Generally Accepted Accounting Principles
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).
Two laws, the Securities Act of 1933 and the Securities Exchange Act of
1934, give the SEC authority to establish reporting and disclosure
requirements. However, the SEC usually operates in an oversight
capacity, allowing the FASB and the Governmental Accounting Standards
Board (GASB) to establish these requirements. The GASB develops
accounting standards for state and local governments.
The current set of principles that accountants use rests upon some
underlying assumptions. The basic assumptions and principles presented
on the next several pages are considered GAAP and apply to most
financial statements. In addition to these concepts, there are other,
more technical standards accountants must follow when preparing
financial statements. Some of these are discussed later in this book,
but other are left for more advanced study.
Economic entity assumption. Financial records must
be separately maintained for each economic entity. Economic entities
include businesses, governments, school districts, churches, and other
social organizations. Although accounting information from many
different entities may be combined for financial reporting purposes,
every economic event must be associated with and recorded by a specific
entity. In addition, business records must not include the personal
assets or liabilities of the owners.
Monetary unit assumption. An economic entity's
accounting records include only quantifiable transactions. Certain
economic events that affect a company, such as hiring a new chief
executive officer or introducing a new product, cannot be easily
quantified in monetary units and, therefore, do not appear in the
company's accounting records. Furthermore, accounting records must be
recorded using a stable currency. Businesses in the United States
usually use U.S. dollars for this purpose.
Full disclosure principle. Financial statements
normally provide information about a company's past performance.
However, pending lawsuits, incomplete transactions, or other conditions
may have imminent and significant effects on the company's financial
status. The full disclosure principle requires that financial statements
include disclosure of such information. Footnotes supplement financial
statements to convey this information and to describe the policies the
company uses to record and report business transactions.
Time period assumption. Most businesses exist for
long periods of time, so artificial time periods must be used to report
the results of business activity. Depending on the type of report, the
time period may be a day, a month, a year, or another arbitrary period.
Using artificial time periods leads to questions about when certain
transactions should be recorded. For example, 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.
Once the time period has been established, accountants use GAAP to
record and report that accounting period's transactions.
Accrual basis accounting. In most cases, GAAP requires the use of accrual basis accounting rather than cash basis accounting.
Accrual basis accounting, which adheres to the
revenue recognition, matching, and cost principles discussed below,
captures the financial aspects of each economic event in the accounting
period in which it occurs, regardless of when the cash changes hands.
Under cash basis accounting, revenues are recognized only when the
company receives cash or its equivalent, and expenses are recognized
only when the company pays with cash or its equivalent.
Revenue recognition principle. Revenue is earned
and recognized upon product delivery or service completion, without
regard to the timing of cash flow. Suppose a store orders five hundred
compact discs from a wholesaler in March, receives them in April, and
pays for them in May. The wholesaler recognizes the sales revenue in
April when delivery occurs, not in March when the deal is struck or in
May when the cash is received. Similarly, if an attorney receives a $100
retainer from a client, the attorney doesn't recognize the money as
revenue until he or she actually performs $100 in services for the
client.
Matching principle. The costs of doing business are
recorded in the same period as the revenue they help to generate.
Examples of such costs include the cost of goods sold, salaries and
commissions earned, insurance premiums, supplies used, and estimates for
potential warranty work on the merchandise sold. Consider the
wholesaler who delivered five hundred CDs to a store in April. 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.
Cost principle. Assets are recorded at cost, which
equals the value exchanged at the time of their acquisition. In the
United States, even if assets such as land or buildings appreciate in
value over time, they are not revalued for financial reporting purposes.
Going concern principle. Unless otherwise noted,
financial statements are prepared under the assumption that the company
will remain in business indefinitely. Therefore, assets do not need to
be sold at fire-sale values, and debt does not need to be paid off
before maturity. This principle results in the classification of assets
and liabilities as short-term (current) and long-term.
Long-term assets are expected to be held for more than one year.
Long-term liabilities are not due for more than one year.
Relevance, reliability, and consistency. To be useful, financial information must be relevant, reliable, and prepared in a consistent manner.
Relevant information helps a decision maker
understand a company's past performance, present condition, and future
outlook so that informed decisions can be made in a timely manner. Of
course, the information needs of individual users may differ, requiring
that the information be presented in different formats. Internal users
often need more detailed information than external users, who may need
to know only the company's value or its ability to repay loans.
Reliable information is verifiable and objective.
Consistent information is prepared using the same
methods each accounting period, which allows meaningful comparisons to
be made between different accounting periods and between the financial
statements of different companies that use the same methods.
Principle of conservatism. Accountants must use
their judgment to record transactions that require estimation. 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. In reporting financial data, accountants follow the
principle of conservatism, which requires that the
less optimistic estimate be chosen when two estimates are judged to be
equally likely. For example, suppose a manufacturing company's Warranty
Repair Department has documented a three-percent return rate for product
X during the past two years, 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.
Unless the Engineering Department provides compelling evidence to
support its estimate, the company's accountant must follow the principle
of conservatism and plan for a three-percent return rate. Losses and
costs—such as warranty repairs—are recorded when they are probable and
reasonably estimated. Gains are recorded when realized.
Materiality principle. Accountants follow the
materiality principle, which states that the
requirements of any accounting principle may be ignored when there is no
effect on the users of financial information. Certainly, tracking
individual paper clips or pieces of paper is immaterial and excessively
burdensome to any company's accounting department. Although there is no
definitive measure of materiality, the accountant's judgment on such
matters must be sound. Several thousand dollars may not be material to
an entity such as General Motors, but that same figure is quite material
to a small, family-owned business.