Question

This week’s is about three common financial statements, namely the balance sheet, income statement, and statement of cash flows. The basis of accounting for these statements for most non-governmental for-profit entities is known as Generally Accepted Accounting Principles (GAAP). One of the underlying principles of GAAP is that items on the balance sheet are listed at Book Value as opposed to Market Value. What are Book Value and Market Value? Under what circumstances could they be the same and under what circumstances could they be different? Is one measure more important than the other? Why do you believe that the developers of GAAP proposed that Book Value govern balance sheet reporting? Net income differs from cash received which is why the statement of cash flows is required to bridge the two. What are the principal differences between net income and cash flow? Cash is obviously important but why might both measures be important for a financial manager?

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Answer 1

One of underlying principles of GAAP is that the items on balance sheet are listed at book value

Book value is nothing but purchase price of the asset. For example if land is purchased at 100,000$, then it will be carried in balance sheet at 100,000$ (less depreciation if any) irrespective of it's market price

Market value is nothing but current realisable value of the asset.

Book value and market value will be same when company goes into liquidation ie selling value is same as it's book value

GAAP proposed book value because it can be easily audited. The market value is subjective. for example one may think that the land is worth $1 million while other may think land is worh $2 million , thus it will mislead the financial statements. Futher Indicating values at historical cost also follows going concern assumption. The revenue recognition is another reason why th book value is recorded

Statement of cash flow shows how much cash is generated at end of year. Yes it is true that net income will differ from actual cash flow because of non cash expenses such as depreciation. In cash flow statement depreciation is added back to net profit to arrive at actual cash flow.

It is true that the cash is important but net profit is also very important for financial manager because company will take all its decision based on net income.Depreciation though non cash expense indicates that small portion of cash s kept aside for purchase of the asset on which depreciation is given , in future when it will be wholly depreciated. Depreciation is just defferement of expense. Thus conisderation of net income is also important