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GAAP: Understanding It and the 10 Key Principles

Par  • Le 30 novembre 2022 à 12:31 • Catégorie : Non classé

It will also prepare adjusting entries for expenses that occurred but were not paid. Accountants often cite the going-concern assumption to justify using historical costs rather than
market values in measuring assets. Market values are of less significance to an entity using its assets
rather than selling them. On the other hand, if an entity is liquidating, it should use liquidation values
to report assets. For instance, a large business
(such as General Motors Corporation) may consist of several separate corporations, each of which is a
separate legal entity.

  • Let’s say there were a credit of $4,000 and a debit of $6,000 in the Accounts Payable account.
  • Hence, the assessment of reliability for the accounting record is one of the essential objectives of the auditor.
  • The International Financial Reporting Standards (IFRS) is the most common set of principles outside the United States.
  • In that situation, they might provide specially-designed non-GAAP metrics, in addition to the other disclosures required under GAAP.
  • Companies that record their financial activities in currencies experiencing hyper-inflation will distort the true financial picture of the company.
  • It also means that financial statements can be prepared for a group of separate legal corporations that are controlled by one corporation.

The two standards treat inventories, investments, long-lived assets, extraordinary items, and discontinued operations, among others. If a financial statement is not prepared using GAAP, investors should be cautious. Without GAAP, comparing financial statements of different companies would be extremely difficult, even within the same industry, making an apples-to-apples comparison hard. Some companies may report both GAAP and non-GAAP measures when reporting their financial results. GAAP regulations require that non-GAAP measures be identified in financial statements and other public disclosures, such as press releases. It is often compared with the International Financial Reporting Standards (IFRS), which is considered more of a principles-based standard.

Introduction to Accounting Principles

The accounting equation can be thought of from a “sources and claims” perspective; that is, the assets (items owned by the organization) were obtained by incurring liabilities or were provided by owners. Stated differently, everything a company owns must equal everything the company owes to creditors (lenders) and owners (individuals for sole proprietors or stockholders what is form 1120 for companies or corporations). Revenues are to be recognized (reported) on a company’s income statement when they are earned. Therefore, a company will report some revenues on its income statement before a customer pays for the goods or services it has received. In the case of cash sales, revenues will be reported when customers pay for their merchandise.

The revenue recognition principle directs a company to recognize revenue in the period in which it is earned; revenue is not considered earned until a product or service has been provided. This means the period of time in which you performed the service or gave the customer the product is the period in which revenue is recognized. Remember, the entire point of financial accounting is to provide useful information to financial statement users. If everyone reported their financial information differently, it would be difficult to compare companies. Accounting principles set the rules for reporting financial information, so all companies can be compared uniformly. Consistency Principle – all accounting principles and assumptions should be applied consistently from one period to the next.

The cost becomes the basis for the accounts during the acquisition and subsequent accounting periods. Application of time period assumption enables companies to divide their financial information into specific periods. This helps them to study the pattern of financial performance and to set an appropriate action if required.

Finally – the period concept also means that businesses should only include transactions from that period when preparing the financial statements. You can’t include any transactions from a future period, or one in the past that has already been reported on (otherwise you’d have double counting). The going concern assumption assumes a business will continue to operate as normal in the foreseeable future. ‘Operate as normal’ means that the business will have sufficient funds from revenue to pay their expenses and debts as they fall due. The ‘foreseeable future’ is quite an uncertain time period, but in most countries – this is prescribed to be twelve months. A company that is failing to repay bank loans and experiencing declining sales is likely to NOT be a going concern.

The going concern assumption assumes a business will continue to operate in the foreseeable future. However, one should presume the business is doing well enough to continue operations unless there is evidence to the contrary. For example, a business might have certain expenses that are paid off (or reduced) over several time periods.

How does IFRS differ from GAAP?

It also would leave stakeholders unable to make
financial decisions, because there is no comparability measurement
between companies. This concept ignores any change in the
purchasing power of the dollar due to inflation. In applying their conceptual framework to create standards, the
IASB must consider that their standards are being used in 120 or
more different countries, each with its own legal and judicial
systems.

Full Disclosure Principle

The board comprises seven full-time, impartial members, ensuring that it works for the public’s best interest. The Governmental Accounting Standards Board (GASB) estimates that about half of the states officially require local and county governments to adhere to GAAP. This group determined that the APB must be dissolved and a new standard-setting structure created.

These disclosures are usually recorded in footnotes on the statements, or in addenda to the statements. The full disclosure principle states that a business must report any business activities that could affect what is reported on the financial statements. There also does not have to be a correlation between when cash is collected and when revenue is recognized.

Expense Recognition (Matching) Principle

The « matching » accounting principle says that you should record revenue and expenses related to revenue at the same time to reveal any cause-and-effect relationships between income and purchases. For example, let’s say you pay a commission to a salesperson for a sale that you record in March. The consistency accounting principle says that once you choose an accounting method (accrual or cash), you should stick with it for all future financial records. This allows you to accurately compare performance in different accounting periods. Many companies support non-GAAP reporting because it provides an in-depth look at their financial performance.

The Purpose of Accounting Principles

As
you know from
Introduction to Financial Statements, each of these
categories, in turn, includes many individual accounts, all of
which a company maintains in its general ledger. A general
ledger is a comprehensive listing of all of a company’s
accounts with their individual balances. The IASB and the FASB have been working on the convergence of IFRS and GAAP since 2002. Due to the progress achieved in this partnership, the SEC, in 2007, removed the requirement for non-U.S.

The content
of these financial statements reports only on the activities, resources, and obligations of that entity. This concept is important when valuing a transaction for which
the dollar value cannot be as clearly determined, as when using the
cost principle. Conservatism states that if there
is uncertainty in a potential financial estimate, a company should
err on the side of caution and report the most conservative amount. This would mean that any uncertain or estimated expenses/losses
should be recorded, but uncertain or estimated revenues/gains
should not. This gives stakeholders a more reliable view of the company’s
financial position and does not overstate income. Critics of principles-based accounting systems say they can give companies far too much freedom and do not prescribe transparency.

Due to the thorough standards-setting process of the GAAP policy boards, it can take months or even years to finalize a new standard. These wait times may not work to the advantage of companies complying with GAAP, as pending decisions can affect their reports. These standards may be too complex for their accounting needs, and hiring personnel to create GAAP definition reports can be expensive. As a result, the FASB works with the Private Company Council to update GAAP with private company exceptions and alternatives.

Objectivity Principle – financial statements, accounting records, and financial information as a whole should be independent and free from bias. The financial statements are meant to convey the financial position of the company and not to persuade end users to take certain actions. Conservatism Principle – accountants should always error on the most conservative side possible in any situation. This prevents accountants from over estimating future revenues and underestimated future expenses that could mislead financial statement users.

Accountants are expected to fully disclose and explain the reasons behind any changed or updated standards in the footnotes to the financial statements. The ultimate goal of GAAP is to ensure a company’s financial statements are complete, consistent, and comparable. This makes it easier for investors to analyze and extract useful information from the company’s financial statements, including trend data over a period of time. GAAP helps govern the world of accounting according to general rules and guidelines. It attempts to standardize and regulate the definitions, assumptions, and methods used in accounting across all industries.


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