It is important that you understand the concepts of Generally Accepted Accounting Principles (GAAP), which form the basis of accounting and are part of the language of accounting and business. This chapter will introduce the agencies responsible for standardizing the accounting principles that are used in the United States and it will describe those principles in full detail.
Once you understand these guiding principles, you will have a solid foundation on which to build a complete set of accounting skills. It is useful and necessary that whether an international company is reporting to its stockholders or a proprietor is presenting information to a bank for a loan, these reports follow a consistent set of rules that everyone understands and agrees to.
Who Are the SEC, AICPA, and the FASB? (or What Is This, Alphabet Soup?)
Congress created the Securities and Exchange Commission (SEC) in 1934.At that time, the Commission was given the legal power to prescribe the accounting principles and practices that must be followed by the companies that come within its jurisdiction.
Generally speaking, companies come under SEC regulations when they sell securities to the public, list their securities on any one of the securities exchanges (New York Stock Exchange or American Exchange for example), or when they become greater than a specified size as measured by the firm’s Assets and number of shareholders. Thus, since 1934, the SEC has had the power to determine the official rules of accounting practice that must be followed by almost all companies of any significant size.
Instead, for the most part, the SEC assigned the responsibility of identifying or specifying GAAP to the American Institute of Certified Public Accountants (AICPA). That role has now been transferred to the Financial Accounting Standards Board (FASB). All rulings from the FASB are considered to be Generally Accepted Accounting Principles (GAAP).
The FASB is currently collaborating on a project with the International Accounting Standards Board to make it easier for companies to report financial statements, so that separate statements are not needed for U.S. and international markets.
A firm must adopt the accounting practices recommended by the FASB or the SEC unless they can identify an alternative practice that has “substantial authoritative support.” Even when a company can find “substantia authoritative support” for a practice it uses which differs from the one recommended, the company must include in the financial statement footnotes (or in the auditor’s report) a statement indicating that the practices used are not the ones recommended by Generally Accepted Accounting Principles (GAAP). Where practicable, the company must explain how its financial statements would have been different if the company had used Generally Accepted Accounting Principles.
Generally Accepted Accounting Principles
Financial statements must present relevant, reliable, understandable, sufficient, and practicably obtainable information in order to be useful.
Relevant information is that information which helps financial statement users estimate the value of a firm and/or evaluate how well the firm is being managed. The financial statements must be stated in terms of a monetary unit, since money is our standard means of determining the value of a company.
In the United States, accountants use the stable monetary unit concept, which means that even though the value of the dollar changes over time (due to inflation), the values that appear on the financial statements normally are presented at historical cost. Historical cost presents the information on the financial statements at amounts the individual or company paid for them or agreed to pay back for them at the time of purchase. This method of accounting ignores the effect of inflation. In many other countries throughout the world, the accounting profession does account for inflation.
ALERT! Changes in the Works: As part of the convergence project discussed above, the FASB has started transitioning from the principles of historical cost to fair value. With fair value, the Assets would be shown on the Balance Sheet at what they could be replaced for, or at a value that has been appraised. This normally would be a value higher than the historical cost, or the amount paid for the Asset by the company. Many accountants argue that this value better represents the true value of the Assets on the Balance Sheet.
Not all information about a firm is relevant for estimating its value or evaluating its management. For example, you don’t need the information of how many individuals over forty years of age work for the company, or what color the machinery is painted in order to make financial decisions about a company. Even some financial information is not relevant, like how much money the owner of a corporation has in the bank, the business’s accounting records are kept separate from its owner’s, and the owner’s financial information is irrelevant to the business.
Reliable information is key in accounting. Sufficient and objective evidence should be available to indicate that the information presented is valid. In addition, the information must not be biased in favor of one statement user or one group of users to the detriment of other statement users. The need for reliable information has caused the federal government to pass laws requiring public companies to have their records and financial statements examined (audited) by independent auditors who will make sure that what companies report is accurate.
The need for verifiable information does not preclude the use of estimates and approximation. If you were to eliminate from accounting all estimates, the resulting statements would not be useful primarily because the statements would not provide sufficient information.
The approximations that are used, however, cannot be “wild guesses.” They must be based on sufficient evidence to make the resulting statements a reliable basis for evaluating the firm and its management.One example of a place in the financial statements where we estimate the value is with depreciation. Once we purchase a Long-Term Asset (anything that the company owns that will last longer than one year; for example, a building), we then need to spread the cost of this building over the life of the Asset. This is called depreciation.
In order to do this we must estimate the life of that particular Asset. We can’t know exactly how long that will be, but since we do have experience with these types of Assets, we can estimate the Asset’s life. We assume that the building will be useable for say twenty years and depreciate (or spread) the cost of the building (the Asset) over twenty years (the estimated life).
For example, if we buy this building for $100,000 and assume that it is going to last twenty years, the annual depreciation would be $5,000 per year ($100,000/20). This $5,000 becomes one of the Expenses for the company and is shown on the Income Statement along with the other Expenses.
To be understandable, the financial information must be comparable. Any item on the Balance Sheet that an accountant labels as an Asset or Liability, users of the financial statements should also call Assets and Liabilities.
Statement users must compare financial statements of various firms with one another, and they must compare statements of an individual firm with prior years’ statements of that same firm in order to make valid decisions.
Thus, the accounting practices that a firm uses for a particular transaction should be the same as other firms use for the identical transaction. This practice should also be the same practice the firm used in previous periods. This concept is called Consistency.Together, information that is comparable and consistent becomes understandable to the users of the financial information.
Information is easier to understand and use if it is quantified. Most information that accountants and users of financial information use is represented by numbers. The information that is presented in the financial statements is presented in a numerical form; however, where that is impossible, the information (if it is relevant, reliable, understandable, and practicably obtainable) will be presented in narrative form, usually in a footnote to the statements.
Accountants include narrative information along with the quantifiable information because of the need for adequate or full disclosure; statement users must have sufficient information about a firm.
An example of non-quantifiable information that might be included in the footnotes to the financial statements would be details of an outstanding patent infringement lawsuit against the company, which would be considered a contingent Liability.
Furthermore, to be useful, information must be reasonably easy to obtain. This fits into the concept of cost vs. benefit. The information must be worth more than what it will cost to obtain it and must be secured on a timely basis. Financial statements must be prepared at least once a year (in many cases, quarterly or monthly) and attempting to incorporate unobtainable information could seriously delay these schedules.
An example of obtainable information is the number of shares sold by the corporation during the year. Another example would be the amount of sales by the business during the year.
An example of information that might not be considered obtainable would be the nitty-gritty details of the pension plan systems used in each of the subsidiaries of a multinational corporation. A more reasonable and easily obtainable piece of data might be the total amount of money that is being spent on the company’s pensions
around the world.
The Entity Concept
Financial statements must also present information representing each separate entity. (This idea is called the Entity Concept). In other words, the transactions of each business or person are kept separate from those of other organizations or individuals.
Therefore, the transactions of the subsidiaries of a multinational corporation must all be kept separate from each other. Even though at the end of the year, the records of all of the subsidiaries might be consolidated into one set of financial statements, the records and transactions of each subsidiary are kept separate during the year.
The Going Concern
It is normally assumed that a company will continue in business into the future. This concept is called the Going Concern Principle.
There are several estimates that we make in order to complete the financial statement presentations (for example, depreciation of an Asset over its life), and if we did not assume that the company was going to remain in business in the indefinite future, we could not use this sort of information.
The alternative to the Going Concern Principle is to assume that management plans to liquidate the business. When this is known for sure about a business, a different set of accounting principles and rules are used. In general, when a company liquidates, the Assets of the company will be listed at what they can be sold at rapidly.
This amount will usually be below their values stated on the Balance Sheet, since they will be sold at “fire sale” prices.
