Generally Accepted Accounting Principles

The Financial Accounting Standards Board (FASB) is a research organization, made up primarily of accountants. The FASB, along with the entire accounting profession, has, over time, developed a series of rules called generally accepted accounting principles (GAAP). In addition, the FASB publishes what are called FASB Bulletins. These are a series of more than one hundred publications that describe what corporate reporting methodologies should be. Most of these methodologies have been adopted and are now incorporated into accounting practice. A broad analogy is that the GAAP rules are the basic constitution and the bulletins are proposed amendments. Here are some of the GAAP rules.

The Fiscal Period

All reporting is done for predetermined periods of time. Reports may be issued for months or quarters and certain reports are issued annually. Accounting fiscal periods usually coincide with calendar periods, although not necessarily with the calendar year. For example, a company’s fiscal year may be July 1 to June 30 or February 1 to January 31.

The Going Concern Concept

When accountants are keeping the books and preparing the financial statements, they presume that the company will continue to be in existence for the foreseeable future. If there is serious doubt about this, or if the company’s ceasing operations is a certainty, the financial statements (essentially the balance sheet) will be presented at estimated liquidation value.

Historical Monetary Unit

Accounting is the recording of past business events in dollars. Financial statements, and in fact all financial accounting, report only in dollars. While units of inventory, market share, and employee efficiency are critical business issues, reporting on them is not within the realm of financial accounting responsibility. Financial statements depicting past years are presented as they occurred. The selling prices of the products and the value of assets may very well be different today, but reports of past periods are not adjusted.

Conservatism

The principle of conservatism requires that ‘‘bad news’’ be recognized when the condition becomes possible and the amount can be estimated, whereas ‘‘good news’’ is recognized only when the event (transaction) has actually occurred. One example of this is the allowance for bad debts on the balance sheet, which is recorded before the losses are actually incurred. Another example is reserves for inventory writedowns, which are recorded before the dated or out of style products are actually put up for sale at distress prices. Revenue, however, is not recorded, no matter how certain it is from a business point Generally Accepted Accounting Principles: A Review 53 of view, until the product is actually delivered or the service is actually provided. Payment in advance, while assuring the certainty of the sale in a business sense, does not change the accounting rule. Revenue is recorded only when it is earned.

Quantifiable Items or Transactions

The value of the company’s workforce and the knowledge the workers possess may in a business sense be the company’s critical competitive advantage. However, because that value cannot be quantified and expressed in dollars, accounting does not recognize it as an asset. The value of trademarks and franchise names is also generally not included. Coke, Windows, and Disney are certainly franchise brand names with worldwide recognition. While the business value of a franchise name can be almost infinite if it is maintained, franchise names are not assets on the balance sheet because that value cannot be quantified.

Consistency

Accountants make many decisions when they are preparing the company’s financial statements. These include but are not limited to the choice of depreciation method for fixed assets and the choice of LIFO or FIFO accounting for inventory. Once these decisions have been made, however, later successive financial statements must employ the same methodology. When a major change is made in accounting methodology, the accountants must highlight that change and redo past financial statements (the reference points) to reflect that change. Only then can comparative analysis and trends be valid.

Full Disclosure

When a major change in methodology occurs, accountants must take steps to be certain that readers of the financial statement 54 Understanding Financial Information are fully aware of that change and how it affected the financial results.

Materiality

An event that is material, or significant, is one that may affect the judgment, analysis, or perception of the reader of the information. Events that are perceived as material must be disclosed separately and highlighted accordingly. This is a relative concept. Something that is significant in a company with annual revenues of $20 million might be largely irrelevant in a multibillion-dollar enterprise.