Generally Accepted Accounting Principles (Gaap)

GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP)

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Generally accepted accounting principles (or GAAP) are the “ground rules” for financial 232 reporting. These principles provide the general frame-work determining what information is included in financial statements and how this information is to be presented. The phrase “generally accepted accounting principles” encompasses the basic objectives of financial reporting, as well as numerous broad concepts and many detailed rules. Thus, such terms as objectives, standards, concepts, assumptions, methods, and rules often are used in describing specific generally accepted accounting “principles”.

The Nature of Accounting Principles

Accounting principles are not like physical laws, they do not exist in nature awaiting discovery. Rather, they are developed by people, in light of what we consider to be the most important objectives of financial reporting. In many ways generally accepted

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accounting principles are similar to the rules established for an organized sport, such as football or basketball. For example, accounting principles, like sports rules:

•Originate from a combination of tradition, experience, and official decree.

•Require authoritative support and some means of enforcement.

•Are sometimes arbitrary.

•May change over time as shortcomings in the existing rules come to light.

•Must be clearly understood and observed by all participants in the process.

Unfortunately, accounting principles vary somewhat from country to country. The phrase “generally accepted accounting principles” refers to the accounting concepts in use in the United States. However, the principles in use in Canada, Great Britain, and a number of other countries are quite similar. Also, foreign companies that raise capital from American investors usually issue financial statements in conformity with the generally accepted accounting principles in use in the United States. Several international organizations currently are attempting to establish greater uniformity among the accounting principles in use around the world.

The Use of Financial Statements by Outsiders

Most “outside” decision makers use financial statements in making investment decisions that is, in selecting those companies in which they will invest resources or to which they will extend credit. For this reason, financial statements are designed primarily to meet the needs of creditors and investors. Two factors of concern to creditors and investors are the solvency and profitability of a business organization.

Creditors are interested in solvency the ability of the business to pay its debts as they come due. Business concerns that are able to pay their debts promptly are said to be solvent. In contrast, a company that finds itself unable to meet its obligations as they fall due is called insolvent. Solvency is critical to the very survival of a business organization a business that becomes insolvent may be forced into bankruptcy by its creditors. Once bankrupt, a business may be forced by the courts to stop its operations, sell its assets (for the purpose of paying its creditors), and end its existence.

Investors as well as creditors are interested in the solvency of a business organization, b\i| they are even more interested in its profitability. Profitable operations increase the value of the owners’ equity in the business. A company that continually operates unprofitably will eventually exhaust its resources and be forced out of existence. Therefore, most users of financial statements study these statements carefully for clues to the company’s solvency and future profitability.

The Short Run versus the Long Run. In the short run, solvency and profitability may be

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independent of each other. A business may be operating profitably, but nevertheless run out of cash, and thereby become insolvent. On the other hand, a company may operate unprofitably during a given year, yet have enough cash to pay its bills and remain solvent. Over a longer term, however, the goals of solvency and profitability go hand in hand. If a business is to survive, it must remain solvent and, in the long run, it must operate profitably.

CASE IN POINT Throughout the 1980s, the business activities of Donald Trump were enormously profitable, increasing Trump’s net worth by several billion dollars. Yet in June 1990, the billionaire became insolvent; he did not have enough cash to meet a scheduled interest payment to his creditors. After days of around-the-clock negotiations with numerous banks, Trump was able to borrow enough cash to make his operations solvent again at least for the moment. Had he not been able to arrange these “eleventh-hour” loans, Trump’s creditors might have forced portions of his financial empire into bankruptcy.

Evaluating Short-term Solvency. One key indicator of short-term solvency is the relationship between an entity’s liquid assets and the liabilities requiring payment in the near future. By studying the nature of a company’s assets and the amounts and due dates of its liabilities, users of financial statements often may anticipate whether the company is likely to have difficulty in meeting its upcoming obligations. This simple type of analysis meets the needs of many short-term creditors. Evaluating long-term solvency is a more difficult matter. In studying financial statements, users should always read the accompanying notes and the auditors’ report.

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