Accounting For Dummies. John A. Tracy

managers. Unfortunately, there have been many cases of CPA auditors failing to detect serious financial fraud that had been going on for years, right under their auditing noses. Cleverly concealed fraud is very difficult to uncover, unless you stumble over it by accident. CPAs are supposed to apply professional skepticism in doing their audits, but this doesn’t always lead to discovery of fraud.

      Why no (or limited) cash distribution from profit?

      Distributions from profit by a business C corporation (see Chapter 5 to understand the different forms of business legal entities) are called dividends (because the total amount distributed is divided up among the stockholders). Cash distributions from profit to owners are included in the final section of the statement of cash flows (refer to Figure 2-3). In our example, the business made a cash distribution in the form of a dividend from profit of $400,000 — even though it earned $4.482 million of net income (see Figure 2-1), or just 8.9 percent of profits. Why so low?

It’s clear that the company has plenty of cash available to issue a dividend, as not only did it generate $4.482 million in net profit, but it also generated another $3.111 million in cash from non-cash expenses and operating activities ($1.739 million plus $1.372 million; see Figure 2-3). Should the business have distributed, say, at least half of its cash flow from profit, or roughly $3.8 million, to its owners? If you owned 20 percent of the ownership shares of the business, you would have received 20 percent, or roughly $760,000, of the dividend. But you got almost no cash return on your investment in the business. Your shares should be worth more because the profit for the year increased the company’s owners’ equity, but you didn’t see any of this increase in your wallet.

      

Deciding whether to make cash distributions from profit to shareowners is in the hands of the directors of a business corporation. Its shareowners elect the directors, and in theory the directors act in the best interests of the shareowners. So, evidently, the directors thought the business had better use for the $3.8 million cash flow from profit than distributing some of it to shareowners. In our example, the company does indeed have something big planned for the use of its cash hoard of $11.281 million, as it has earmarked funds to support buying a complimentary business in future years. Generally, the main reason for not making cash distributions from profit is to finance the growth of the business — to use all the cash flow from profit for expanding the assets needed by the business at the higher sales level (which is the case here). Ideally, the directors of the business would explain their decision not to distribute any money from profit to the shareowners. But generally, no such comments are made in financial reports.

Complying with Accounting and Financial Reporting Standards

      When an independent CPA audits the financial report of a business, there’s no doubt regarding which accounting and financial reporting standards the business uses to prepare its financial statements and other disclosures. The CPA explicitly states which standards are being used in the auditor’s report. What about unaudited financial reports? Well, the business could clarify which accounting and financial reporting standards it uses, but you don’t see such disclosure in all cases.

      When the financial report of a business is not audited and does not make clear which standards are being used to prepare its financial report, the reader is entitled to assume that appropriate standards are being used. However, a business may be way out in left field (or out of the ballpark) in the “guideposts” it uses for recording profit and in the preparation of its financial statements. A business may make up its own “rules” for measuring profit and preparing financial statements. In this book, we concentrate on authoritative standards, of course.

Imagine the confusion that would result if every business were permitted to invent its own accounting methods for measuring profit and for putting values on assets and liabilities. What if every business adopted its own individual accounting terminology and followed its own style for presenting financial statements? Such a state of affairs would be a Tower of Babel.

      

The goal is to establish broad-scale uniformity in accounting methods for all businesses. The idea is to make sure that all accountants are singing the same tune from the same hymnal. The authoritative bodies write the tunes that accountants have to sing.

      Looking at who makes the standards

      Who are the authoritative bodies that set the standards for financial accounting and reporting? In the United States, the highest-ranking authority in the private (nongovernment) sector for making pronouncements on accounting and financial reporting standards — and for keeping these standards up to date — is the Financial Accounting Standards Board (FASB). This rulemaking body has developed a codification of all its pronouncements. This is where accountants look to first.

      Outside the United States, the main authoritative accounting-standards setter is the International Accounting Standards Board (IASB), which is based in London. The IASB was founded in 2001. More than 8,000 public companies have their securities listed on the several stock exchanges in the European Union (EU) countries. In many regards, the IASB operates in a manner similar to the Financial Accounting Standards Board (FASB) in the United States, and the two have very similar missions. The IASB has already issued many standards, which are called International Financial Reporting Standards. Without going into details, FASB and IASB are not in perfect harmony (even though congruence of their standards was the original goal of the two organizations).

      Also, in the United States, the federal Securities and Exchange Commission (SEC) has broad powers over accounting and financial reporting standards for companies whose securities (stocks and bonds) are publicly traded. Actually, because it derives its authority from federal securities laws that govern the public issuance and trading in securities, the SEC outranks the FASB. The SEC has on occasion overridden the FASB but not very often.

      

Consider taking the time to Google the acronyms of these three authoritative sources of financial accounting standards. You’ll find which particular financial accounting standards and problem areas are under active review and development. In late 2015, for instance, lease accounting and revenue accounting were under active review and transition to new standards, to say nothing about a host of other financial accounting problems (for example, how to account for derivatives).

      Knowing about GAAP

      The authoritative standards and rules that govern financial accounting and reporting by businesses in the United States are called generally accepted accounting principles (GAAP). The financial statements of an American business should be in full compliance with GAAP regarding reporting its cash flows, profit-making activities, and financial condition — unless the business makes very clear that it has prepared its financial statements using some other basis of accounting or has deviated from GAAP in one or more significant respects.

      

If GAAP are not the basis for preparing a business’s financial statements, the business should make very clear which other basis of accounting it’s using and avoid using titles for its financial statements that are associated with GAAP. For example, if a business uses a simple cash receipts and cash disbursements basis of accounting — which falls way short of GAAP — it should not use the terms income statement and balance sheet. These terms are part and parcel of GAAP, and their use as titles for financial statements implies that the business is using GAAP.

      There are upwards of 7,000 public companies in the United States and easily more than a million privately owned businesses. Now, are we telling you that