& GAAP Rules
by Bean Counter's Dave Marshall
Copyright Bean Counter
|Financial Reporting and GAAP|
Purpose Of Bean Counter's Quick Insights
Bean Counter's Quick Insights are brief summaries and overviews about accounting topics that are not covered in one of my tutorials or topics that are briefly covered and need additional clarification and are provided to present you with additional information that will add to your understanding of bookkeeping and accounting.
The objective of this quick insight is to provide you with a basic understanding of what Generally Accepted Accounting Principles (GAAP) are, who makes the rules, what they're based on, and how they apply to reporting financial information. Don't be fooled by the brevity of this insight. Accounting students at universities are usually required to take at least one semester of an Accounting Theory course.
That being said, let's dive in and learn a little about the "Game" of Accounting.
What are Generally Accepted Accounting Principles ?
In The United States your Financial Statements and the Methods used in preparing them must abide by several rules, standards, assumptions, principles, guidelines, and modifying conventions. Other countries also have similar rules and standards. Collectively, these are referred to as Generally Accepted Accounting Principles (GAAP). In other words GAAP consists of the basic principles, assumptions and guidelines , the detailed rules and standards issued by the Financial Accounting Board (FASB), and the generally accepted industry practices.
Generally Accepted Accounting Principles (GAAP) are the accounting rules used by companies (public and private) to prepare financial statements. Special rules apply to local and state governments and are determined by the Governmental Accounting Standards Board (GASB).
Generally Accepted Accounting Principles are not laws per se, but the Securities and Exchange Commission (SEC) requires publicly traded companies to adhere to these rules.
GAAP attempts to standardize the methods and rules used by businesses so that we don't have each business "doing their own thing". This allows the users of financial statements to compare one company with another or compare a company's financial statement with their related industry statistics derived from the financial statements of companies common to that industry.
GAAP provides the foundation for accounting by providing basic rules and concepts that aid in handling the various accounting issues a business encounters.
Shoot even games have Rules. Look at all the rules for our game of football. Think of GAAP as the rules for the "Game" of Accounting.
These rules of accounting (GAAP) have evolved from a basic framework and basic objectives of Financial Reporting.
What are the Basic Objectives OF Financial Reporting ?
Provide the users
of financial information such as managers, owners, potential
investors, creditors, and other users with useful information that
may affect the decisions they are confronted with.
To be useful and helpful to users,
financial statements and information must have the following
Qualitative Characteristics: In other words, the information
possesses these qualities or characteristics. Constraints and Modifying
Conventions: Constraints: Modifying
Conventions: Lets use a simple table to
summarize, organize, and present the useful qualities of financial
information that we just discussed. This table is based on a
diagram from Statements Of Financial Accounting Concepts (SFAC)
Number 2 issued by the Financial Accounting Standards
Board. The two constraints on financial information Cost Benefit and
Materiality are highlighted in yellow. Normally information that
doesn't fall within these constraints (boundaries) is not provided
to users of financial information. Exceptions would be if certain
information was required by a governmental agency regardless of the
materiality or the cost of obtaining the information. Financial Reporting Should Also .......
To be useful and helpful to users, financial statements and information must have the following Qualitative Characteristics: In other words, the information possesses these qualities or characteristics.
Constraints and Modifying Conventions:
Lets use a simple table to summarize, organize, and present the useful qualities of financial information that we just discussed. This table is based on a diagram from Statements Of Financial Accounting Concepts (SFAC) Number 2 issued by the Financial Accounting Standards Board.
The two constraints on financial information Cost Benefit and Materiality are highlighted in yellow. Normally information that doesn't fall within these constraints (boundaries) is not provided to users of financial information. Exceptions would be if certain information was required by a governmental agency regardless of the materiality or the cost of obtaining the information.
Financial Reporting Should Also .......
You should now at least have a pretty good idea of what the accounting profession considers as useful financial information.
Let's take a look at an accounting joke to illustrate what we mean by useful and timely information.
A fellow has been learning to be a balloonist and takes his first solo flight. Unfortunately the wind gets up, he is blown off course and is forced to land. He is in a paddock close to a road but has no idea where he is. He sees a car coming along the road and hails it. The driver gets out and the balloonist says, "G'day sir, can you tell me where I am?"
"Yes, of course", says the motorist. "You have just landed in your balloon and with this wind you have obviously been blown off course. You are in the back field on John Dawson's farm, 13.5 miles from Knoxville. John will be plowing and sowing corn in the back field next week. There is a bull in the field. It is behind you and about to attack you."
At the moment the bull reaches the balloonist and tosses him over the fence. Luckily he is unhurt. He gets up, dusts himself off and says to the motorist, "I see you're an accountant".
"Good Grief", says the driver, "you're right. How did you know that?"
"I employ accountants", says the balloonist. "The information you gave me was detailed, precise and accurate. Most of it was useless and it arrived far too late to be of any help."
