Question

1. What is Generally Accepted Accounting Principles (GAAP) and how does it affect accounting?

2.   Discuss the concepts and assumptions of GAAP, .

Answer 1

1. Generally Accepted Accounting Priniciples (GAAP) are also known as principles of accounting for the preparation of financial statements.The common set of accounting principles, standards and procedures that companies use to compile their financial statements.
GAAP are a combination of authoritative standards (set by policy boards) and simply the commonly accepted ways of recording and reporting accounting information. These are used by all the companies in the preparation of financial statements. These financial statements are used by investors, bankers, stakeholders and all others who have substantial interest in the business of the company.

In order to have a proper comparison and evaluate the results of various companies, the financial statements of all the companies should in similar format. this can be done with the help of GAAP. Although there is no comprehensive list of generally accepted accounting principles, the structure is based around four key assumptions, four basic principles and four basic constraints.

The Generally accepted accounting principles (GAAP) are varied but based on a few basic principles that must be upheld by all GAAP rules. These principles include consistency, relevance, reliability, and comparability.

Consistency means that all information should be gathered and presented the same across all periods.

Relevance means that the information presented in financial statements (and other public statements) should be appropriate and assist a person evaluating the statements to make educated guesses regarding the future financial state of a company.

Reliability means simply that the information presented in financial statements is reliable and verifiable by an independent party. To ensure the reliability of the financial statements, Audits are made made compulasory for many companies.

Comparability is one of the most important GAAP categories and one of the main reasons having something similar to GAAP is necessary. By ensuring comparability, a company’s financial statements and other documentation can be compared to similar businesses within its industry.

Accountants use generally accepted accounting principles (GAAP) to guide them in recording and reporting financial information. Before implementaion of GAAP, every company prepare financial statements considering its own assumptions, principles & Standards.

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.

2. Concepts and assumptions of GAAP :

Concepts and Assumptions of GAAP:

The four basic assumptions of GAAP are going concern, business entity, monetary unit and time principle unit.

a. The Business Entity Concept

The business entity concept provides that the accounting for a business or organization be kept separate from the personal affairs of its owner, or from any other business or organization. This means that the owner of a business should not place any personal assets on the business balance sheet. The balance sheet of the business must reflect the financial position of the business alone. Also, when transactions of the business are recorded, any personal expenditures of the owner are charged to the owner and are not allowed to affect the operating results of the business.

b.The Going Concern Concept

The continuing concern concept assumes that a business will continue to operate, unless it is known that such is not the case. The values of the assets belonging to a business that is alive and well are straightforward. For example, a supply of envelopes with the company's name printed on them would be valued at their cost. This would not be the case if the company were going out of business. In that case, the envelopes would be difficult to sell because the company's name is on them. When a company is going out of business, the values of the assets usually suffer because they have to be sold under unfavourable circumstances. The values of such assets often cannot be determined until they are actually sold.

c.The Principle of Conservatism

The principle of conservatism provides that accounting for a business should be fair and reasonable. Accountants are required in their work to make evaluations and estimates, to deliver opinions, and to select procedures. They should do so in a way that neither overstates nor understates the affairs of the business or the results of operation.

d.The Objectivity Principle

The objectivity principle states that accounting will be recorded on the basis of objective evidence. Objective evidence means that different people looking at the evidence will arrive at the same values for the transaction. Simply put, this means that accounting entries will be based on fact and not on personal opinion or feelings.

e.The Time Period Concept

The time period concept provides that accounting take place over specific time periods known as fiscal periods. These fiscal periods are of equal length, and are used when measuring the financial progress of a business.

f.The Revenue Recognition Convention

The revenue recognition convention provides that revenue be taken into the accounts (recognized) at the time the transaction is completed. Usually, this just means recording revenue when the bill for it is sent to the customer. If it is a cash transaction, the revenue is recorded when the sale is completed and the cash received.

It is important to take revenue into the accounts properly. If this is not done, the earnings statements of the company will be incorrect and the readers of the financial statement misinformed.

g.The Matching Principle

The matching principle is an extension of the revenue recognition convention. The matching principle states that each expense item related to revenue earned must be recorded in the same accounting period as the revenue it helped to earn. If this is not done, the financial statements will not measure the results of operations fairly

h.The Cost Principle

The cost principle states that the accounting for purchases must be at their cost price. This is the figure that appears on the source document for the transaction in almost all cases. There is no place for guesswork or wishful thinking when accounting for purchases. The value recorded in the accounts for an asset is not changed until later if the market value of the asset changes. It would take an entirely new transaction based on new objective evidence to change the original value of an asset.

i.The Consistency Principle

The consistency principle requires accountants to apply the same methods and procedures from period to period. When they change a method from one period to another they must explain the change clearly on the financial statements. The readers of financial statements have the right to assume that consistency has been applied if there is no statement to the contrary. The consistency principle prevents people from changing methods for the sole purpose of manipulating the figures of financial statements.

j.The Materiality Principle

The materiality principle requires accountants to use generally accepted accounting principles except when to do so would be expensive or difficult, and where it makes no real difference if the rules are ignored. If a rule is temporarily ignored, the net income of the company must not be significantly affected, nor should the reader's ability to judge the financial statements be impaired.

k.The Full Disclosure Principle

The full disclosure principle states that any and all information that affects the full understanding of a company's financial statements must be include with the financial statements. Some items may not affect the ledger accounts directly. These would be included in the form of accompanying notes. Examples of such items are outstanding lawsuits, tax disputes, and company takeovers.

ASSUMPTIONS OF GAAP: