Introduction to Accounting
1.3 Generally Accepted Accounting Principles (GAAP)
People and organizations make decisions based on financial information prepared by accountants. That is why it is important for these people and organizations to understand how accounting information is measured. To facilitate communication, rules are established that business people can use to ensure they compare oranges to oranges. For example, assume a store sells goods. When should an accountant record the sale, at the moment the goods are shipped (accrual accounting) or at the time cash for these goods is received (cash accounting)? Whether the store owner applies the accrual or cash accounting is not important as long as a third rule is established requiring the owner to disclose the method selected for the reporting purposes. Accounting rules in the USA are grouped and called Generally Accepted Accounting Principles (GAAP).
Generally Accepted Accounting Principles (GAAP) are common standards that indicate how to report economic events.
Financial Accounting Standards Board (FASB) issues Statements of Financial Accounting Standards (SFAS) that comprise a large portion of GAAP. You can find more information about SFAS, their issuance process and current projects on FASB's website. Other organizations playing a significant role in regulating the accounting profession are Securities and Exchange Commission and Public Company Accounting Oversight Board. The last two mostly regulate public companies, while the first one establishes standards for private companies.
1.4 Financial reporting and financial statements
Businesses communicate accounting information to the public through a process known as financial reporting.
Financial reporting is a process through which companies communicate information to the public.
The central means of external financial reporting is a set of financial statements. The four general-purpose financial statements are the following:
- Income Statement
- Statement of Changes in Equity
- Balance Sheet
- Statement of Cash Flows
An income statement presents revenues and expenses and resulting net income or loss for a period of time. An income statement is also called Statement of Operations, Earnings Statement, or Profit and Loss Statement (P/L).
A statement of changes in equity shows all changes in owner's equity for a period of time. This statement is also called Owners' Equity Statement.
A balance sheet presents assets, liabilities and owner's equity at a specific date. A balance sheet is also called Statement of Financial Position.
A cash flow statement summarizes information about cash outflows (payments) and inflows (receipts). This statement may also include certain information not related to actual cash flows.
1.4.1 Elements of financial statements
All financial statements consist of classes or categories known as elements. There are ten elements: assets, liabilities, equity, contributed capital, revenue, expenses, distributions, net income, gains, and losses (which will be explained later in this or further chapters).
Assets are economic recourses of a business used to accomplish its main goal, i.e., increase owners' wealth.
To be formally recognized as an asset, the following two conditions must be met:
- potential economic benefit must be assignable to a particular entity, and
- event giving rise to the assignment must have already occurred.
For example, if a company has purchased a piece of equipment and uses it in generating profits, it is considered as an asset. However, if the company just considers buying new equipment, it can't be deemed or recorded as an asset.
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