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The general rules that apply to financial statements distributed by a US company to external users are called
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Since 1973, US GAAP has been developed and maintained by the Financial Accounting Standards Board (FASB), a non-governmental, not-for-profit organization. In 2009, the FASB became operational
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, which he continues to update. This electronic database contains the official accounting standards (equivalent to several thousand printed pages) that apply to the financial statements of US companies and nonprofit organizations.[There is also the International Accounting Standards Board (IASB), which issues International Financial Reporting Standards (IFRS), which we will not discuss.]
In addition to GAAP, US corporations whose capital is traded on the stock exchange must also comply with the rules
Which are based on complex and detailed accounting standards. Examples include historical cost, revenue recognition, full disclosure, materiality and consistency.
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We then consider the impact of these key principles and concepts on the company’s financial statements, such as:
The following table provides an overview of the efforts of accountants to develop US GAAP (
Some of the accounting principles in the Accounting Research Bulletins remain valid today and are included in the Codification of Accounting Standards. However, due to the complexity and sophistication of today’s global business and finance, GAAP has become broader and more detailed.
Our focus is on basic, fundamental principles and concepts and their relevance to business financial reporting.
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Taking over an economic entity enables the accountant to manage the business of the sole proprietor separately from the personal business of the sole proprietor.
It also means that it is possible to prepare financial statements for a group of separate legal entities controlled by a single company. This group of general companies is called an economic entity. A set of financial statements that report on the combined activities of a group are called consolidated financial statements.
For US companies, the currency assumption allows accountants to express a wide range of company assets in dollars. In addition, it is assumed that the US dollar does not lose its purchasing power over time. As a result, the accountant combines the $10,000 spent on the land in 1960 with the $300,000 spent on a similar adjacent piece of land in 2021. As a result, the total value of the two parcels on the company’s balance sheet will be $310. , 000.
The going concern assumption means that the accountant believes that the company will not be liquidated in the foreseeable future. In other words, the company will be able to operate long enough to meet its obligations. As a result, the accountant can continue to report most assets at their original cost and can defer some expenses to future periods.
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If the business is not considered to be going concern (meaning the business will not be able to continue as a going concern), it must be liquidated and the liquidation value will be the appropriate amount.
Accountants believe that the ongoing complex business operations and financial results of a company can be broken down into different time periods such as months, quarters and years.
To report the company’s net income for each month, the company will prepare adjusting entries to record each month’s portion of expenses for depreciation, property taxes, insurance, etc. It will also prepare adjusting entries for expenses incurred but not paid. Examples include repairs, interest, utilities, etc.
The cost principle (historical cost principle) means that the accountant will record transactions in the monetary (or equivalent) amount at the time of the transaction. As a result, the company’s most valuable asset is not recorded or reported. Examples include company brands, a talented team of researchers, unique website domain names, search engine rankings, etc.
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With the exception of certain marketable investment securities, the recorded value of the asset generally will not change due to inflation or market fluctuations.
The principle of full disclosure requires a company to provide enough information to enable a reasonable user to make an informed decision. Because of this principle, a company’s financial statements will include many disclosures and schedules
. Therefore, the company will report some revenue on the income statement before the customer pays for the goods or services received. For cash sales, revenue will be reported when customers pay for their products. If customers pay in advance, revenue will be recognized (reported) when the money is received.
For example, if an insurance company receives $12,000 in coverage for 2022 on December 28, 2021, the insurance company will report $1,000 in revenue for each of the 12 months in 2022.
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The ideal way of recognizing (showing) expenses in the income statement is based on cause and effect. For example, if a company sells 5,000 units of Product X, it must report the cost of the 5,000 units on the same income statement as the sales revenue. (Since cost of goods sold can be as much as 60% of sales, it is critical that cost of goods sold be accurately calculated.)
If the cause-and-effect relationship is not clear, the costs are shown in the accounting period when the costs are exhausted. For example, equipment with a 10-year life of $120,000 would be billed at $1,000 per month.
If none of the above is logical, the expense is recognized in the accounting period in which the expense was incurred. Examples are advertising costs, research costs, salary costs and many others.
The concept of materiality means that an accounting principle can be disregarded if the amount is insignificant. For example, large companies usually have a policy of immediately depreciating cheap equipment, rather than depreciating it over its useful life, which may be 5 years.
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Materiality also allows a medium-sized company to report amounts in its financial statements to the nearest thousand dollars.
If a business has two acceptable ways to record and/or report a transaction, conservatism forces the accountant to choose the alternative that results in lower net income or lower total assets. An accountant must be objective, but when in doubt, conservative
From period to period. If the change is justified, the change must be disclosed in the financial statements.
Means that the user can compare the financial statements of one company with the financial statements of another company in the same industry. Comparability is enhanced by the requirement to use generally accepted accounting principles.
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In order to be relevant, financial statements must be issued as soon as possible after the end of the reporting period. In other words, relevance is enhanced by timeliness.
Accountants are expected to be objective (impartial). Many companies need to audit their financial statements to provide users with objectivity and reliability of the amounts.
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The concept of full disclosure accounting requires that all information relevant to the user of the financial statements be disclosed. This accounting constraint allows irrelevant and irrelevant information to be omitted or combined with other financial information.
Accounting constraints related to prudence or conservatism mean that all potential losses are accounted for in the financial statements, but not all potential gains.
The accounting assumptions and concepts used in the preparation of the financial statements must be applied consistently from year to year. This allows users to make meaningful comparisons.
The costs of applying an accounting concept should not exceed the benefits derived from it. If the cost exceeds the benefit, then this concept needs to be changed.
The Importance Of Generally Accepted Accounting Principles (gaap)
The constraints are part of a framework established by an agreed set of principles, as shown in the diagram below:
Chartered Accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for over 25 years, creating financial models for all types of industries. He was the financial director or controller of small and medium-sized companies
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