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if salaries are paid to work on consulting projects during a year, the net realizable value of those services should be, in general, recognized as revenue during that same period even though cash for those services
may not be received until the subsequent year.
• Objectivity: Revenues, expenses, assets, and liabilities should be booked at values that can be established through objective evidence. Documentation supporting any value used in the accounting records should be maintained and made available to authorized third parties to verify
(e.g., tax authorities, auditors, investors).
• Consistency: Financial statements should be prepared on a consistent basis from period to period using similar methodologies in order to
yield meaningful comparisons among time periods.
• Disclosure: Financial statements should be complete in disclosing to investors and managers all pertinent information to ensure that the statements by themselves are not misleading. Explanatory notes normally are included with financial statements and are intended to supplement the numbers presented to ensure that the complete package presents fairly critical information to prevent the statements from being misleading.
Such disclosures include: changes of accounting methods, summary of
significant accounting policies, descriptions of lease and other long-term debt obligations, stock option plans, and significant subsequent events.
• Materiality: Accounting principles recognize that it may be impractical to account for all transactions in the same theoretically correct manner; thus, immaterial transactions do not necessarily need to be accounted for in a manner consistent with larger transactions. This is particularly true if the cost of doing so exceeds the value of ref lecting the transaction in the theoretically correct manner. For example, a $500 chair may have a useful life of 10 years or more, but the cost of capitalizing that asset and depreciating it over 10 years would far outweigh the cost of expensing it in the period it was purchased.
• Conservatism: In preparing financial statements, many assumptions and estimates are made in order to present fairly the full financial position of the firm. When a reasonable basis exists for two or more different estimates or values to be used for a particular item in the financials, the one that shows the least favorable effect on the firm in the current period should be selected. By selecting the least favorable method, management enhances the quality of the earnings reported, which, over time, can strengthen both the firm’s credibility and its relative financial position.
In summary, GAAP are the set of rules to be followed in the preparation of all financial statements, and these general principles form the basis of all other accounting concepts and practices. Other key concepts and issues of which professional firm executives should be aware include:
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• Cash versus accrual basis of accounting: GAAP call for the financial records of an organization to be maintained using the accrual basis of accounting. Accrual accounting requires revenues to be recognized when earned and costs to be expensed when incurred, without regard to the time period in which cash is received or payment is made. Cash basis accounting, which does not follow the matching principle described earlier, recognizes revenue when cash is collected and expenses when they are paid in cash. Because the cash basis does not follow the matching principle, it is not GAAP; however, some form of it may be used in specific cases for income tax purposes, particularly in partnerships.
• Book versus tax: Financial statements prepared for management and investors normally are referred to as the official “books” of the firm. Although large firms should always follow GAAP and prepare financials
using the accrual method, smaller firms that are not publicly traded may employ either the cash or accrual basis of accounting or a hybrid thereof that best suits its business purpose relative to the cost of adhering to a full accrual system. Use of the cash method frequently defers income taxes because revenue is not recognized until collected, and expenses, particularly personnel costs, are deducted when paid. However, when preparing tax returns, a specific set of rules set forth by federal, state, and local taxing authorities must be followed. When tax methods are used for “book” purposes in the preparation of financial statements, the firm will invariably report results different from those
prepared using GAAP. Such differences include depreciation and
amortization methods, limits on executive compensation, allowable
meal expenses, pension expenses, and the tax calculation itself.
• Revenue recognition: As stated earlier, under GAAP, revenue should be recognized when it is earned, not when an agreement is made or cash is collected. Many of the accounting scandals that have occurred over
time have involved material problems with the timing of revenue recognition. When in doubt, a good general rule of thumb to follow is to determine whether it would be likely that a judge would order your client to pay you solely based on the work performed through the closing date of the financials—without any further work being completed. To answer that question affirmatively, client compensation agreements need to be written carefully to ensure that revenue can be recognized in tandem with costs incurred (i.e., the matching principle).
The Matching Principle
A mid-size Western professional services firm that used the calendar year for its financial statements performed a variety of services for its client, normally using separate written agreements to summarize the
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scope of work and compensation terms. The client’s fiscal year began on December 1 each year, and the annual letter agreements were written
with that December 1 start date. For many years, the firm recognized the full 12-month value of the contract in December, in effect taking 12
months of revenue for only one month’s work (payment was made quar-
terly over the year). During the remaining 11 months, the firm did not recognize any revenue even though it continued to employ staff to serve its client. This situation clearly conf licted with two accounting principles—revenue recognition and matching.
• Expense recognition: Expenses should be recognized in the financial statements during the period to which they pertain. In general, this means that costs should be expensed in the month in which an irrevocable commitment was made to secure the goods or services, unless it
qualifies for special capitalization treatment. Capital items are generally assets that are material in value (e.g., over $1,000) and have a useful life in excess of one year. Unless a purchase meets both those
criteria, in general, it should be expensed in the month incurred (not necessarily the month paid).
Value of Labor
The same professional services firm capitalized the significant cost of temporary help used to help prepare a proposal to a client during the fourth quarter. Financial managers in the firm based that decision on the argument that the cost was material and, under the matching principle, the value of that labor would benefit the firm for many years to come if it won the proposal. This treatment, which did not conform to GAAP because such costs should always be treated as period costs and expensed immediately, resulted in an overstatement of profit during the year the costs were incurred.
• Audits versus reviews versus compilation services: CPAs offer three types of accounting services: audits, reviews, and compilations. Audits are comprehensive reviews of a firm’s financial statements and are required of publicly held companies. Other organizations may secure audits of their financials if they are in a position of public trust, have multiple investors, or if required by other creditors. Because of the amount of time involved in testing the firm’s internal controls and a sufficient percentage of its transactions, audits are the most expensive of the three types of services, but yield the highest level of assurance that the financials conform to GAAP and that the system of internal
controls is satisfactory to protect the assets of the organization.
Reviews of financial statements are just that; the CPA conducts a
relatively high-level review of the financial statements and reports his
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or her findings in a letter report but does not opine that the statements present fairly the financial position of the firm in accordance with GAAP as he or she would in an audit. Reviews, which in general are
more appropriate for small closely held firms, consist of an analysis of the statements, noting the reason for significant variances and an overall test for reasonableness. In general, a review would not include a detailed study of internal controls nor would it involve extensive testing of account balances, but it does provide owners with a basic level of assurance that the financials generally conform to GAAP.
Compilations, as the name suggests, involve the CPA acting in the
client role of assisting in the preparation, or compilation, of the financial statements themselves. Because the CPA essentially prepares the statements based on the balances presented in the books and does not per-
form testing of the underlying data, the CPA does not opine as to the fairness of the statements themselves because it would be a conf lict in his or her attestation duties. In general, this is the least expensive service but also provides investors with the lowest level of assurance that the financials conform to GAAP. However, in a small, closely held firm, a compilation may be more than adequate to meet the needs of the owners.