Accountants utilize the generally accepted accounting principles (GAAP) to record and report financial information. GAAP is a comprehensive set of principles established by both the accounting profession and the Securities and Exchange Commission (SEC). The SEC, empowered by the Securities Act of 1933 and the Securities Exchange Act of 1934, has the jurisdiction to establish reporting and disclosure requirements. However, it primarily operates in an oversight capacity, delegating responsibility for setting these requirements to FASB and GASB.
The Governmental Accounting Standards Board (GASB) is in charge of creating accounting standards, or Generally Accepted Accounting Principles (GAAP), for state and local governments. These standards are built on specific assumptions and principles that are applicable to most financial statements. Although this book provides an overview of the fundamental concepts, accountants must also follow additional technical standards when preparing financial statements. Some of these standards will be addressed later in this book, while others necessitate more advanced study.
The economic entity assumption necessitates maintaining distinct financial records for each economic entity, including businesses, governments, school districts, churches, and other social organizations. Although accounting information from multiple entities can be consolidated for financial reporting purposes, every economic event must be attributed to a specific entity and duly documented. Additionally, the business records should exclude any personal assets or liabilities of the owners.
The monetary unit assumption states that a company’s accounting records only include quantifiable transactions. Difficult-to-quantify economic events, like hiring a new CEO or introducing a new product, are not recorded. Accounting records must be maintained in a stable currency, commonly U.S. dollars for businesses in the United States. This principle is aligned with the full disclosure principle.
Financial statements typically present information about a company’s previous performance. However, the financial status of the company can be greatly impacted by pending lawsuits, incomplete transactions, or other circumstances. The principle of full disclosure mandates that financial statements should include the disclosure of such information. Footnotes are used to provide additional details and describe the company’s policies regarding the recording and reporting of business transactions. This principle is based on the assumption of a specific time period.
Reporting the results of business activity often involves the use of artificial time periods, as many businesses operate over long durations. These time periods can vary depending on the type of report, such as a day, month, year, or any other arbitrary interval. However, utilizing these artificial time periods raises concerns about when to record specific transactions. For instance, determining when to account for the cost of equipment with a projected lifespan of five years poses challenges. If the entire expense is recorded in the year of purchase, it may create an appearance of unprofitability in that particular year and inflated profitability in subsequent years.
Once the time period is determined, accountants utilize GAAP to document and present the transactions of that accounting period. Accrual basis accounting is predominantly employed by GAAP instead of cash basis accounting. Accrual basis accounting complies with the revenue recognition, matching, and cost principles mentioned below, capturing the financial aspects of every economic event in the accounting period in which it happens, regardless of cash exchange timing.
Under cash basis accounting, revenues are only recognized when the company receives cash or its equivalent, and expenses are only recognized when the company pays with cash or its equivalent. The revenue recognition principle states that revenue is earned and recognized upon product delivery or service completion, regardless of the timing of cash flow.
For example, if a store orders five hundred compact discs from a wholesaler in March, receives them in April, and pays for them in May, the wholesaler would recognize the sales revenue in April when the delivery occurs, not in March when the deal is struck or in May when the cash is received.
Similarly, according to the matching principle, an attorney does not categorize a $100 retainer from a client as revenue until $100 worth of services are actually provided. This principle ensures that the costs related to generating revenue are recorded in the same period. These costs can include expenses such as cost of goods sold, earned salaries and commissions, insurance premiums, used supplies, and estimated expenses for potential warranty work on sold merchandise.
The wholesaler delivered 500 CDs to a store in April. These CDs are considered inventory until revenue is recognized, at which point they become cost of goods sold. This change in classification is necessary to calculate profit from the sale. It follows the cost principle, which requires assets to be recorded at their acquisition cost. Unlike land and buildings, which do not get revalued for financial reporting purposes even if their value increases over time, this principle does not apply to them. The going concern principle assumes that the business will continue operating in the future.
Financial statements are created under the assumption that the business will operate indefinitely. This means that assets do not have to be sold at lower prices and debt does not need to be paid off before its maturity date. As a result, assets and liabilities are classified as short-term (current) or long-term. Long-term assets are anticipated to be held for over one year, while long-term liabilities are not due in the upcoming year. Furthermore, these financial statements adhere to the principles of relevance, reliability, and consistency.
Financial information needs to be valuable, which requires it to have relevance, reliability, and consistency in its preparation. Relevance means that the information assists decision makers in understanding a company’s past performance, current status, and future prospects so they can make informed decisions efficiently. The presentation formats may differ depending on the specific needs of different users. Internal users generally require more comprehensive details while external users may only need to evaluate the company’s value or its ability to repay loans.
Information that is reliable is both verifiable and objective. Consistent information is prepared using the same methods each accounting period, enabling meaningful comparisons between different periods and companies that use the same methods. The principle of conservatism necessitates accountants to exercise judgment when recording transactions that involve estimation. Examples of such estimations include determining the productive lifespan of equipment and estimating the portion of accounts receivable that will not be paid.
In the reporting of financial data, accountants adhere to the principle of conservatism. This principle dictates that when faced with two equally probable estimates, the more pessimistic estimate should be selected. To illustrate, imagine a manufacturing company’s Warranty Repair Department has recorded a three-percent return rate for product X in the last two years. However, the Engineering Department of the same company argues that this return rate is merely a statistical oddity and predicts that less than one percent of product X will necessitate servicing in the upcoming year.
Unless the Engineering Department provides compelling evidence to support its estimate, the company’s accountant must adhere to the principle of conservatism and anticipate a return rate of three percent. Losses and costs, such as warranty repairs, are documented when they are likely to occur and reasonably estimated. Gains are recorded when they are actually achieved. Accountants also follow the materiality principle, which allows for the disregard of any accounting principle if it does not impact users of financial information.
Tracking every single paper clip or piece of paper would be deemed unnecessary and burdensome by the accounting department of any company. Although there is no specific standard for materiality, accountants must use their judgment wisely in such cases. While a sum in the realm of several thousand dollars may not carry much significance for a major corporation like General Motors, it can hold immense importance for a small, family-owned business.
