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,
 ..31..

‘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 decision-

mciking process is illustrated in the Diagram 2.1. It shows
 ..32..

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.
<Diagram 2.1

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.
 ..33..

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.
<Diagram 2.2
Flow of Accounting Information

Management
Source: Financial Accounting by Robert Meigs & Walter Meigs 6th
edition, Page 7. McGrow Hill edition
 ..34..

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.
i

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.
 ..35..

<ra6k2.1
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
 ..36..

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
i

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
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
 .37..

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.
 ..38..

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).
 ..39..

While Sorter and Gans (1974), Me Cormick (1960), and

also Trueblood Committee Report - one of the most
significant reports on objectives of financial 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).
 ..40..

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
 ..41..

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
 ..42..

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 reports, managers and
their accountants 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.
 ..43..

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
 ..44..

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
 ..45..

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
i

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
I

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
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
 ..46..

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 general acceptance and hence
‘uniformity’ in regard 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
 ..47..

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. There is no such thing as a
“generally accepted accounting method/procedure.”5
 ..48..

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
 ..49..

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
 ..50..

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,
 ..51..

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

 ..52..

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
 ,53,

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
 ..54..

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
i

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
 ..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. Include all cash on hand and in banks as one item.
2. 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. Show receivables at gross amount.
2. Show receivables at gross amount less allowances for
unearned interest and doubtful accounts.
3. Show receivables classified by type (accounts, notes,
etc.) and/or by time, and/or by source (customers,
employees, government, etc.).
4. Exclude receivables unless earned and due, as in lease
payments receivable.

Marketable securities ttemporary investments!

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

Inventories
1. Show inventories at gross cost and/or by classes
(supplies, raw materials, work in process, finished
goods ready for sale).
2. Show inventories at cost or market, whichever is lower.
3. Show inventories at market or selling price.
4. Determine “cost” or “price” by assuming average costs
or standard costs.
5. Report flow of costs and value of goods remaining by
assuming last-in-first-out, or first-in first-out, or
 ..56..

average costs in and out, or standard costs in and out,

etc. (Also see Cost of goods sold below).

Land, plant, and equipment

1. Show land, plant, and equipment at original cost,
and/or adjusted original cost, and/or cost or market
value, whichever is lower.
2. Show plant and equipment at current value.
3. 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.
4. Charge all purchases of plant and equipment as
expense in period purchased.
5. Show land at original cost less depletion caused by
mining, harvesting, or extraction of gases or fluids.

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

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

Current liabilities
1. Show liabilities at face amount.
 ..51..

2. Show liabilities at amount at which obligations could

be satisfied plus any costs of doing so.

Long-term liabilities
1. Show long-term liabilities at face amount.
2. Show long-term liabilities at face amount adjusted for
discounts or premiums given at acceptance and
amortized over period of the liability.
3. Show liabilities, including commitments on leases,
pensions, and other contractual agreements, at face
amount or adjusted for effects of interest.

Owners’ equity
1. Show owners’ equity as the amount of assets less the
amount of liabilities.
2. Show owners’ equity classified to show original source.
3. Show owners’ equity classified by original source but
modified by transactions between the entity and
shareholders, and/or extraordinary reclassifications or
adjustments.
4. Within owners’ equity, segregate earnings retained by
implied use of resources earned.
i

Revenues
1. Recognize revenue in period when products or services
are delivered.
2. Recognize revenue in period when product is ready for
delivery (as in case of precious gems or metals).
3. Recognize revenue in period when payment is received
from customer or client.

Cost of goods sold

1. Recognize expense in the period and at purchase of
product delivered.
2. Recognize expense in the period and at purchase cost
of some assumed unit of product delivered.
3. Recognize expense in the period and at cost of
replacement of the product delivered (Also see
Inventories above).
 ..58..

Expenses
1. Recognize as expenses of the period, all or selected
cash payments.
2. 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.
3. 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. Show all increase or decreases in net value of owners’
equity as net income, regardless of source.
2. 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
!
 ..59..

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