The above noted complexities require both the preparers and the users of the financial information to get a solid understanding of the source of GAAP and the hierarchy of those sources, the qualitative characteristic of good accounting information, fundamental differences between accrual and cash accounting and the differences between various business forms.
Importance of the hierarchy of various sources of generally accepted accounting principles
Generally accepted accounting principles (“GAAP”) is a set of accounting standards private or public companies use for financial reporting purposes. Since GAAP primarily serves the interest of the private sector the government did not codify the accounting guidelines rather let the accounting profession develop them.
Several sources of GAAP create a quilt work of standards, interpretations and rules, therefore it is important to assign a different level of authority each successive category in the hierarchy (Sauter, 1991). "Like any other structure, the house of GAAP rests on a foundation, in this case a foundation of the basic concepts and broad principles that underlie financial reporting, without which, like a house of cards, the house of GAAP would tumble." (Rubin, 1984).
The foundation of the GAAP hierarchy built on three pillars. The most prominent sources of GAAP are the statements and interpretations issued by Financial Accounting Standards Board (“FASB”), opinions issued by the Accounting Principles Board (“APB”) and accounting research bulletins issued by the American Institute of Certified Public Accountants (“AICPA”). In addition, there are several, less prominent source of accounting rules such as AICPA Statements of Position and Industry Audit and Accounting Guides in the second tier, FASB Emerging Issues Task Force (“EITF”) and AICPA AsSec Practice Bulletins as third tier and AICPA Accounting Interpretations, FASB Implementation Guides and industry practices in the less authoritative fourth tier.
The various sources sometimes are in conflict with each other therefore a clear hierarchy is critical to guide the users which source should be followed. The entities should always follow the higher category in case of conflict, considering the lower categories only when the higher category does not provide guidance on the accounting treatment.
FASB has recently issued Statement of Financial Accounting Standard No. 162 (“SFAS No. 162”) The Hierarchy of Generally Accepted Accounting Principles to identify the sources of accounting principles and provide the framework to the entities for selecting the principles to be used in the preparation of financial statements that are presented in conformity with GAAP., however, it has not been expected to result in any significant change in the current practice. (Anonymous, Official releases, 2008).
Qualitative characteristics of financial reporting
The principal purpose of financial reporting is to provide primarily capital providers and also various other stakeholders on the economic resources and claims on those resources of the reporting entity with such information, which is useful to make financing or other business decisions. Good financial information has some important qualities embedded into it (The FASB Report, 2006)
One of the primary qualitative factors are relevance, which refers to the timeliness of the financial information and its ability to serve the decision makers’ to estimate about future events as well as confirm past performance. The other primary qualitative characteristic of accounting information is reliability, which requires the accounting information to represent facts, disclosed in unbiased fashion and independently verifiable. Financial information must be relevant and reliable in order to in fact make a positive difference in the decisions of its users. Secondary qualitative factors, such as comparability and consistency, enable decision makers to identify similarities and differences between various entities or the same entity over time, respectively.
Qualitative characteristics of the financial information and consistently applied accounting practices will promote financial statements which are consistent, relevant and reliable, which in turn, provide the users of the financial statements with increased level of confidence in the integrity and quality of the information.
Accrual accounting versus cash accounting
The accounting principles are fundamental to ensure basic consistency and quality of financial reporting. From the four key principles the revenue recognition principle and the matching principle serve as the basis of the accrual accounting concept.
The revenue recognition principle in GAAP requires revenue to be recognized when the following two criteria are met 1) the revenue realized or readily realizable and 2) the entity earned the revenue that is services performed or products delivered irrespective of when the cash collected. The matching principle in GAAP further requires expenses to be recognized in the same period as the corresponding revenue, that is expenses follow the revenues. Expenses are recognized as they incurred as compared to cash accounting when they recognized when paid. To better reflect economic reality, GAAP requires businesses to use what is known as the accrual method of accounting.
Various legal forms of businesses
In starting a business, entrepreneurs have several legal structures to choose from in deciding based on the nature of their operations and what the best is for them from administrative, liability limitation and taxation standpoint considering both current needs and future plans. (Howard, 2003).
