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Rules and regulations are a part of life for everyone, including those in the accounting industry. In this lesson, you will learn about GAAP standards, what they mean to accounting, and who establishes them.
Hi there! Let me introduce myself. My name is GAAP, and I am an accounting superhero! I bet you wonder why, don't you? If you'll give me a few minutes of your undivided attention, I'll not only explain to you why I'm an accounting superhero, but I'll also give you a brief history of myself. I'll even go so far as to introduce you to some acquaintances of mine - SEC, FASB, and IASB. Are you ready?
First of all, I should tell you that GAAP is actually my nickname. My full name is Generally Accepted Accounting Principles. My name refers to a specific set of guidelines that have been established to help publicly-traded companies create their financial statements. Publicly-traded companies are companies that have made stock in their organization available for sale to the public. Unlike some superheroes that are made up of plutonium and kryptonite, I am made up of 10 basic accounting principles. They are:
Let's take a minute to look at what each of my parts mean:
The economic entity assumption means that any activities of a business must be kept separate from the activities of the business owner.
The monetary unit assumption means that only activities that can be expressed in dollar amounts can be included in accounting records.
The time period assumption means that business activities can be reported in distinct time intervals. These intervals may be in weeks, months, quarters, or in a fiscal year. Whatever the time period is, it must be identified in the financial statement dates.
The cost principle refers to the historical cost of an item that is reported on the financial statements. Historical cost is the amount of money that was paid for an item when purchased and is not changed to account for inflation.
The full disclosure principle means that all information that is relative to the business be reported either in the content of the financial statements or in the notes to the financial statements.
The going concern principle refers to the intent of a business to continue operations into the foreseeable future and not to liquidate the business.
The matching principle refers to the manner in which a business reports income and expenses. This principle requires that businesses use the accrual form of accounting and match business income to business expenses in a given time period. For example, a sales expense should be recorded in the same accounting period that sales income was made.
The revenue recognition principle addresses the manner in which revenue, or income, is recognized. This standard requires that revenue be reported on the income statement in the period in which it is earned.
The materiality principle refers to the measure of importance of a misstatement in accounting records. For example, if the price of an asset is understated by $10.00, will that misstatement have enough effect on the financial statements to matter? This is a gray area in accounting standards that requires professional judgment to be used.
The last principle that makes me up is conservatism. Conservatism is the principle that calls for potential expenses and liabilities to be recognized immediately if you are unsure whether they will actually occur or not, but potential revenue not to be recognized until it is actually received.
Now that you know what I am made of, let's talk about why I was created. Way back in 1929, a significant event in American history occurred. It was called the Stock Market Crash of 1929, and it affected not only those people who had placed their hard-earned money into corporate stocks and bonds but also every single person in America. The 1929 stock market crash was a precursor to one of the hardest economic times that has ever been known, the Great Depression.
During this time, many people lost faith in the stock market and in the American economy. The government decided that there needed to be some way to rebuild that lost faith, and so, in the early 1930s, the Securities and Exchange Commission (SEC) was created.
The purpose of the SEC was to regulate financial practices among publicly-traded companies. In 1934, the SEC asked for assistance from the American Institute of Accountants, or the AIA, in examining the formation of financial statements. Two years later, in a report on financial statement formation, the concept of GAAP was mentioned for the very first time.
In the late 1930s, the AIA created a subcommittee to specifically create the GAAP principles. It was called the Committee on Accounting Procedure, or CAP, and comprised 18 accountants and three accounting professors. Shortly after CAP was formed, the first set of GAAP standards was created. In 1973, the SEC decided to replace CAP with the Financial Accounting Standards Board (FASB), which is still in place today.
There are a couple of organizations that have a direct influence on what I do. First of all, of course, is the SEC. When the SEC was created, it was given the authority to regulate financial markets and accounting standards boards. The SEC is directly responsible for creating another organization that has a good bit of say in how much power I have.
This organization is the Financial Accounting Standards Board (FASB). The FASB is the board that actually sets the standards that I represent. The FASB is made up of seven members, all of whom are private-sector accounting professionals. These members are elected to five-year terms as members of the FASB. They can be re-elected to a second five-year term but can only serve a maximum of 10 years on the board. Upon accepting a position as a member of the FASB, the person must immediately disassociate himself from the organization in which he worked.
A third important relation of mine is the International Accounting Standards Board (IASB). The IASB is the body that sets the global standards for international accounting. There are 16 members of this board that is based out of London. The members of this board are from diverse nationalities, but each has the common interest of setting globally accepted accounting principles.
Now we get to the best part - Why am I an accounting superhero? The answer is simple. I am the standards by which financial statements are prepared. Without me, a company could choose what information it wanted to include on its financial statements. My mission is to ensure that information on financial statements is relevant, reliable, comparable, and consistent.
Relevant information in accounting is information that has an impact on the financial status of a company. Reliable information is information that can be verified as accurate if need be and is not just an educated guess. Comparable and consistent go hand-in-hand. These terms mean that information on the financial statements is reported in the same manner for every publicly-traded company. It is important for financial information to meet all those criteria so that potential investors and creditors can make sound decisions on whether they do or don't want to enter into a business relationship with a company.
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Let's review everything I've told you about myself. First of all, I was created as a direct result of the Stock Market Crash of 1929. Following this catastrophic demise of the financial world at the time, government leaders felt the need to create the Securities and Exchange Commission (SEC). The purpose of the SEC was to regulate financial practices of publicly traded companies. The SEC turned around and created a committee that had the responsibility of developing standards that publicly-traded companies would have to adhere to in creating their financial statements.
The first committee was called the Committee on Accounting Procedures, or CAP for short. Several years later, CAP was replaced with the Financial Accounting Standards Board (FASB). FASB is the current committee that reviews and sets the standards for financial reporting in the United States. In the international business world, it is the International Accounting Standards Board (IASB) that sets the standards that foreign countries abide by for financial reporting.
My nickname, GAAP, stands for generally accepted accounting principles. These are the principles that were developed by CAP and are currently overseen by the FASB. There are 10 concepts of accounting that make up GAAP.
First is the economic entity assumption, which states that company financial activity and the private financial activity of the company owner must be kept separate. Second is the monetary unit assumption that is based on the idea that all financial activities must be expressed in dollars. The third concept is the time period assumption, which means that business activities are to be reported in time periods, and the length of the time period must be identified in the financial statement dates.
Next is the cost principle, which states that the historical cost of an item is what is reported on the financial statements. The historical cost is the price that was paid for the item in its original purchase date. The fifth concept is the full disclosure principle. The full disclosure principal means that all information that is relevant to the business be reported on the financial statements. The going concern principle is the next concept that makes up GAAP. This concept refers to the intent of a company to continue operating into the future. The matching principle is the concept that requires a company to match income and expenses in a given time period. The revenue recognition principle requires that revenue be reported on the income statement in the period that it was earned.
The ninth concept is materiality. Materiality is a concept that requires judgment be made by an accountant when determining if a misstatement will have enough impact on a company to alter financial records. The last concept that is part of the makeup of GAAP is conservatism. Conservatism is the principle that requires that expenses and liabilities be recognized immediately and the revenue to be recognized only when it is received.
As you can see, I have quite a bit of responsibility when it comes to financial reporting and the accounting world, and that's what makes me an accounting superhero!
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