Assets normally are not shown on the Balance Sheet at more than either their historical cost or an amount for which they can be sold below historical cost. For example, if a company has Inventory that is listed at a historical cost of $100,000, but due to the economy, the competition, or new technology, is today only worth $8,000, this Asset should be written down and shown on the Balance Sheet at $8,000.
The section on conservatism (page 20) sheds more light on this topic. An example of an exception to this rule is with marketable securities (stocks). These Assets are shown on the Balance Sheet at their current market price.
Alert! Accounting Outside the U.S.: In the United States, for the purpose of preparing financial statements, accountants are not allowed to write up Assets to value higher than the historical cost . This is not true in all countries of the world, where accountants may argue that if you can write down an Asset to reflect “reality,” why not do the same when an Asset increases in value?
Thus, in many countries outside of the United States, the accountants are allowed to write up Assets when they increase in value to reflect “market value,” as well as write them down when the market value is lower than historical cost. This is an important point to keep in mind when reviewing financial statements prepared in companies domiciled outside of the United States
Financial statements’ data must be as simple and concise as possible. An item is considered material when its inclusion or exclusion in the financial statements would change the decision of a statement user. A rule of thumb in accounting might be that any item worth 10 percent of the business’ Net Income is considered material and should be reported in financial statements; there is no firm dollar amount to be followed here.
The important factor to remember is whether the amount in question will change the user’s decision. This concept is called the Materiality Principle. Items that are not material should not be included on the statements separately. If these items were included in the financial statements they would obscure the important items of interest to the reader.
Thus, in some cases, many immaterial items should be grouped together and called “miscellaneous” or the items could be added to other items, so that the total becomes material. That is, the items can be lumped in together with other items that are material and the entire bundle can be considered material.
QUIZ : The owners of a business decide to write up the value of their land, which ten years ago cost $10,000 to purchase and today sits in a prime location of the city and has been appraised at $40,000. Should they value their land on the Balance Sheet at $10,000 or $40,000?
ANSWER : In the United States a company cannot write the value of their Assets above the historical cost of that Asset. The argument is that if they do write the value, it leaves too much room for manipulating the financial statements, which could mislead the users of the financial statements. The practice of writing up Assets, even though accepted in other foreign countries, would violate such generally accepted accounting principles as: 1) conservatism, 2) reliability, and 3) verifiability.
Another traditional practice that accountants use to guide them in preparing financial statements is called Conservatism. Whenever two or more accounting practices appear to be equally suitable to record the transaction under consideration, the accountant should choose the one that results in the lower or lowest Asset figure on the Balance Sheet and the higher or highest Expense on the Income Statement, so as to not be overly optimistic about financial events.
This principle of accounting is highly controversial since while being conservative, we may be violating other generally accepted accounting principles like consistency. In addition, it is often asked,“Why is the lower value better, if the higher value better represents the true value of the Asset?” An example of the Conservatism Principle in action might be in the presentation of Inventory on the Balance Sheet. There are several different generally accepted accounting methods that are allowed to assign a value to Inventory. The accountant should choose the one that presents Inventory at the lowest value so as not to overstate this particular Asset.
The conservatism idea is misused, however, when the accountant chooses a practice that is not as suitable to the situation as an alternative practice merely to report lower Assets and higher Expenses.
American Institute of Certified Public Accountants (AICPA): The professional organization of the Accounting profession. This group has the responsibility to set the ethics regulations for the profession as well as writing and grading the Certification Public Accountants’ Examination (CPA Examination).
Conservatism Principle: Whenever two or more accounting practices appear to be equally suitable to the transaction under consideration, the accountant should always choose the one that results in the lower or lowest Asset figure on the Balance Sheet and the higher or highest Expense on the Income Statement.
Consistency: Practices and methods used for presentation on the financial statements should be the same year to year and process to process. If for any reason the company and their accountants decide to change the method of presentation for any item on the financial statements, they must present a footnote to the financial statements explaining why the methods were changed.
