Vaibhaw Iom Assingn

Assignment on Generally Accepted Accounting Principles – GAAP

Vaibhaw Prakash Mishra S-8, C.S.E. Roll no: 42 Industrial Org. & Mgmt. CUCEK,CUSAT. dt: 10:04:2006

Q. no. 55. Generally Accepted Accounting Principles – GAAP 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. GAAP are imposed on companies so that investors have a minimum level of consistency in the financial statements they use when analyzing companies for investment purposes. GAAP cover such things as revenue recognition, balance sheet item classification and outstanding share measurements. Companies are expected to follow GAAP rules when reporting their financial data via financial statements. If a financial statement is not prepared using GAAP principles, be very wary!

The Accrual Principle :- The Accrual Principle may be called the mother of all accounting principles. It ensures that revenues and expenses are booked (recorded) when earned and incurred and not necessarily when cash is exchanged. The Accrual principle therefore brings into play other important principles such as Revenue Recognition and matching. The company will therefore book revenue when the sale is made (based on the principles of revenue recognition) and will book expenses when incurred and against the revenue it helped to generate the matching principle . Principle of going concern :- The going concern concept is all about the assumption that the business will continue into the foreseeable future. At first glance, this may be considered mundane, however it is important that the going concern status of the business be extremely clear. Where it is known that the business will not continue to operate it should be clearly stated as well. For a business that is not a going concern, the value of the assets will be determined differently than for a going concern. This will therefore affect any analytical review of the accounts. Principle of Entity : - It is important that the accounts of the business be kept separate from the personal accounts of the owners. The business is what is referred to as a separate legal entity and maintains its separate accounts. For those with advanced knowledge in

accounting, you will realize that this applies not only to small companies but to large complicated companies as well. For example, the payment of dividends which is a transaction between the business and its owners (basically the owners withdrawing cash or other assets from the business) is not treated as an expense, but as distribution to owners. Principle of materiality :- Finally the regular straight jacketed accountants get a chance to do their own thing. This principle allows the accountant to ignore generally accepted accounting principles if doing so would not influence the financial position of the company and/or would be costly and difficult to accomplish. Where an entry affects the financial position of the business entity, the entry is considered material and should to be recorded according to GAAP stipulations. Cost Concept :- "Assets are recorded at the price paid to acquire them" . It is

absolutely critical to be constantly aware of this accounting principle. When you look at a balance sheet you are seeing assets valued at their original cost less accumulated depreciation. The "fair market value" of the assets might be significantly higher. For example if you bought land twenty years ago for $20,000 and that land is today worth $300,000, the balance sheet would show $20,000 as the value of that asset. 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. The Conservative Principle:- Accountants are not supposed to be too optimistic or ambitious in their work. In personal life they may well be the most ambitious and optimistic among us, but not at work. Accountants are required to be conservative in their preparation of the books. While the analysis should be as sound as possible, it is always better for an accountant to err on the “low” side. The accountant should be careful therefore not to overstate assets or understate liabilities. Provision for bad debt is a good example of the conservatism principle at work.

The provision is made because it is generally accepted that not all debtors will pay all of what they owe. The accountant will therefore make a deduction for a percentage she/he thinks will not be collected. Consistency Concept : - "For a given type of transaction, the same method is used from one period to another" . Accountants have considerable latitude within "generally accepted accounting practices" in terms of the methods they use to record financial transactions. It is important therefore that they use the same method from one accounting period to another, otherwise the reader of the statements will be looking at "apples and oranges". Accountants can change accounting methods from time to time when there is good justification for a change. However if they do change methods, the change must be highlighted in the financial statements. Double Entry Book keeping : - A business transaction involves an exchange between two accounts. For example, for every asset there exists a claim on that asset, either by those who own the business or those who loan money to the business. Similarly, the sale of a product affects both the amount of cash (or cash receivable) held by the business and the inventory held . Recognizing this fundamental dual nature of transactions, merchants in medieval Venice began using a double-entry bookkeeping system that records each transaction in the two accounts affected by the exchange . In the late 1400's, Franciscan monk and mathematician Luca Pacioli documented the procedure for double-entry bookkeeping as part of his famous Summa work, which described a significant portion of the accounting cycle Double-entry bookkeeping spread throughout Europe and became the foundation of modern accounting. Two notable characteristics of double-entry systems are that 1) each transaction is recorded in two accounts, and 2) each account has two columns. In a double-entry system, two entries are made for each transaction - one entry as a debit in one account and the other entry as a credit in another account. The two entries keep the accounting equation in balance so that:- Asset = liabilities + owner's equality.

