Generally Accepted Accounting Principles

Part I.

A. Generally Accepted Accounting Principles.

GAAP is not a fixed set of rules. It is a guideline or more precisely a group of objectives and concepts that have evolved over 500 years from the basic concepts of Luca Pacioli set forth in the 1400s. It governs how financial statements are prepared and presented in the United States. The Financial Accounting Standards Boards (FASB), the American Institute of Certified Public Accountants and the Securities and Exchange Commission (SEC) provide guidance about acceptable accounting practices. Some of the reasons we use GAAP are that any business that expects anyone from outside their company to look at their financial data needs to use GAAP. Compliance with GAAP helps maintain creditability with creditors and stockholders because it reassures outsiders that a company’s financial reports accurately portray their financial position. Additionally anyone who reads your financial statements will automatically assume they are prepared and comply with GAAP. Another reason to use GAAP is that banks and finance companies often require their clients to use GAAP or have audited financial statements. It would be cheaper in the long run to prepare statements using GAAP than pay someone to audit them all the time. Additionally investors who are accustomed to using financial information prepared according to GAAP might balk if your statements don’t meet their expectations, which could lead to unhappy investors ultimately leading to a loss of profits. Finally the SEC requires companies to comply with GAAP.

The basic point of the Generally Accepted Accounting Principles is to put everything in one format so that every business is not doing things there own way and it makes it easier for the investment community to read the business’s financial statements.

B. Historical Cost.

Historical cost is the actual purchase price plus incidental costs incurred in getting the fixed asset in a condition and position ready for initial use. Under U.S. Generally Accepted Accounting Principles (US GAAP), the historical cost principle dictates that most assets and liabilities should be recorded at their historical cost. For example, a tract of land which was purchased 50 years ago for $10,000 may be worth $1 million today, but it will be recorded on the balance sheet at its historical cost of $10,000. The historical cost principle is used because of its reliability and freedom from bias when compared to the fair market value principle.

C. Accrual Basis vs. Cash Basis Accounting.

In accrual basis accounting, income is reported in the fiscal period it is earned, regardless of when it is received, and expenses are deducted in the fiscal period they are incurred, whether they are paid or not. In other words, using accrual basis accounting, you record both revenues and expenses when they occur. The difference between the two types of accounting is when revenues and expenses are recorded. In cash basis accounting, revenues are recorded when cash is actually received and expenses are recorded when they are actually paid (no matter when they were actually invoiced).

D. Current Assets and Liabilities vs. Non-Current items.

Before you go into this first you must know what the definition of assets is. Assets equal things of value. Three requirements of an asset are, it has to be controlled by the entity, valuable to the entity and have measurable costs. Controlled by the entity basically means the item has to be owned, like rental space, employees and contracts for valuable people. Valuable to the entity assets would include collectable amounts owed by customers, regular stock in an inventory and equipment in working condition. Measurable costs means that the item must have been acquired or purchased like trademarks instead of self developed reputation.

The definition of current assets is that it has to be cash and assets expected to become cash or used up soon, usually within one year. The following are examples of current assets; cash, securities, marketable securities, accounts receivable, notes receivable, inventory and prepaid items.

The definition of non-current assets is they are assets that are expected to be useful for more than a year and are broken into tangible and intangible assets. Tangible assets consist of assets with physical substance, property, plant and equipment and accumulated depreciation. Intangible assets are other non-current assets, without physical substance or investments. Types of intangible assets are patents and trademarks along with goodwill. Goodwill can be created when one company buys another company out in excess of the value of its