Now that we have a basic understanding of the type of information needed and used for reporting financial results, lets take a look at the foundation upon which the detailed Generally Accepted Accounting Principles are built.
GAAP Basic Foundation
GAAP has four basic assumptions, four basic principles, and four basic constraints and modifying conventions.
1. The Business or Economic Entity Assumption
This assumption requires every business to be accounted for separately from the owner. Personal and business-related transactions are kept apart from each other. In other words, the separate personal transactions of owners and others is not commingled with the reporting of the economic activity of the business. One of the first recommendations almost all accountants tell a client is to at least establish a business checking account and to use it to only record their business transactions.
2. The Going-Concern Assumption
This assumption assumes that a business will continue operating and will not close or be sold. It assumes that a business will be in operation for a long time. Based on this assumption, actual costs instead of liquidation values are used for presenting financial information. This assumption is abandoned in the event that a business is actually going out of business.
3. Monetary Assumption
4. Time Period (Periodicity) Assumption
This assumption assumes that business operations can be recorded and separated into different time periods such as months, quarters, and years. This is required in order to provide timely information that is used to compare present and past performance.
1. The Historical Cost Principle
This principle requires that most assets are recorded at their original acquisition cost and no adjustment is made for increases in market value. In other words, the value of an asset is never "written up" even though the asset may actually be worth more than its cost. On the other hand, cost is sometimes "written down" for example marketable securities and inventory. See conservatism convention.
The purpose of this principle is to provide reliable and unbiased financial information but some of the values whose values are materially greater than cost are not very relevant information. This deficiency is often addressed by supplying additional supplementary information that also includes market values.
Wouldn't we have a mess if we let every business state their assets at what they think they're worth ?
2. Realization Principle - Revenue Recognition
The revenue recognition principle requires companies to record revenue when it is realized or realizable and actually earned. In other words, at the time the goods are actually sold or the services are rendered.
When revenue is earned normally has no relationship to when the cash resulting from the earnings is actually received. This principle is the basis for accrual accounting.
3. Matching Principle
The Matching Principle goes hand in hand with the Revenue Realization Principle. The matching principle is recording the revenues earned during a period using the revenue realization principle and matching (offsetting) the revenues with the expenses incurred in generating this revenue.
Expenses are recorded in the period and matched with the revenues recorded using the following methods:
Many costs can be directly linked to the revenue they help to produce. Cost of Goods Sold and Sales Commissions for example are directly related to the sale of the product.
Some costs such as the cost of Equipment Purchased provide benefit for many years and to many periods. Instead of recording the entire cost as an expense in the period the equipment was purchased which would greatly distort earnings, the cost is allocated to revenue recognized in the periods that receive benefit from the use of the equipment. Allocating or spreading the cost of the equipment over many periods (expensed) is called depreciation.
4. Adequate Disclosure (Full Disclosure Principle)
The Adequate Disclosure Principle states that all pertinent and material financial information concerning the business and its activities is fully disclosed in an understandable form. Information is presented in the main body of the financial statements, in the notes to the financial statements, or as supplementary information. What actually constitutes adequate disclosure often involves professional judgment.
Constraints and Modifying Conventions
1. Materiality Convention
2. Cost-Benefit Convention
3. Conservatism Convention
4. Industry Practices Convention
These constraints and conventions should already look familiar to you. They were discussed earlier in our section about the Objectives Of Financial Reporting.
In order to "Play" the "Game Of Accounting" a business has to learn and play by the Rules. The Rules (GAAP) have been established so that everyone plays the "Accounting Game" in a similar manner. In order to properly play the "Game of Accounting" a key requirement is to provide useful and understandable information that provides feedback or predictive value that can aid in decisions and analysis.
Shoot that wasn't too bad ! Don't fool yourself - what we discussed is just the tip of the iceberg. The rules we discussed just lay the general ground work for the more detailed rules. There have been more than 150 detail Statements of Financial Accounting Standards ( most authoritative GAAP setting publications ) issued by the Financial Accounting Standards Board.
Who's Responsible for Making The Rules
If you were paying attention, the previous paragraph provides a big hint. Originally, the American Institute Of Certified Public Accountants (AICPA), the membership association for CPAs, was the organization in charge of defining accounting standards. This duty was assumed by the Financial Accounting Standards Board (FASB) in 1973.
These organizations influence developing General Accepted Accounting Principle (GAAP) in the United States.
The Interpretations and Technical Bulletins provide additional clarification and guidelines to help in utilizing and applying the Statements Of Financial Accounting Standards.
For those of you wanting or needing additional information about Accounting Principles, I've provided some additional links to useful sites.
FASB-Statements, Concepts, Etc.
Note: Adobe Reader Required for PDF Publications
You can find the following types of publications presented in PDF Format:
Some publications that we briefly discussed in this Insight and/or that you may want to take a look at: