (which in effect is the balance sheet). Accounting period in the example was one month. It must also be noted no business activity (commissions/ fees/ Revenues & Expenses) was involved in above example. Only setting up of business was involved and therefore owner’s equity remains the same.
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