Generally Accepted Accounting Principles (GAAP)
Generally Accepted Accounting Principles are a set of common principles, standards and procedures in accounting that are accepted by all organizations in a country. Financial statements provide information about a company to various stakeholders. Investors rely on financial statements to make investment decisions. Creditors and suppliers get an idea about the company’s liquidity and solvency, and use the statements to assess risks and decide on terms.
In order that all these parties are able to understand the information in a standard manner, and obtain a common perspective while reading the statements of several companies, it is important for these companies to follow standard practices and procedures in maintaining the accounts and preparing the financial statements. In the absence of such practices, wide variations in reporting could result, and companies might have scope for manipulating the figures. The existence of standards minimizes such scope for malpractice, but does not eliminate it altogether.
Historical cost is the actual cost at which an asset was acquired, and is the most commonly used method for ascertaining the value of an asset in a company’s balance sheet. Other methods of ascertaining the cost of an asset include methods that adjust for inflation. The advantage of the historical cost method is that leaves little room for manipulation as it is the actual price paid for the acquisition of the asset. At the same time, under conditions of inflation (or deflation), the market value of an asset may vary considerably from its value at the time of acquisition. Because of this, historical costs may sometimes fail to represent the true value of a firm in its balance sheet.
Accrual Basis v/s Cash Basis Accounting
A company’s profit or loss during a particular period is determined as the difference between its total revenues and the costs that it has incurred during the period. There are two different methods used by firms to record their incomes, namely accrual basis and cash basis. Under accrual basis, a firm records all transactions that have taken place during the period as income, irrespective of whether cash has been received against the transaction or not. Under cash basis, the firm records only those transactions against which cash has been physically received.
Thus a company selling goods on credit would record the sale as soon as the invoice is made, if it is operating under accrual system, while another company operating under cash basis system would include the sale in its income statements only if the cash has been received against the sale. The method adopted is significant because it can alter the profitability during a period. The accrual basis is preferred by all large organizations, as it represents the true state of affairs.
At the same time, there is some scope for manipulation under accrual system, as firms can show higher sales by invoicing without actually making a sale. The accrual system also makes it necessary to make adjustments against non-receipt of dues, and for writing off bad debts and making provisions for doubtful debts. Failure to make appropriate adjustments, when required, could also vitiate the accuracy of accounts.
Current Assets and Liabilities v/s Non-Current Items
Assets and liabilities can be of two types – current or non-current. Current assets and liabilities are those that can be realized, or those that are due, in the short term, which is typically understood as less than one year. Thus trade debts that fall due in the short term, inventory that can be sold and converted into cash in the short term, and cash itself, are all current assets or liabilities.
As against these, there are a number of items in the balance sheet of an organization such as fixed assets, comprising of building, plant and machinery, vehicles and so on that provide returns over a longer term. Similarly, long-term loans that need to be repaid over a number of years, debentures and share capital are long-term or non-current liabilities.
The division of assets and liabilities into current and non-current is important in several respects to anyone reading the statements of accounts. First of all, the current items indicate the short term health of a company. If the current assets are insufficient to meet current liabilities, the firm may face short term liquidity problems. On the other hand, too much of debt as compared to equity in a company’s long-term capital structure might indicate risks of default or solvency.
Secondly, current assets and liabilities are made up of items that can be quickly converted to cash, and usually represent actual market values, or values that are close to actual market values. Long term assets on the other hand, may be showing historical figures that may have validity only on a going concern basis. In other words, they may not represent the actual realizable value in the event of a sale.
Organization of Financial Statements
The income statement of GM shows consolidated figures for several of its divisions and regional operations, with details being shown separately for each major division. The income is mainly shown under two heads, namely Automotive and Financial, since these are the two major divisions in the company. In the case of Home Depot the total sales and costs of the company are shown under one single unit, but the statements themselves are consolidated figures of several regions.
Thus the income statement shows a single type of operation performed at different locations. In the case of Billabong, there is a single activity performed at one unit so that there is no consolidation of accounts. Thus GM’s statement is consolidated on the basis of operations and region, Home depot on the basis of region, while Billabong has no need to consolidate its results.
The balance sheet of GM is organized into automotive division and insurance division. In the case of the other two companies consolidated balance sheets showing total assets and liabilities are included.