Entity Concept: The principle that requires separation of the transactions of each business or person from those of other organizations or individuals. So for example, when a company is owned by one person, the personal finances of the individual who owns the company are not included on the company’s financial statements. The opposite is also true; the financial information of the company is not included in the financial statements of the individual owner.
Financial Accounting Standards Board (FASB): The FASB sets the accounting standards to be followed for the preparation of financial statements. All rulings from the FASB are considered to be Generally Accepted Accounting Principles (GAAP).
Generally Accepted Accounting Principles (GAAP): A standardized set of accounting rules used in the United States and prescribed by various organizations, like the FASB and the SEC. These rules guide the uniform preparation of financial statements.
Going Concern Principle: This principle assumes that a company will continue in business into the future. Without this assumption most of the accounting information could not be presented in the financial statements since we are always making assumptions (e.g., what is the life of a LongTerm Asset). The only way to make this assumption is to further assume that the business will be in existence into the indefinite future.
Historical Cost Principle: According to this rule, most Assets and Liabilities should be represented on the Balance Sheet at the amount that was paid to acquire the Asset, or for the Liabilities, at the amount that was contracted to be paid in the future. No account is taken for either inflation or changing value of Assets over time.
Materiality Principle: This principle states that an item should only be included on the Balance Sheet if it would change any decisions of a statement user. If, for example, a multimillion-dollar corporation were to donate $100 to a charity, this information would not change any decision that management or an owner would make. However, since corporate money was spent, this distribution of the $100 must be combined with other small expenditures and reported as a “miscellaneous Expense.”
Obtainable Information: Information reported in financial statements must be accessible in a timely manner without an unreasonable expenditure of resources—for example, time, effort, and money—to be included in the financial statements.
Quantifiable Information: Information is easier to understand and use if it is quantified. However, when the information cannot be quantified but is still relevant to the users of the financial statements, it must be shown in the financial statements in narrative form in the footnotes.
Realizable Value Principle: This indicates that Assets should normally not be shown on the Balance Sheet at a value greater than they can bring to the company if sold. If the original historical cost for example is $5,000, and the maximum that the company can sell that Asset for today is $4,000, this Asset should be shown on the Balance Sheet at the lower amount because of this principle.
Relevant Information: Information reported on financial statements must be relevant in that it helps statement users to estimate the value of a firm and/or evaluate the firm’s management. Not all information about a company is relevant to this decision-making process. For example, the number of women versus men currently employed at the company would not be considered relevant, even though it might be important data in other contexts. Thus, this type of information is not included in the financial statements.
Securities and Exchange Commission (SEC): The body created by
Congress in 1934. One of its duties is to prescribe the accounting principles and practices that must be followed by the companies that come within its jurisdiction.
Recognition Principle: This is the process of recording Revenue into the financial statements. Revenue is recorded at the point of the transfer of the merchandise or service, and not at the point of receiving the cash. That means, for example, that once a service is provided for which a charge has been incurred, that service should be shown on the financial statements regardless of whether money has actually changed hands.
Similarly, Expenses are recognized when incurred, not when the money is exchanged for that particular Expense.
Reliable Information: There should be sufficient and objective evidence available to indicate that the information presented is valid.
Separate Entities: See Entity Concept
Stable-Monetary-Unit Concept: Even though the value of the dollar changes over time (due to inflation), the values that appear on the financial statements in the United States are normally presented at historical cost and do not take inflation into account.
Understandable Information: Financial information must be comparable and consistent. If one accountant calls a particular item an Asset, the accountant must follow the set of rules known as generally accepted accounting principles to arrive at the definition of that Asset. Thus, when any user of the financial statements reads these statements, he understands the meaning and classification of the Asset.
Verifiable Information: Information on the financial statements must be based on sufficient evidence that can be substantiated and provides a reliable basis for evaluating the firm and its management.