GAAP VERSUS OTHER BASIS OF ACCOUNTING REPORTING
Financial Reporting is the process a company uses to convey financial information to creditors, current and future investors to help with capital allocation decisions. Also it is a formal record of the financial activities of a business, person, or other entity.
Financial statements and disclosure notes are the primary means a company uses (employs) to relate its financial information to users.
"The objective of financial statements is to simply provide information about the financial position, performance and changes in financial position of an enterprise that is useful to a wide range of users in making economic decisions. (Financial Statements provide a company’s history in monetary terms and can be used to predict its future.)
The most frequently used financial statements are:
The Balance Sheet
It reports the assets, liabilities, and stockholders’ equity of an enterprise at a specific date. It provides information on investments in resources, obligations to creditors and owners equity in net resources.
The Income Statement
It measures the success of a company’s operations for a given period of time. It is used to determine profitability, investment value, and credit worthiness.
The Statement of Cash Flows
It provides information on cash receipts and disbursements during a period. It relates cash effects of operating, financing and investing activities.
Statement of owners or stockholders equity
It provides a report on the changes in stockholders accounts during the year. However, financial information can also be relayed through president’s letter, prospectus, news releases etc. The main objective of financial reporting is to provide creditors with credible information that would help them make wise investment decisions.
Methods of Financial/Accounting Reporting
There are various methods companies can implement to relay financial information to external users. The different methods include cash basis, accrual basis, modified cash basis, and income tax basis accounting. These methods are used to prepare financial statements that conform with GAAP or are non-GAAP
Generally Accepted Accounting Principles (GAAP)
Generally accepted accounting principles (GAAP) is a set of common rules or standards used by private companies to prepare financial statements, (It is based) which is on the fundamental principles of accounting concepts. It is important that companies abide by the same financial reporting standards this way investors can compare financial statements among companies. GAAP is used in order to help facilitate the financial statement comparison process.
GAAP includes rules issued by the Financial Accounting Standards Board (FASB). FASB is the designated organization that establishes standards of financial accounting for private companies. These standards are recognized by the Securities Exchange Commission (SEC). Therefore, any US private company that wants their stocks listed on the NYSE must have their financial statements prepared in accordance with the standards set by FASB. The SEC establishes financial reporting standards for publicly held companies whose stocks are publicly traded under the securities Exchange Act of 1934.
Many companies are required to provide an annual report to their stockholders as well as to the SEC. An independent certified public accountant is also required to audit the financial statements for irregularities; this ensures that (These way) investors are not being misled by falsified financial statements.
GAAP financial statements are prepared under accrual basis method accounting.
Accrual Basis Accounting
This method measures revenues in the period they are earned and expenses when accomplished without regard for when cash is either received or paid. The result of accrual accounting is net income or net loss (when expenses are greater than revenue). It aids in predicting future cash flows by reporting transactions and events with cash consequences when it occurs rather than when cash exchanges hands. Financial statements prepared using the accrual basis method is in conformity with GAAP.
Other Comprehensive Basis of Accounting Method (OCBOA)
AU Section 623.04, Special Reports, states that “a comprehensive basis of accounting other than generally accepted accounting principles is one of the following:-
i. A basis of accounting that the reporting entity uses to comply with the requirements or ﬁnancial reporting provisions of a governmental regulatory agency to whose jurisdiction the entity is subject. An example is a basis of accounting insurance companies use pursuant to the rules of a state insurance commission.
ii. A basis of accounting that the reporting entity uses or expects to use to ﬁle its income tax return for the period covered by the ﬁnancial statements.
iii. The cash receipts and disbursements basis of accounting, and modiﬁcation(s) of the cash basis having substantial support, such as recording depreciation on ﬁxed assets or accruing income taxes.
iv. A deﬁnite set of criteria having substantial support that is applied to all material items appearing in ﬁnancial statements, such as the price-level basis of accounting.”
Other comprehensive basis of accounting is an alternative to GAAP used by small non public entities who find the cost of adhering to GAAP exceeding the benefits they receive. Common OCBOA statements are prepared based on tax, cash, and modified cash basis accounting.
