The Usefulness of the GAAP in Financial Analysis

This reflection paper intends to discuss five concepts that I have taken from the course. The five concepts include a balance sheet, income statement, generally accepted accounting principles (GAAP), audit, and efficient market hypothesis. Examples made are to explain and provide clarity of the concepts.

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I learned that a balance sheet is the most basic financial statement which can be used for decision making (Gibson, 2007).

The balance sheet basically contains the assets, liabilities, and equity of the business and from it, one can know how much of the assets or those that would provide economic benefits at present and in the future until they are used up. The obligations to creditors arise basically from the acquisition of assets or incurrence of expenses. The assets, therefore, are owned by the proprietors in the case of a sole proprietorship or partners in the case of a partnership or stockholders in the case of a corporation and some may be partly financed by creditors. An owner in the meantime is vested with the power of management and therefore becomes the agent of creditors in the management of the assets while the business is going concerned. The equity in the balance sheet is therefore owned by the owners.

The benefits that are expected to be realized from the use of assets must be measured, thus the need for the income statement which measures these benefits and calls them revenues. However, when these assets are used in business, expenses are necessarily incurred from assets used in the generation of benefits. Thus, at the end of every period, there would be the need to compute the net income through the income statement.

GAAP is needed as the set of standards in the preparation of the financial statements including the balance sheet and the income statement. There are used across industries to afford users comparative usefulness which may be acquired if said financial information possesses relevance and reliability by making sure that financial statements comply with these standards. The compliance to standards would be enhanced through the work of an auditor.

The auditor is therefore basically referring to an external auditor who must make an opinion as to the compliance of the financial information with the GAAP and if the auditors find compliance to be in order the auditor could give a clean opinion and this would in effect be enhancing the credibility of the financial statements. Otherwise, auditors may give qualified or other opinions but the result would be less reliable of information to users (Whittington & Pany, 1995).

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After the financial statements are found reliable, the users can now apply better financial analysis of the financial statement as the basis for decision making.

One user is the owner which will make a decision whether the business should be continued and further expansion is justified or should the same owner pursue another course of action. Another is a creditor which must determine whether debts be further extended to the borrowing company. Financial analysis may be made using profitability, liquidity, and solvency ratios. Profitability ratios may take the form of return on equity, net profit margin, and return on assets. The numerator for these ratios would be net income and the denominator would be average equity, total revenues, and average total assets respectively. On the other hand, liquidity measures the capacity of a company to meet its currently maturing obligations using the current ratio and the quick asset ratio (Bernstein, 1993). To understand liquidity there is a need to understand how to compute these ratios. Current ratios need current assets as the numerator and current liabilities as of the denominator while quick ratios need quick assets as numerator while maintaining the same current liabilities. Quick assets encompass, marketable securities, accounts receivable, and cash. Inventory and prepaid expenses are not part of quick assets but are considered current assets. From a decision maker’s view and the use of a quick asset, the ratio would be more much relevant if the intention is to have a higher form of measuring liquidity (Bernstein, 1993).

Separate from profitability and liquidity is solvency which refers to the company’s long-term capacity to keep up its stability over the long term. Normally measured by the debt to equity ratio, with the formula of having the total debt of the company divided by its total equity, the said measures of solvency may or may not assure investors that the company is not to just to exist in the short term but it must also have a long life to recover long term investments which take years to produce the needed returns (Bernstein, 1993).

To conclude, operating a business normally generates profits and funds that should make a company liquid. Therefore, a loss in operation may mean a loss of funds to meet maturing obligations. Profitability also helps a business to have good solvency. A business must therefore earn profits and doing so will help attain other business objectives. To do this, however, financial statements must be produced that must include the income statement and balance sheets with the use of GAAP, the compliance of which requires an external auditor. The financial analysis becomes more useful if the information processed is reliable and relevant through the use of GAAP.

References

Bernstein, J. (1993). Financial Statement Analysis, Sydney: IRWIN.

Gibson, C. H. (2007). Financial reporting & analysis: Using financial accounting information (10th Ed.). Mason OH: Thompson Southwestern. ISBN: 0324304455.

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Whittington & Pany (1995). Principles of Auditing. Chicago: IRWIN.

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Paperroni. 2022. "The Usefulness of the GAAP in Financial Analysis." March 8, 2022. https://paperroni.com/the-usefulness-of-the-gaap-in-financial-analysis/.

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Paperroni. (2022) 'The Usefulness of the GAAP in Financial Analysis'. 8 March.

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