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Accountants use Generally Accepted Accounting Principles (GAAP) to guide them in recording and reporting financial information. GAAP comprises a broad set of principles that have been developed by the accounting profession and the Securities and Exchange Commission (SEC). There are general rules and concepts that govern the field of accounting. These general rules—referred to as basic accounting principles and guidelines—form the groundwork on which more detailed, complicated, and legalistic accounting rules are based. For example, the Financial Accounting Standards Board (FASB) uses the basic accounting principles and guidelines as a basis for their own detailed and comprehensive set of accounting rules and standards. The phrase "Generally Accepted Accounting Principles" (or "GAAP") consists of three important sets of rules: (1) The basic accounting principles and guidelines, (2) The detailed rules and standards issued by FASB and its predecessor the Accounting Principles Board (APB), (3) The generally accepted industry practices. If a company distributes its financial statements to the public, it is required to follow generally accepted accounting principles in the preparation of those statements. Further, if a company's stock is publicly traded, federal law requires the company's financial statements be audited by independent public accountants. Both the company's management and the independent accountants must certify that the financial statements and the related notes to the financial statements have been prepared in accordance with GAAP.
If you have anything to do with the financial reporting of a company or government entity, you should understand the principles of GAAP. However, if you are simply preparing your individual income tax statements, understanding GAAP probably isn't as important to you. Usually, financial statements prepared for income tax purposes are significantly different than statements prepared under GAAP, mainly because they each measure income differently. The FASB measures GAAP-based income so that the information provided is useful to those making economic decisions (i.e., investors and creditors). The IRS, on the other hand, uses income tax reporting to achieve social and economic objectives, such as reducing unemployment and encouraging investment in capital assets.
Following are some principles and guidelines which are the constituents of GAAP:-
© Ibad bin Rashid (EPO120319)
A company usually lists its significant accounting policies as the first note to its financial statements. © Ibad bin Rashid (EPO120319) 2 . let's say a company is named in a lawsuit that demands a significant amount of money. Economic entities include businesses. therefore. Furthermore. Certain economic events that affect a company. churches. and other social organizations. dollars for this purpose. incomplete transactions. it is assumed that the dollar's purchasing power has not changed over time. Businesses in the United States usually use U.Economic Entity Assumption: Financial records must be separately maintained for each economic entity. Full Disclosure Principle: Financial statements normally provide information about a company's past performance. but for accounting purposes they are considered to be two separate entities. pending lawsuits. If certain information is important to an investor or lender using the financial statements. that information should be disclosed within the statement or in the notes to the statement. However. or other conditions may have imminent and significant effects on the company's financial status. Because of this basic accounting principle. As a result accountants ignore the effect of inflation on recorded amounts. governments. Footnotes supplement financial statements to convey this information and to describe the policies the company uses to record and report business transactions. accounting records must be recorded using a stable currency. For legal purposes. business records must not include the personal assets or liabilities of the owners. a sole proprietorship and its owner are considered to be one entity. such as hiring a new chief executive officer or introducing a new product. In addition. It is because of this basic accounting principle that numerous pages of "footnotes" are often attached to financial statements.S. As an example. When the financial statements are prepared it is not clear whether the company will be able to defend itself or whether it might lose the lawsuit. Although accounting information from many different entities may be combined for financial reporting purposes. dollars from a 1960 transaction are combined (or shown with) dollars from a 2012 transaction. For example. school districts. every economic event must be associated with and recorded by a specific entity. do not appear in the company's accounting records. As a result of these conditions and because of the full disclosure principle the lawsuit will be described in the notes to the financial statements. Monetary Unit Assumption: An economic entity's accounting records include only quantifiable transactions. The full disclosure principle requires that financial statements include disclosure of such information. cannot be easily quantified in monetary units and.
whether that purchase happened last year or thirty years ago. Relevant information helps a decision maker understand a company's past performance. Reliable information is verifiable and objective. they are not revalued for financial reporting purposes. who may need to know only the company's value or its ability to repay loans. reliable. This principle results in the classification of assets and liabilities as short-term (current) and long-term. Of course. Going Concern Principle: This accounting principle assumes that a company will continue to exist long enough to carry out its objectives and commitments and will not liquidate in the foreseeable future. which equals the value exchanged at the time of their acquisition. financial information must be relevant. In the United States. present condition. even if assets such as land or buildings appreciate in value over time. and future outlook so that informed decisions can be made in a timely manner. Consistent information is prepared using the same methods each accounting period. © Ibad bin Rashid (EPO120319) 3 . the information needs of individual users may differ. the amounts shown on financial statements are referred to as historical cost amounts. Therefore. For example. which allows meaningful comparisons to be made between different accounting periods and between the financial statements of different companies that use the same methods. accountants use GAAP to record and report that accounting period's transactions. requiring that the information be presented in different formats. Once the time period has been established. Reliability & Consistency: To be useful. Long-term assets are expected to be held for more than one year. From an accountant's point of view. and prepared in a consistent manner. Internal users often need more detailed information than external users. Depending on the type of report. For this reason. the term "cost" refers to the amount spent (cash or the cash equivalent) when an item was originally obtained. Relevance. so artificial time periods must be used to report the results of business activity. a year. assets do not need to be sold at fire-sale values. a month.Time Period Assumption: Most businesses exist for long periods of time. Cost Principle: Assets are recorded at cost. and debt does not need to be paid off before maturity. how should an accountant report the cost of equipment expected to last five years? Reporting the entire expense during the year of purchase might make the company seem unprofitable that year and unreasonably profitable in subsequent years. Using artificial time periods leads to questions about when certain transactions should be recorded. or another arbitrary period. the time period may be a day. Long-term liabilities are not due for more than one year.
