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 Expenses
Jan 4 Performed repair service 275.00

In double entry system transaction will be recorded as follows :

Date Accounts Debit Credit

Jan 4 Cash 275.00
Revenue 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.