Introduction to Accounting
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 people and organizations to understand the ways in which accounting information is measured. To ensure consistency, rules are established that business people can use to make sure they are comparing oranges to oranges.
For example, assume a store sells goods. Should the store's 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 accrual or cash accounting is not important to interested parties, as long as the owner follows a rule requiring him to disclose the chosen accounting method for the reporting purposes.
Accounting rules such as these are grouped together and called Generally Accepted Accounting Principles (GAAP).
Generally Accepted Accounting Principles (GAAP) are common standards that guide accountants in reporting economic events.
The Financial Accounting Standards Board (FASB) regularly 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.
In 2009, all SFAS statements and other pronouncements were included in the Accounting Standards Codification (ASC), which is the single source of authoritative U.S. accounting and reporting standards, other than guidance issued by the Securities and Exchange Commission (SEC).
Other organizations playing a significant role in regulating the accounting profession are the Securities and Exchange Commission and the Public Company Accounting Oversight Board (PCAOB). The SEC and PCAOB mostly regulate public companies, while the FASB establishes standards for private companies.
4. Financial reporting and financial statements
Businesses communicate accounting information to the public through a process known as financial reporting.
Financial reporting is the process through which companies communicate information to the public.
The central means of external financial reporting is a set of financial statements. There are four general-purpose financial statements:
- 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 net loss for a period of time. An income statement is also called a Statement of Operations, an Earnings Statement, or a Profit and Loss Statement (P/L).
A statement of changes in equity shows all changes in owners' equity for a period of time. This statement is also called an Owners' Equity Statement.
A balance sheet presents assets, liabilities and owners' equity on a specific date. A balance sheet is also called a 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.
Notes to the financial statements are another important aspect of reporting. Notes can be found in most financial statements and are required to be included in the financial statements of publicly traded companies. Notes include, among other things, additional information about the financial condition and performance of a company. The information presented in the notes may differ greatly from one company to another.
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. These elements are explained later in this tutorial or are covered in other tutorials.
Assets are the economic resources a business uses to accomplish its main goal (i.e., increasing the owners' wealth).
Formally recognized assets must meet the following two conditions:
- they must represent a potential economic benefit that is assignable to a particular entity, and
- an event giving rise to the assignment must have occurred (i.e., a transaction resulting in an asset has already occurred).
For example, if a company has purchased a piece of equipment and uses it to generate 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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