1.4: Generally Accepted Accounting Principles (GAAP)
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- Identify and explain the Generally Accepted Accounting Principles (GAAP).
The goal of accounting is to ensure information provided to decision makers is useful. To be useful, information must be relevant and faithfully represent a business's economic activities. This requires ethics, beliefs that help us differentiate right from wrong, in the application of underlying accounting concepts or principles. These underlying accounting concepts or principles are known as Generally Accepted Accounting Principles (GAAP).
GAAP in Canada, as well as in many other countries, is based on International Financial Reporting Standards (IFRS) for publicly accountable enterprises (PAE). IFRS are issued by the International Accounting Standards Board (IASB). The IASB's mandate is to promote the adoption of a single set of global accounting standards through a process of open and transparent discussions among corporations, financial institutions, and accounting firms around the world. Private enterprises (PE) in Canada are permitted to follow either IFRS or Accounting Standards for Private Enterprises (ASPE), a set of less onerous GAAP-based standards developed by the Canadian Accounting Standards Board (AcSB). The AcSB is the body that governs accounting standards in Canada. The focus in this book will be on IFRS for PAEs (It should be noted, however, that at the introductory level, there are no significant differences in how IFRS and ASPE are applied.) .
Accounting practices are guided by GAAP which are comprised of qualitative characteristics and principles. As already stated, relevance and faithful representation are the primary qualitative characteristics. Comparability, verifiability, timeliness, and understandability are additional qualitative characteristics.
Information that possesses the quality of:
- relevance has the ability to make a difference in the decision-making process.
- faithful representation is complete, neutral, and free from error.
- comparability tells users of the information that businesses utilize similar accounting practices.
- verifiability means that others are able to confirm that the information faithfully represents the economic activities of the business.
- timeliness is available to decision makers in time to be useful.
- understandability is clear and concise.
Table 1.1 lists the nine principles that support these qualitative characteristics.
|Business entity||Requires that each economic entity maintain separate records.
Example: A business owner keeps separate accounting records for business transactions and for personal transactions.
|Consistency||Requires that a business use the same accounting policies and procedures from period to period.
Example: A business uses a particular inventory costing method. It cannot change to a different inventory costing method in the next accounting period.
|Cost||Requires that each economic transaction be based on the actual original cost (also known as historical cost principle).
Example: The business purchases a delivery truck advertised for $75,000 and pays $70,000. The truck must be recorded at the cost of $70,000, the amount actually paid.
|Full disclosure||Requires that accounting information communicate sufficient information to allow users to make knowledgeable decisions.
Example: A business is applying to the bank for a $1,000,000 loan. The business is being sued for $20,000,000 and it is certain that it will lose. The business must tell the bank about the lawsuit even though the lawsuit has not yet been finalized.
|Going concern||Assumes that a business will continue for the foreseeable future.
Example: All indications are that Business X will continue so it is reported to be a 'going concern'. Business Z is being sued for $20,000,000 and it is certain that it will lose. The $20,000,000 loss will force the business to close. Business Z must not only disclose the lawsuit but it must also indicate that there is a 'going concern' issue.
|Matching||Requires that financial transactions be reported in the period in which they occurred/were realized.
Example: Supplies were purchased March 15 for $700. They will be recorded as an asset on March 15 and then expensed as they are used.
|Materiality||Requires a business to apply proper accounting only for items that would affect decisions made by users.
Example: The business purchases a stapler for $5 today. Technically, the stapler will last several years so should be recorded as an asset. However, the business will record the $5 as an expense instead because depreciating a $5 item will not impact the decisions of financial information.
|Monetary unit||Requires that financial information be communicated in stable units of money.
Example: Land was purchased in 1940 for $5,000 Canadian. It is maintained in the accounting records at $5,000 Canadian and is not adjusted.
|Recognition||Requires that revenues be recorded when earned and expenses be recorded when incurred, which is not necessarily when cash is received (in the case of revenues) or paid (in the case of expenses).
Example: A sale occurred on March 5. The customer received the product on March 5 but will pay for it on April 5. The business records the sale on March 5 when the sale occurred even though the cash is not received until April 5.
Note: Some of the principles discussed above may be challenging to understand because related concepts have not yet been introduced. Therefore, most of these principles will be discussed again in more detail in a later chapter.