© Ibad bin Rashid (EPO120319) 4 . an accountant may write inventory down to an amount that is lower than the original cost. The number of years that equipment will remain productive and the portion of accounts receivable that will never be paid are examples of items that require estimation. Although there is no definitive measure of materiality. accountants follow the principle of conservatism. but it does not allow a similar action for gains. In reporting financial data. suppose a manufacturing company's Warranty Repair Department has documented a three-percent return rate for product X during the past two years.Principle Of Conservatism: The basic accounting principle of conservatism leads accountants to anticipate or disclose losses. Also. but the company's Engineering Department insists this return rate is just a statistical anomaly and less than one percent of product X will require service during the coming year. Certainly. An example of an obviously immaterial item is the purchase of a $150 printer by a highly profitable multi-million dollar company. which requires that the less optimistic estimate be chosen when two estimates are judged to be equally likely. but will not write inventory up to an amount higher than the original cost. For example. Because the printer will be used for five years. Gains are recorded when realized. the accountant's judgment on such matters must be sound. but that same figure is quite material to a small. For example. which states that the requirements of any accounting principle may be ignored when there is no effect on the users of financial information. Unless the Engineering Department provides compelling evidence to support its estimate. potential losses from lawsuits will be reported on the financial statements or in the notes. Accountants must use their judgment to record transactions that require estimation. Losses and costs—such as warranty repairs—are recorded when they are probable and reasonably estimated. the company's accountant must follow the principle of conservatism and plan for a three-percent return rate. The materiality guideline allows this company to violate the matching principle and to expense the entire cost of $150 in the year it is purchased. the matching principle directs the accountant to expense the cost over the five-year period. Several thousand dollars may not be material to an entity such as General Motors. The justification is that no one would consider it misleading if $150 is expensed in the first year instead of $30 being expensed in each of the five years that it is used. but potential gains will not be reported. tracking individual paper clips or pieces of paper is immaterial and excessively burdensome to any company's accounting department. family-owned business. Materiality Principle: Accountants follow the materiality principle.
and pays for them in May. Revenue is earned and recognized upon product delivery or service completion. if sales commissions expense should be reported in the period when the sales were made (and not reported in the period when the commissions were paid). if an attorney receives a $100 retainer from a client. receives them in April. 2013. the attorney doesn't recognize the money as revenue until he or she actually performs $100 in services for the client. matching. Consider the wholesaler who delivered five hundred CDs to a store in April. and supplies used. regardless of when the cash changes hands. If a company agrees to give its employees 1% of its 2012 revenues as a bonus on January 15. Wages to employees are reported as an expense in the week when the employees worked and not in the week when the employees are paid. Further more. the company should report the bonus as an expense in 2012 and the amount unpaid at December 31. These CDs change from an asset (inventory) to an expense (cost of goods sold) when the revenue is recognized so that the profit from the sale can be determined. Under cash basis accounting. Accrual basis accounting. revenues are recognized only when the company receives cash or its equivalent. Examples of such costs include the cost of goods sold. (The expense is occurring as the sales are occurring. Suppose a store orders five hundred compact discs from a wholesaler in March. Matching Principle: This accounting principle requires companies to use the accrual basis of accounting. without regard to the timing of cash flow.) © Ibad bin Rashid (EPO120319) 5 . The wholesaler recognizes the sales revenue in April when delivery occurs. and cost principles discussed below. and expenses are recognized only when the company pays with cash or its equivalent.Accrual Basis Accounting: In most cases. salaries and commissions earned insurance premiums. captures the financial aspects of each economic event in the accounting period in which it occurs. not in March when the deal is struck or in May when the cash is received. 2012 as a liability. Revenue Recognition Principle: Under the accrual basis of accounting (as opposed to the cash basis of accounting). and estimate for potential warranty work on the merchandise sold. Similarly. GAAP requires the use of accrual basis accounting rather than cash basis accounting. which adheres to the revenue recognition. The matching principle requires that expenses be matched with revenues.
we can make reasonably confident conclusions when comparing one company to another. Because of generally accepted accounting principles we are able to assume that there is consistency from year to year in the methods used to prepare a company's financial statements.Summarizing GAAP: GAAP is exceedingly useful because it attempts to standardize and regulate accounting definitions. or comparing one company's financial statistics to the statistics for its industry. And although variations may exist. creditors and others can make rational investment. GAAP makes a company's financials comparable and understandable so that investors. Over the years the generally accepted accounting principles have become more complex because financial transactions have become more complex. and methods. credit and other financial decisions. assumptions. comparable and consistent. © Ibad bin Rashid (EPO120319) 6 . reliable. In order to be useful and helpful to users. GAAP requires information on financial statements to be relevant.
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