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G.A.A.P.
GENERALLY ACCEPTED ACCOUNTING PRINCIPLES
Objectives
Identify and describe:
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Business Entity
Conservatism
Consistency
Cost
Full Disclosure
Matching
Materiality
Monetary Unit
Time Period
Identify revenue recognition methods and their impact on reported net income
◦ Point of Sale
◦ Installment Sales
◦ Percentage of Completion
Business Entity
Financial accounting is based on the premise that the transactions and balances of a business
entity are to be accounted for separately from its owners.
The business entity is therefore considered to be distinct from its owners for the purpose of
accounting.
Therefore, any personal expenses incurred by owners of a business will not appear in the
income statement of the entity.
Business Entity
Similarly, if any personal expenses of owners are paid out of assets of the entity, it would be
considered to be drawings for the purpose of accounting much in the same way as cash
drawings.
Example:
◦ Owner of a business pays the rent on her personal home from her business account.
◦ She should pay back the rent and take away from owner’s equity/withdrawls
◦ Owner of a business buys a new computer system for the business with their personal credit card.
◦ This should be listed as a business expense and be reimbursed by the business.
Conservatism
The general concept of recognizing expenses and liabilities as soon as possible when there is
uncertainty about the outcome, but to only recognize revenues and assets when they are
assured of being received.
Thus, when given a choice between several outcomes where the probabilities of occurrence are
equally likely, you should recognize that transaction resulting in the lower amount of profit, or at
least the deferral of a profit.
Similarly, if a choice of outcomes with similar probabilities of occurrence will impact the value of
an asset, recognize the transaction resulting in a lower recorded asset valuation.
Conservatism
Under the conservatism principle, if there is uncertainty about incurring a loss, you should tend
toward recording the loss.
Conversely, if there is uncertainty about recording again, you should not record the gain
The conservatism principle can also be applied to recognizing estimates.
The conservatism principle is the foundation for the lower of cost or market rule.
Consistency Principle
The consistency principle states that, once you adopt an accounting principle or method,
continue to follow it consistently in future accounting periods.
Only change an accounting principle or method if the new version in some way improves
reported financial results.
If you make such a change, fully document its effects and include this documentation in the
notes accompanying the financial statements.
Cost Principle
The cost principle is the general concept that you should initially record an asset, liability, or
equity investment at its original acquisition cost.
The principle is widely used to record transactions, partially because it is easiest to use the
original purchase price as objective and verifiable evidence of value.
A variation on the concept is to allow the recorded cost of an asset to be lower than its original
cost, if the market value of the asset is lower than the original cost.
Cost Principle
However, this variation does not allow the reverse - to revalue an asset upward.
Thus, this lower of cost or market concept is a conservative view of the cost principle.
Full Disclosure Principle
The full disclosure principle states that you should include in an entity's financial statements all
information that would affect a reader's understanding of those statements.
The interpretation of this principle is highly judgmental, since the amount of information that
can be provided is potentially massive.
To reduce the amount of disclosure, it is customary to only disclose information about events
that are likely to have a material impact on the entity's financial position or financial results.
Full Disclosure Principle
This disclosure may include items that cannot yet be precisely quantified, such as the presence
of a dispute with a government entity over a tax position, or the outcome of an existing lawsuit.
Full disclosure also means that you should always report existing accounting policies, as well as
any changes to those policies (such as changing an asset valuation method) from the policies
stated in the financials for a prior period.
Full Disclosure Principle
Several examples of full disclosure are:
◦ The nature and justification of a change in accounting principle
◦ The nature of a non-monetary transaction
◦ The nature of a relationship with a related party with which the business has significant transaction
volume
◦ The amount of encumbered assets
◦ The amount of material losses caused by the lower of cost or market rule
◦ A description of any asset retirement obligations
◦ The facts and circumstances causing goodwill impairment
Matching Principle
The matching principle is one of the cornerstones of the accrual basis of accounting.
Under the matching principle, when you record revenue, you should also record at the same
time any expenses directly related to the revenue.
Thus, if there is a cause-and-effect relationship between revenue and the expenses, record them
in the same accounting period.
Matching Principle
Here are several examples of the matching principle:
◦ Commission. A salesman earns a 5% commission on sales shipped and recorded in January. The
commission of $5,000 is paid in February. You should record the commission expense in January.