Cash Flow Statements
The GM cash flow statement shows very elaborate bifurcation of cash flows under each of the headings. Under cash flows from operating activities, the GM cash flow statement shows continuing operations and discontinued operations separately. In the case of the other two companies no such distinction has been made.
Importance of the statements to the companies
GM has reported loss in both the years. The loss has increased in 2007 as compared to 2006. The cash flow has been positive in both years although marginal, and has been higher in 2007 compared to 2006. Cash flow from operations has been critical to the ongoing activates of the company, but have been at satisfactory levels. At the same time, the continuing and increasing loss is a matter of concern that needs to be addressed. In view of this the income statement is the more important one for GM.
In the case of Billabong, there has been a profit in both years, and the cash flow position is also positive. However, the growth rate is very low, and this is what the company should be really concerned about. In view of this, it is the income statement that should receive greater attention in the case of Billabong.
In the case of Home Depot, the net income shows a steadily declining trend. The cash flow position shows a fluctuating trend with cash flows from operations showing an increase in 2007 as compared to 2006, and a decrease in 2008. However, the cash flow of the company does not represent a cause for concern. It is the declining profitability that needs attention, and hence in this case also it is the income statement that appears to be more important.
GM has been making losses for the past few years. The balance sheet of the company shows that its current assets are less than its current liabilities, and the gap between the two has shown an increasing trend between the two years 2006 and 2007. Moreover, the current assets are almost equal to the total non-current assets. These are not very healthy trends. It appears that working capital management in the company is, for some reason, not optimal. If the current trend continues, the company may have problems in meeting its short-term commitments.
A look at the balance sheet of the company for the two years 2006 and 2007, for which figures are available, shows that the total non-current liabilities of the company has increased by about 34% from $458 million to $613 million. During the same period, the equity base of the company has, for all practical purposes, remained constant. This means that the gearing of the company has undergone a major change in one year. If this trend continues, the company will not have further scope for borrowing, and its long term solvency will come into question.
A look at the Income Statement of the company reveals that the total operating expenses have been increasing over the three years 2006-2008, while the net sales after going up in the intermediate year has fallen to the original level in 2008. The ratio of operating expenses to gross sales has risen from 21.9% in 2006 to 24.2% in 2008. Consequently, the net margin has fallen from 21.9% to 9.4%. If this trend continues the company might soon be making a net loss instead of a profit.
In spite of making losses over consecutive years, GM has shown good growth in its automotive sales, particularly between 2005 and 2006. The growth is more modest in 2007. GM foresees a huge potential global market for its products, and consequent growth in the years to come. This growth will, however, be meaningful only if the company is able to reduce costs substantially. While turnaround measures have yielded some results, the company will have to further strengthen these measures if it is to compete in a global market.
Billabong has shown impressive growth in all the three geographical divisions – America, Europe and Australasia. However, the earnings have been most impressive in the case of Australasia followed by Europe. The margins and absolute figures of earnings in the Americas show that they have reached saturation levels. In fact the Australasian region has recorded EBITDA almost equal to that of the Americas on gross revenues of about 67% of that of the Americas. This shows that the company has a good potential to expand in the Australasian region.
Home depot is a retail business, and the company has clearly identified it as such. Retail businesses need to be closely tailored to local requirements, if they are to succeed and grow in a competitive environment. Moreover, the customers in retail businesses are many, and are widely spread, with most lacking intimate technical knowledge of the products. In order to help these customers select the right products, and to bring the products of the company closer to the local requirements, Home Depot has introduced the new role of Master Specialists in their stores. This should help the company to retain its existing customers and also attract new customers.
- Billabong International Limited (2008). Billabong International Limited 07-08 Full Financial Report. Retrieved on 12 November 2008 from http://www.billabongcorporate.com/documents/20080926_FullFinancialReport30June2008Website_Version.pdf
- General Motors Corporation (2008). General Motors Corporation 2007 Annual Report. Retrieved on 12 November 2008 from http://www.gm.com/corporate/investor_information/docs/fin_data/gm06ar/index.html
- Home depot (2008). 2007 Annual Report. Retrieved on 12 November 2008 from http://www.homedepotar.com/html/pdf/HDAR2007.pdf
- Investopedia (2008). Generally Accepted Accounting Principles – GAAP. Retrieved on 11 November 2008 from http://www.investopedia.com/terms/g/gaap.asp