GAAP and Core Accounting Principles - Study Notes

GAAP Overview

  • Generally Accepted Accounting Principles (GAAP) 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 (ASC) – comparable to the law statute books that attorneys may use as a reference guide.
  • GAAP are established by the Financial Accounting Standards Boards (FASB).
  • Why GAAP is important:
    • An auditor is a professional who conducts an independent examination of accounting records.
    • Part of the job of an auditor is to make sure the financial statements are prepared in conformity with GAAP.
  • Financial statements are written reports that outline or summarize the financial activities of a business.
  • Financial statements include income statements and balance sheets.
  • They are used by investors, banks, and creditors to determine the financial health of the company.
  • To properly compare and evaluate companies and their results, the financial statements must provide similar information in a similar format — that is why GAAP is important.
  • Financial Statements:
    • Are used to determine financial health. For example, a company in good financial health is one who has higher assets than liabilities (i.e., they can easily pay their bills).
    • Provide similar information in a similar format, because if companies simply used their own principles, standards, and formatting of financial statements, then it would be difficult to compare one company with another.
  • Assumptions for GAAP: GAAP is based upon three key assumptions: Business entity, Going concern, and Time period.

Financial Statements

  • Financial statements include the Income Statement and Balance Sheet.
  • They are used to determine financial health and are used by investors, banks, and creditors.
  • To compare and evaluate companies, statements must provide similar information in a similar format.
  • Income Statement:
    • Revenues – Expenses = Net Income
    • The Income Statement is often looked at to see if the company is successful and profitable.
  • Balance Sheet:
    • Assets = Liabilities + Equity
    • The Balance Sheet discloses the state of affairs of the business as of the last date of the accounting period by listing what a company owns (assets) and all the financing methods (liabilities and equity).
  • Companies prepare financial statements at least once a year.
  • Time period concept is key to understanding annual reporting and analysis.

GAAP Assumptions

  • Business Entity:
    • The business functions as a legal and financial entity separate from its owners or any other business.
    • The amounts shown as assets, liabilities, revenues or expenses in the financial statements are for the business alone and do not include personal items of the owner(s).
    • Example: Personal residence of the owner is not reported as an asset; buildings owned by the business are included.
    • Question (from the transcript): Which of the following items should be reported as assets of the business?
    • 1. Delivery truck owned by the business.
    • 2. The payment of the company-supplied cell phone bills for employee use.
    • Answer: C. and D. should be reported as assets of the business.
  • Going Concern:
    • The assumption that the business will operate for the foreseeable future.
    • We can assume that the business will not go bankrupt within the next year.
    • This is important when calculating the value of assets and depreciation.
    • Example context: If a business expects to go bankrupt within a year or two, it cannot use the same depreciation amount because they will not be in business for the entire useful life of the asset.
    • Question (from the transcript): 1. Cars owned personally by the owner. 2. The payment of the electric bill for the owner's vacation home. 3. Delivery truck owned by the business. 4. The payment of the company-supplied cell phone bills for employee use.
    • Answer: 1. Cars owned personally by the owner and 2. The payment of the electric bill for the owner's vacation home should not be reported as assets of the business. (A and B not assets.)
  • Time Period:
    • 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, such as daily, monthly, quarterly, etc.
    • At the end of each accounting period (fiscal period), an income statement and balance sheet are prepared.
    • Income Statement details:
    • The income statement discloses the profit or loss made by the business during an accounting period.
    • Revenues−Expenses=Net Income\text{Revenues} - \text{Expenses} = \text{Net Income}
    • Balance Sheet details:
    • Discloses the state of affairs as of the last date of the accounting period by listing assets, liabilities, and equity.
    • Assets=Liabilities+Equity\text{Assets} = \text{Liabilities} + \text{Equity}
    • Companies prepare financial statements at least once a year.
    • Why divide activities into different time periods (example questions):
    • 1. For each year, a profit or loss amount is needed for income tax purposes.
    • 2. Annual financial statements allow a business to make comparisons year by year.
    • It is implied there may be a quiz item: Accounting Principles ○ No ○ Yes.

Cost Principle and Disclosure Principle (Two main accounting principles)

  • Cost Principle:
    • Purchases must be recorded at their cost price, not at fair market value.
    • The cost figure is the amount that appears on the source document for the transaction.
    • Example: The purchase of a vehicle is recorded at the price paid as shown on the invoice, not the current value.
    • Example: A computer worth $2,000 is purchased at its sale price of $1,500. Last year it sold for $2,500. Which amount would be used as the cost figure when recording this transaction?
    • 1. $2,000
    • 2. $2,500
    • 3. $1,500
    • Answer: 1,5001{,}500
    • In addition to its original cost, you could determine the fair market value of an asset by taking into consideration declining value, which is:
    • 1. Time Period
    • 2. Depreciation
    • 3. Disclosure
    • Answer: Depreciation (2)
  • Disclosure Principle:
    • Requires accountants to disclose any pertinent information that may bear upon the financial statements.
    • Information can be presented in the main body of financial statements or in notes included with the statements.
    • Each country has a financial accounting standards board; in the United States, this is the Financial Accounting Standards Board (FASB).
    • Publicly traded companies must comply with both SEC (Securities and Exchange Commission) and GAAP requirements.

Regulatory Bodies and Standards

  • FASB (Financial Accounting Standards Board) develops and maintains GAAP in the United States and works with boards in other countries to set accounting standards and resolve common problems.
  • Publicly traded companies must comply with both SEC and GAAP requirements.