Generally Accepted Accounting Principles (GAAP) Overview

Generally Accepted Accounting Principles (GAAP) Overview

Introduction to GAAP

  • GAAP: Nickname for Generally Accepted Accounting Principles.

  • Purpose: Guidelines for publicly-traded companies in creating financial statements.

  • Publicly-traded companies defined: Companies that offer stock for sale to the public.

  • GAAP consists of 10 fundamental accounting principles.

The Ten Basic GAAP Principles

  1. Economic Entity Assumption

    • Definition: Activities of the business must be kept separate from the activities of the owner.

  2. Monetary Unit Assumption

    • Definition: Only activities that can be expressed in dollar amounts are included in accounting records.

  3. Time Period Assumption

    • Definition: Business activities can be reported in distinct time intervals (weeks, months, quarters, fiscal year).

    • Importance: Each financial statement must clearly identify its reporting period.

  4. Cost Principle

    • Definition: Assets are reported at their historical cost, i.e., the amount that was paid at the time of purchase.

    • Note: Historical cost does not change with inflation.

  5. Full Disclosure Principle

    • Definition: All relevant information must be disclosed in the financial statements or in accompanying notes.

  6. Going Concern Principle

    • Definition: Assumes the business intends to continue operations into the foreseeable future, rather than liquidating.

  7. Matching Principle

    • Definition: Requires that businesses use the accrual form of accounting to match expenses with revenues in the same period.

    • Example: Sales expenses should be recorded in the same period as sales income.

  8. Revenue Recognition Principle

    • Definition: Revenue should be recognized on the income statement in the period it is earned, not necessarily when received.

  9. Materiality Principle

    • Definition: This principle weighs the significance of a misstatement against its potential impact on financial statements.

    • Example: A $10.00 understatement needs judgment on whether it will materially affect decisions based on financials.

  10. Conservatism

    • Definition: Requires potential expenses and liabilities to be recognized as soon as they are even slightly likely; revenue is only recognized once it is realized.

History of GAAP

  • 1929 Stock Market Crash: Major event leading to a loss of faith in the financial markets and subsequent need for more regulation.

  • Formation of the SEC (1930s): Established to restore investor confidence, regulate financial practices among publicly-traded entities.

  • AIA and Initial GAAP Recognition (1934): The SEC enlisted the AIA to develop financial statement formation, leading to the first mention of GAAP.

  • Creation of the Committee on Accounting Procedure (CAP): A subcommittee formed in the late 1930s to establish GAAP standards.

  • Transition to FASB (1973): SEC replaced CAP with the Financial Accounting Standards Board, which still functions today.

Influences on GAAP

  • Securities and Exchange Commission (SEC): Regulates financial markets and accounting standards.

  • Financial Accounting Standards Board (FASB): Comprises private-sector professionals who set GAAP standards.

    • Structure: 7 members elected for five-year terms (max 10 years).

    • Requirement: Members must disassociate from their previous organizations upon accepting the role.

  • International Accounting Standards Board (IASB): Establishes global standards for international accounting, based in London with 16 members from various nationalities.

GAAP's Role as an Accounting Superhero

  • GAAP's primary function: Sets standards ensuring that financial statements' information is relevant, reliable, comparable, and consistent.

    • Relevant Information: Information impacting the financial status.

    • Reliable Information: Information verifiable as accurate.

    • Comparability & Consistency: Financial statements should be reported consistently across different periods for comparability.

  • Importance of GAAP: Ensures transparency and completeness in financial reporting, thus influencing investor and creditor decisions.

  • Example of GAAP’s impact: New leasing standard (effective Jan 1, 2022) mandates most leases be recorded as finance leases, displaying both asset and liability on financial statements for transparency.

Summary of Lesson

  • GAAP was established post the 1929 Stock Market Crash to restore confidence in financial reporting.

  • SEC was formed to regulate practices of publicly traded companies, leading to the development of GAAP by AIA and later through FASB.

  • Key Concepts of GAAP: 10 principles that provide clarity, accountability, and trust in financial reporting.

Learning Outcomes

  • Ability to identify and state the ten basic accounting principles.

  • Understanding GAAP's background, its creation, and the role of the SEC in financial reporting.

  • Knowledge of the domestic (FASB) and international (IASB) boards overseeing GAAP standards.