BA Lesson #5 - Generally Accepted Accounting Principles

Accounting is very conservative. It requires unity, comparability and understandability. To achieve these, accountants follow Generally Accepted Accounting Principles.

As starting accountancy students, it is very essential for you to know the Generally Accepted Accounting Principles because there are times that you have to intellectually assume principles and treatments in certain scenarios where you have no idea on your head. Shall you recognize this profit/expense immediately or just defer it?

ECONOMIC ENTITY CONCEPT

This principle states that the business is separate and distinct from its owners. Any expenses for the personal good of the owner are not considered as expenses of the business. Suppose a business is situated exactly on the house of the owner, who shall incur the electrical expense? The answer is both because both of the owner and the business benefited from electric consumption. However, there must be an accurate basis as to the proration of the expense.

MONETARY UNIT ASSUMPTION

            Monetary Unit Assumption is the easiest GAAP to understand. It just says that the figures in financial statements are in money terms and they are in the currency of your country. For example, in a financial statements published by a reporting entity in the United States, the figures are in US Dollar. You shall not assume that they are in Canadian Dollar.

GOING CONCERN ASSUMPTION

This assumption explains that the business has an indefinite period of existence unless otherwise it has prima facie evident to the contrary. No matter how much a business incurs loss for consecutive periods, accountants still prepare financial statements.

Going Concern Assumption is also the underlying principle to accrual basis of accounting (See accrual basis). Why would a creditor lend if he knows that a business shall terminate tomorrow or next week? Why shall you record a receivable if you know that you cannot collect it this next month? You could have written it off.

PERIODICITY CONCEPT

Periodicity concept explains the indefinite life of business is divided into equal periods and accountants have to present financial statements at the end of each period. When a period starts in the first of January and ends in the 31^st of December, then it is called as calendar year. When a period is exactly one year, regardless when it started, then it is called as fiscal year. Therefore, a period that starts from the first of January and ends in the 31^st of December is both a calendar year and a fiscal year.

            Entities may also decide to report in less than a year and we call this period as interim period. Interim period can be weekly, bi-weekly, monthly, quarterly and semi-annually.

            Note that the periodicity concept divides the indefinite life of business into equal periods. Dividing it into equal periods gives accurate insights. Do you think you can compare the net income of the financial statements done annually and weekly?

ACCRUAL BASIS OF ACCOUNTING

This is one of the famous generally accepted accounting principles. Accrual basis is the common practice of all accountants. It states that a revenue shall be recorded when realized regardless when it is collected. Because of this, we shall record Accounts Receivable or any appropriate accounts title. On the other hand, it also states that an expense shall be recorded when incurred regardless when it is paid. This assumption gives birth to an account called Accounts Payable or any appropriate accounts.

        Because of accrual basis, there shall be a need for adjusting entries to update the balances of the accrued and deferred accounts. Adjusting entries shall be discussed on our future lesson in Basic Accounting 1.

CASH BASIS OF ACCOUNTING

Cash basis of accounting is considered to be the opposite of the accrual basis. You only record revenue and an expense when collected and paid respectively. This practice is done by tax accountants as they appear to be more accurate in computing the income of the firm and it also gives a more truthful result when it comes to assessing financial performance of an entity.

MATCHING PRINCIPLE

This states that you record an expense upon the record of income or revenue. Matching principle is the underlying principle in accounting for warranties and premiums. For example, you sold a washing machine with warranty certificate. In matching principle of accounting, you must record the warranty expense and the warranty liability immediately from the time of its sale.

OTHER CONSERVATIVE ASSUMPTIONS

When there is no existing generally accepted accounting principles of recording and you are FORCED (note that this is your last resort) to assume among alternative amounts of expense, always choose whichever is higher and among alternative amounts of revenue, always choose whichever is lower. These are more conservative assumptions. To be conservative in accounting, you must always choose which amount likely results to lower revenue.

These are just the basic GAAPs that you need to know in Basic Accounting. We will review these and discuss more accounting principles in our Intermediate Accounting lessons.