ACCT 101 – Professor Farina Lecture Notes – Chapter 1 Introducing Accounting in Business GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP) What is GAAP? In the United States, GAAP is a set of rules and standards that guide accountants as to when and ho w to properly record transactions and prepare financial statements. GAAP is not like the laws of physics. GAAP is designed to meet the needs of society. GAAP is always evolving as the economic environment changes. Also, GAAP only refers to rules of accounting in the United States. Different countries have different rules for different purposes. Broad GAAP There are a few broad GAAP principles that provide general guidance and that apply to all types of transactions. These are fundamental accounting rules. These are like general traffic laws. Some of these are discussed below. Specific GAAP Specific GAAP rules offer specific direction for important kinds of specific situations. As you continue your study of accounting and learn how to record specific types of transactions, you will be learning specific GAAP rules. Examples of some specific GAAP rules are: how uncollectible accounts receivable should be recorded acceptable methods for calculating inventory cost how interest should be calculated on certain kinds of debt Where does GAAP come from? There is no single source or listing of GAAP. There are a number of different sources, some more important than others. Official Pronouncements: An official pronouncement is a formal and authoritative document issued by the Financial Accounting Standards Board (FASB), which is the highest standard-setting authority in accounting. The FASB is an independent organization that derives its authority from the Federal Securities and Exchange Commission and the fact that all state licensing boards for accountants accept the FASB pronouncements as highest authority. The pronouncements of the FASB are called Statements of Financial Accounting Standards (SFAS). An SFAS prescribes how certain kinds of transactions must be recorded and presented. It is the highest authoritative directive. FASB Technical Guides: The next level below an SFAS is a technical guide, usually dealing with narrow or very specific subject matter. 1 Examples: ----FASB Technical Bulletins ----AICPA (American Institute ----EITF (Emerging Issues Task Force) Positions and Recommendations Industry Practice: Industry practice is a source of GAAP. Historically, some industry practices have achieved wide acceptance over many years. Sometimes this has created conflict and a lack of consistency within GAAP, because the practices serve the purposes of different groups. This process continues today, to a diminished degree. Other Accounting Literature: Research publications by educators, journal articles, textbooks, professional association publications, and AICPA technical practice aids are examples of this source of GAAP. These are the least authoritative GAAP sources. FOUR IMPORTANT BROAD GAAP PRINCIPLES Reliability principle An important qualitative characteristic of information is that it must be reliable. In order for this to happen, accountants must follow the reliability principle. This principle requires that accountants record only that information into the accounting system which can be verified by objective evidence. Examples of objective evidence are documents such as receipts, invoices, canceled checks, bank statements, and verified measurements such as physical counts of merchandise inventories. Estimates are often required in the accounting process.This is an especially tricky and difficult problem. To conform to the reliability principle in these situations, the accountant must take extra effort to demonstrate that the estimate is free of bias, was made by a qualified and completely independent person, and conforms as closely as possible to known objective evidence. Cost principle The “cost principle” is also called the “historical cost principle.” The cost principle requires that all transactions be recorded at original (historical) cost. They must also be stored in the records and presented on the financial statements at historical cost. Historical cost is what was paid or charged for something. Example: Land purchased for $50,000 10 years ago and worth $200,000 today is shown on the balance sheet at a cost of $50,000. Exceptions to historical cost: there are certain exceptions to the cost principle. One of those is accounting for investments in stocks. Current GAAP requires investments to be recorded at cost, but adjusted to market value. 2 Revenue recognition principle The “revenue recognition principle” requires that accountants only record revenue when it is earned. As a general rule, revenue from the sale of goods or services is considered earned when all three of the following conditions are satisfied: The seller has delivered the correct service or product. The amount of revenue is measurable. The buyer can reasonably be expected to pay. The revenue recognition principle is particularly important because many businesses are often too eager to prematurely record revenues in order to show net income at a higher number. The revenue recognition principle is the accountant’s guideline when confronting these situations. Matching principle Businesses must incur expenses in order to generate revenue. The “matching principle” requires accountants to identify which expenses have helped to generate revenues, and then “match” those expenses with revenue in the same accounting principle. We will learn more about this when you study adjusting entries. TIP: Don’t confuse “cost” with expense.” The word “cost” means the expenditure of money or other resources to acquire an asset. For example, if a business spends $3,500 to purchase supplies, it has expended money and the cost is $3,500. If the cost is used up in the process of generating business revenues, then the cost becomes an “expense.” So, if $500 worth of the supplies is used up, then $500 of the cost becomes $500 of “Supplies Expense.” In practice, the words “cost” and “expense” are often used interchangeably, and you have to be careful about their intended meanings. ACCOUNTING ASSUMPTIONS Basic conditions Underlying assumptions are the most basic conditions that must exist before GAAP can be applied. If these conditions do not exist, accounting as we know it cannot be used. Underlying assumptions are the “foundation” of the operating guidelines. 3 MODIFYING CONSTRAINTS Modifying constraints are rules that are used to make sure that GAAP rules are applied sensibly, and not in some arbitrary way that would result in undesirable outcomes. Materiality: GAAP need not be followed if an item is immaterial. Information is material if it can effect a decision made by a user of the financial statements. For example, the purchase of a pencil sharpener by Cerritos College may be charged to expense, rather than recorded as equipment (asset), as the amount of the purchase is not significant. Conservatism: When two alternatives equally satisfy GAAP requirements, select the least favorable alternative. Cost/benefit: The cost of providing specific information should not exceed the benefits to the users of it. Monetary unit assumption: Transactions are expressed in monetary amounts (i.e., the US dollar). Time period assumption: accounting reports are prepared according to time periods. For example the income statement is prepared annually, or quarterly. Going-concern assumption: The business issuing financial statements is expected to continue operating indefinitely. Business entity assumption: A business is accounted for separate from its owners. SARBANES-OXLEY (SOX) Congress passed SOX to curb financial abuses of publicly-held companies. SOX makes it a violation of law if such companies do not apply stringent financial and internal controls. Chief Executive Officer s and Chief Financial Officers now must sign statements accompanying the annual report to stockholders that internal controls are effective. These officers face imprisonment, and fines, if found to have signed these statements falsely. 4 RULES OF DEBIT AND CREDIT FOR CORPORATIONS CATEGORY ACTION DEBIT CREDIT Assets Increase X Decrease X Liabilities Increase X Decrease X Equity Capital Stock: X increase Retained Earnings: X Increase Retained Earnings: X Decrease Dividends: Increase X Revenues Increase X Expenses Increase X The Capital Stock account shows investments by the owners, now called stockholders or shareholders. The Retained Earnings account accumulates all net income earned, less all dividends paid, since the business started operations. The Dividends account takes the place of the Owner, Drawing account used by sole proprietorship business. 5
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