◦ Depreciation. A company acquires production equipment for $100,000 that has a projected useful life of
10 years. It should charge the cost of the equipment to depreciation expense at the rate of $10,000 per
year for ten years.
◦ Employee bonuses. Under a bonus plan, an employee earns a $50,000 bonus based on measurable
aspects of her performance within a year. The bonus is paid in the following year. You should record the
bonus expense within the year when the employee earned it.
◦ Wages. The pay period for hourly employees ends on March 28, but employees continue to earn wages
through March 31, which are paid to them on April 4. The employer should record an expense in March
for those wages earned from March 29 to March 31.
Materiality Principle
The materiality principle states that you are allowed to ignore an accounting standard if the net
impact of doing so has such a small impact on the financial statements that a reader of the
financial statements would not be misled.
Under generally accepted accounting principles (GAAP), you do not have to implement the
provisions of an accounting standard if an item is immaterial.
This definition does not provide definitive guidance in distinguishing material information from
immaterial information, so you must exercise judgment in deciding if a transaction is material.
(It’s kind of relative)
Monetary Unit Principle
The monetary unit principle states that you only record business transactions that can be
expressed in terms of a currency.
Thus, a company cannot record such non-quantifiable items as employee skill levels, the quality
of customer service, or the ingenuity of the engineering staff.
Time Period Principle
The time period principle is the concept that a business should report the financial results of its
activities over a standard time period, which is usually monthly, quarterly, or annually.
Once the duration of each reporting period is established, use the guidelines of Generally
Accepted Accounting Principles or International Financial Reporting Standards to record
transactions within each period.
You must include in the header of a financial statement the time period covered by the
statement.
For example, an income statement or statement of cash flows may cover the "Eight Months
ended August 31."
However, the balance sheet is dated as of a specific date, rather than for a range of dates.
Thus, a balance sheet header might state "as of August 31."
Point of Sales
Collection probability- If it is not possible to make a reasonable estimate of the amount of the
allowance for doubtful accounts, then do not recognize a sale until it is possible to do so.
◦ If you are uncertain of the collection of cash from a sale transaction, defer sale recognition until
payment has been received.
Delivery is complete- Ownership of the goods must have shifted to the buyer, as well as the risks
of ownership.
◦ The buyer must also have accepted the goods.
◦ The SEC does not like bill and hold transactions, and only allows them under restricted circumstances.
Point of Sales
Persuasive evidence of an arrangement- The substance of a transaction (and not just its form)
should indicate that a sale transaction has indeed taken place.
◦ For example, the consignment of goods does not constitute a sale until the consignee sells the goods to
a third party.
◦ The SEC specifically points out that the transfer of goods solely for demonstration purposes is not an
actual sale, nor is a transfer when the "seller" is obligated to take the goods back at a specific price, or
when the "buyer" has no obligation to pay for the received items.
Point of Sales
The price can be determined- The buyer no longer has the contractual right to unilaterally
terminate the contract and be paid back for any amounts already paid.
◦ If the price to be paid is contingent on a future event, then you must wait for that event before
recognizing the sale.
◦ Also, if it is not possible to reasonably estimate the amount of any customer returns, then you must
wait for more certainty regarding this item before recognizing the sale.
Installment Sales
Many companies allow their credit customers to make periodic payments over several months
Under the installment method, only the gross profits on those sales for which cash payment has
been received are recognized.
All gross profits associated with uncollected receivables are parked on the balance sheet as an
offset to receivables, where they remain until customer payments are received
Referred to as installment accounts receivable
◦ Amounts owed by customers from credit sales for which payment is required in periodic amounts over
an extended time period
◦ Customer is usually charged interest
◦ Example
◦ Buying a car or getting a mortgage
Percentage of Completion
Involves ongoing recognition of revenue and income related to longer-term projects.
By doing so, the seller can recognize some gain or loss related to a project in every accounting
period in which the project continues to be active.
The method works best when it is reasonably possible to estimate the stages of project
completion on an ongoing basis, or at least to estimate the remaining costs to complete a
project.
Percentage of Completion
The percentage of completion method allows you to recognize as income that percentage of
total income that matches the percentage of completion of a project