Difference between single entry and double entry book keeping : To illustrate, consider a repair shop with a transaction involving repair service performed on Jan 4 for a cash payment of $275.00. In a single-entry bookkeeping system, the transaction would be recorded as follows: Single Entry Example Date

Description

Revenues

Jan 4

Performed repair service

275.00

Expenses

In double entry system transaction will be recorded as follows : Date Jan 4

Accounts Cash Revenue

Debit 275.00

Credit 275.00

A notation may be added to this journal entry to indicate that the revenue was from repair services. Note that two accounts (revenue and cash) are affected by the transaction. If the customer did not pay cash but instead was extended credit, then "accounts receivable" would have been used instead of "cash". In this system, the double entries take the form of debits and credits, with debits in the left column and credits in the right. For each debit there is an equal and opposite credit and the sum of all debits therefore must equal the sum of all credits. This principle is useful for identifying errors in the transaction recording process. Double-entry accounting has the following advantages over single-entry: •

Accurate calculation of profit and loss in complex organizations.

•

Inclusion of assets and liabilities in the bookkeeping accounts.

•

Preparation of financial statements directly from the accounts.

• Easier detection of errors and fraud. To appreciate the importance of double-entry bookkeeping, it is interesting to note that the industrial revolution might not have been possible without it. At that time, businesses increased in size and complexity. Accurate bookkeeping was required for

managers to understand the financial status of their businesses in order to keep them solvent and offer a degree of transparency to investors. While a single-entry system can be adapted by a skilled bookkeeper to meet some of these needs, only a double-entry system provides. The Fundamental Accounting Equation : - The Fundamental Accounting Equation is Capital + Liabilities = Assets. The total idea of accounting is built around an equation which is as good as a mathematical equation called the "Fundamental Accounting Equation". It is a statement of equality between assets and liabilities. For a business assets should and are always equal to its liabilities. Now question arises Is Liabilities = Assets? Yes, the fundamental accounting equation in its true sense should be Liabilities = Assets and it is true even. The explanation for the equation being written as Capital + Liabilities = Assets lies in the separate entity concept. Since owner is also alien to business, the amount that is contributed by the owner towards his capital should also be treated as a liability of the business. But since it is of a special nature and it is a liability which differs from the others in the sense that it takes the maximum amount of risk in the business it would be appropriate always to show it separately. Therefore the liabilities on the LHS of the accounting equation are divided into two as capital and liabilities. Total Liabilities = Total Capital Employed = Owned Capital + Loaned Capital . The total capital employed in the business comes from two sources. One the ownership of the business (which we call owned capital) and two as liabilities (which we call loaned capital) . Since the owners contribution is also to be treated as a liability we can say that total liabilities is equal to total capital. An asset is something capable of being liquidated. eg: Motor Car, Buildings, Land, Furniture etc. Debtors (those who owe us money) are also assets since they are cleared off by paying off (which can be thought of as liquidation of debtors). Goodwill is also an asset is it can also be sold and realised as cash at the time of sale of business. Liquidation is the process of converting something into cash. The greater and faster an assets ability to get converted to cash, the more liquid it is. Cash is the highest liquid

asset as you need no time to convert into cash. Good will of a business is the least liquid asset as it can be realised only when the business is sold.