GAAP Key Concepts and Principles Notes

GAAP Fundamentals

  • GAAP stands for generally accepted accounting principles, which are rules, standards, and procedures for reporting financial information.

  • GAAP are the standard procedures used by accountants.

  • GAAP are published in the Accounting Standards Codification, which is comparable to the law statute books that attorneys reference.

  • GAAP are established by the Financial Accounting Standards Board (FASB).

  • Why GAAP is important:

    • An auditor is a professional who conducts an independent examination of accounting records.

    • A key part of an auditor’s job is to ensure financial statements are prepared in conformity with GAAP.

  • Financial statements are written reports that outline or summarize the financial activities of a business, and include income statements and balance sheets.

  • Financial statements are used by investors, banks, and creditors to determine the financial health of a company.

  • To properly compare and evaluate companies, financial statements must provide similar information in a similar format; that is why GAAP is important.

Financial Health Indicators and Statements

  • Financial statements are used to determine financial health; for example, a company in good financial health often has higher assets than liabilities (i.e., they can pay their bills more easily).

  • Financial statements must provide consistent information in a similar format across companies to enable comparison.

Assumptions Under GAAP

  • GAAP is based on three key assumptions:

    • Business entity: The business functions as a legal and financial entity separate from its owners or any other business.

    • Going concern: The business will continue to operate for the foreseeable future.

    • Time period: All transactions reported occurred within the listed time period.

    • Note: The three assumptions are expanded upon in the material as Business Entity, Going Concern, and Time Period.

Time Period Concept

  • The time period concept provides that accounting takes place over specific time frames known as fiscal periods.

  • Management should review the company’s performance at regular intervals (e.g., daily, monthly, quarterly).

  • At the end of each accounting period, an income statement and balance sheet are prepared.

  • Income Statement (profit and loss statement):

    • Purpose: answers, “Is this company making money? Is this company profitable?”

    • Key equation: extRevenues−extExpenses=extNetIncomeext{Revenues} - ext{Expenses} = ext{Net Income}

  • Balance Sheet (statement of financial position):

    • Purpose: discloses the state of affairs of the business as of the last date of the accounting period.

    • Lists what the company owns (assets) and how it is financed (liabilities and equity).

  • Additional core identity:

    • Assets = Liabilities + Equity

    • extAssets=extLiabilities+extEquityext{Assets} = ext{Liabilities} + ext{Equity}

Time Period Rationale and Tax/Comparison Reasons

  • Companies prepare financial statements at least once a year, highlighting the importance of the Time Period assumption.

  • Why divide activities into different time periods and prepare statements for each period (e.g., yearly)?
    1) To determine profit or loss for tax purposes.
    2) To allow year-by-year comparisons of performance.

Accounting Principles: Two Main Principles

  • GAAP basics are built on three assumptions (Business Entity, Going Concern, Time Period) and two main principles:

    • Cost Principle

    • Disclosure Principle

Cost Principle

  • Definition: All values listed and reported must be the cost to obtain or acquire the asset, not its fair market value.

  • The cost figure is the amount that appears on the source document for the transaction.

  • Example: purchase of a vehicle is recorded at the price paid (cost), not current value.

  • Example: A computer worth $2,000 is purchased at $1,500. Last year it sold for $2,500. Which amount is used as the cost figure when recording?

    • Options: 1) $2,000 2) $2,500 3) $1,500

    • Correct answer: 3) $1,500

    • Explanation: The cost principle uses the actual cost to obtain the asset, not its current market value or resale price.

  • Additional concept: In addition to its original cost, you can determine the fair market value of an asset by considering declining value, which is called depreciation.

    • Question from the material: “In addition to its original cost, you could determine the fair market value of an asset by taking into consideration declining value, which is____”

    • Options: 1. Time Period 2. Depreciation 3. Disclosure

    • Correct answer: 2) Depreciation

  • Explanation: Depreciation accounts for the systematic decline in an asset’s value over its useful life.

    Depreciation and Market Value Notes

  • The material emphasizes that fair market value can be estimated through depreciation, not by market price at acquisition.

  • Depreciation is a method to allocate the cost of a tangible asset over its useful life.

Disclosure Principle

  • Definition: The disclosure principle requires accountants to disclose any pertinent information that may affect the full understanding of a company’s financial statements.

  • Information may be presented in the main body of financial statements or in notes accompanying the statements.

  • Governance and standard-setting:

    • Each country has a financial accounting standards board.

    • In the United States, the board is the Financial Accounting Standards Board (FASB).

  • Compliance for public companies:

    • Publicly traded companies must comply with both the Securities and Exchange Commission (SEC) and GAAP requirements.