Cash Basis Accounting
This provides a measure between cash receipts and cash disbursement (which is also) referred to as net operating cash flow. It recognizes revenue when received and expenses when paid.
Cash basis accounting is ideal as it uses factual information and helps predict future cash flows. However, in today’s economy been (is) driven by credit (and) while the cash method does not recognize credits. Another major flaw of cash basis accounting is its inability to predict future cash flows over short reporting periods, where it ignores the revenue recognition and matching principle. Thus (and therefore) does not conform with GAAP which (It) is mostly used by smaller entities whose financial statements users’ primary importance is the flow of cash. It is also used by the average individual taxpayer. CPA’s often refrain from using the pure cash basis accounting method.
Modified Cash Basis Accounting
This is a combination of the cash and accrual basis. A modified cash basis comes into play when (some) a number of modifications need to be made to a pure cash basis financial statement to make it more (useful) valuable. Modifications to financial statements should have substantial support such as capitalizing and depreciating plant assets. (It is mostly)In most cases, it is used by professional firms to include, lawyers, consultants, doctors etc. It is also used by retail, real estate and agricultural operations. Note that inter related accounts need to be reported on the same basis. CPA’s should ensure they do not over modify a cash basis statement as this can lead to producing a GAAP statement. For example, they should not accrue trade receivables and payables as this would make it a GAAP statement.
Income Tax Basis Accounting
The tax basis financial statement is prepared in accordance to federal income tax laws. It can be prepared using the cash or accrual basis. The method used depends on the nature of the taxpayer. The method is the same (method used) for preparing GAAP financial statements however, tax basis measure gross income and deductions while GAAP measure revenue and expenses.
Advantages of Using OCBOA
Financial statements prepared according to OCBOA are less costly to prepare.
An entity’s Income tax returns financial statements are prepared using the same information
It is not as complicated as a GAAP financial statement due to less details being required.
Simpler measurement principles are used.
Clients understand them better than GAAP basis statements.
External users are willing to accept financial statements prepared in accordance with OCBOA.
Disadvantages of Using OCBOA
Not all companies can use it therefore limiting financial statement comparability
CPA’s face an issue with the adequacy of disclosures due to the unique disclosures required for OCBOA statements.
Entities that can report under OCBOA
According to Grice (2003), the following entities can report under OCBOA
“Entities where the owner/manager is actively involved and understands the entity’s financial condition
A small closely held business with little or no unsecured debt.
An entity that is not highly leveraged” (P. 6).
Entities that should not use OCBOA
According to Grice (2003), the following entities should not use OCBOA
“Entity that anticipates going public
Entity that has loan covenants requiring GAAP-based statements
Entity that has numerous absentee owners
Entity with substantial unfunded obligations, commitments, and contingent obligations that would not be recorded on an OCBOA basis” (p. 6).
The disclosure requirements for generally accepted accounting principles and other comprehensive basis of accounting are the same except for some specific disclosure requirements related to OCBOA statements. One major difference is that statement of cash flows is not required for OCBOA statements and the title of the statement should reflect the basis of accounting used. In addition (Also), a summary of significant principles should be identified discussing how it differs from GAAP.
These requirements apply to statements prepared on either the tax basis of accounting or the cash basis of accounting.
Guidance for OCBOA
There is no set guidance for OCBOA due to most financial standards being prepared in accordance with GAAP. However the following provide some guidance
• SAS No. 62 or AU Section 623, Special Reports.
• SSARS No. 7 Omnibus Statement on Standards for Accounting and Review Services.
• AICPA Practice Aid Series [PAS] document, Preparing and Reporting on Cash and Tax Basis Financial Statements
• Auditing Interpretation No 14, Evaluating the Adequacy of Disclosure in Financial Statements Prepared on the Cash, Modified Cash, or Income Tax Basis of Accounting.
I was unaware of the (other) (many / additional) comprehensive basis of financial accounting. After further research, (Now that I am familiar with it )I foresee a growing trend in its use, which shows there is no need for a small entity to provide its statement based on GAAP and rack up more cost when it is able to prepare its financial statements in accordance with OCBOA. Not only is it cheaper to produce but it is also more understandable and will be more useful to investors to make decisions.
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