Sole proprietorships are attractive legal forms for any entrepreneur, who wants to avoid double taxation related to the income generated by his business as well as opt for minimal administrative burden. On the other hand the liabilities of the sole proprietorship is inseparable for those of the owner, therefore the entrepreneurs risk his own personal wealth, therefore it is suitable for businesses, which are unlikely to be sued. (Brammer, 2002).
Limited partnerships are similar to sole proprietorships in terms the limited administration, pass through tax treatment and unlimited personal liability for the partnership’s liabilities. A well structured partnership agreement is important, since it governs the rights and obligations of the partners. Licensed professionals, such as accountants, can use a variation of partnerships, the limited liability partnership to avoid liability of another partner’s wrongdoing.
One of the most popular business forms is the limited liability company (LLC), since it is still relatively easy to register with the state and enjoys the benefits of pass through tax treatment, members can flexible allocate the results of the operations and gives the same liability protection to the members as a corporation. Unless the owners plan to go public in short term, LLCs are ideal for family businesses.
Corporations are definitely choice of entrepreneurs, who plan rapid growth and tapping the investing public for capital investment. The benefits of liability protection, better access to additional capital can be outweighed by the administration burden of registering a corporation as well as by the double taxation of the income, once at the corporation level and at distribution at the owners’ level.
Future trends
Recent events prove that the evolution of new accounting rules has not stopped. The second half of 2008 and first half of 2009 saw several new standards, interpretations and staff positions to ensure that financial reporting provide relevant and reliable information to the decision makers and restores the confidence in the quality of accounting information. The globalization also forces further changes in financial reporting. On 14 November 2008, the US Securities and Exchange Commission (“SEC”) issued a proposed “Roadmap” on the potential use of International Financial Reporting Standards (“IFRS”) in financial statements prepared by US issuers. A single, global set of accounting rules, which improve the usefulness of the information, is the reality of the next decade.
Limitations, Conclusions and Recommendations
The paper attempted to provide a brief overview on the hierarchy of various sources of generally accepted accounting principles, the relevance of qualitative characteristic of accounting information, the differences between accrual accounting and cash accounting and finally the characteristics of various business legal forms. The negative impact and the cost of the unreliable, fraudulent financial reporting on the capital markets, and in turn, on the entire society are significant. Successful companies can go bankrupt, investors can lose their investment and employees can end up unemployed. The accounting profession’s responsibility is to address the concerns of various stakeholders and restore the confidence in financial reporting by improving the quality of financial information.
References
Anonymous, HOW TO: CHOOSE THE RIGHT LEGAL STRUCTURE. (2009, January). Inc, 31(1), 49-52. Retrieved July 9, 2009, from Entrepreneurship. (Document ID: 1628929351).
Brammer, Roland. (2002, September 16). Identifying a legal structure for your business. The Weekly Gleaner: Gleaner Extra, (North American Ed.), p. 7. Retrieved July 9, 2009, from Entrepreneurship. (Document ID: 495906991).
Ernest F Howard. (2003, September). What's your type-of business entity? California CPA, 72(3), 14-17. Retrieved July 9, 2009, from Entrepreneurship. (Document ID: 420374351).
Financial Accounting Standards Board. . (2009). CON 2(AM) -- Qualitative Characteristics of Accounting Information. In Original Pronouncements - As Amended (as of February 11, 2009) . Retrieved July 8, 2009, from Accounting & Tax with Standards. (Document ID: 1132293121).
Retrieved July 8, 2009 from ACC/537 FINANCIAL ACCOUNTING course materials.
Moehrle, S., Reynolds-Moehrle, J., & Tomlinson, W. (2002, September). Is There a Gap in Your Knowledge of GAAP?. Financial Analysts Journal, 58(5), 43. Retrieved July 8, 2009, from Business Source Complete database.
Wendell, P.. (2008, July). FASB Issues FAS 162 on GAAP. SEC Accounting Report, 34(8), 1-3. Retrieved July 8, 2009, from Accounting & Tax Periodicals. (Document ID: 1517885191).
Williams, J.. (2009, May). Proposed FASB Statement, The Hierarchy of Generally Accepted Accounting Principles, a replacement of FASB Statement No. 162. Miller GAAP Update Service, 9(10), 1-4. Retrieved July 8, 2009, from Accounting & Tax with Standards. (Document ID: 1721390301).
