01. What is GAAP?
GAAP, or Generally Accepted Accounting Principles, is a collection of accounting standards and common
industry usage that represent the authoritative standards of accounting practices. GAAP is used primarily
in the United States and is established by the Financial Accounting Standards Board (FASB).
02. Difference between GAAP and IFRS
Aspect GAAP IFRS
Primarily used in the United
Scope and Jurisdiction Used in over 120 countries globally.
States.
Financial Accounting Standards International Accounting Standards
Regulatory Body
Board (FASB). Board (IASB).
Principle-based (Focuses on the
Rule-based (Focuses on adhering underlying principles behind
to a specific set of detailed rules accounting standards, allowing for
Basis
and guidelines for accounting professional judgment in their
practices.) application.)
Does not allow LIFO, only FIFO or
Inventory Accounting Allows LIFO.
weighted average.
Detailed criteria and industry- General framework focused on
Revenue Recognition
specific rules. transfer of control.
Allows revaluation to reflect fair
Fixed Assets Valuation Generally uses historical cost.
market value.
Accounting Principles
1. Business Entity Principle:
Explanation: The business entity concept (also known as the separate entity and economic
entity concept) states that the transactions related to a business must be recorded separately
from those of its owners and any other business entity.
This concept is very important because if the transactions of a business are mixed up with those
of its owner or another business, the accounting information would lose its usefulness.
The business entity concept is applicable to all types of business organizations (i.e., sole
proprietorship, partnership, and corporation), even if a law does not recognize a business and its
owner as separate entities.
Importance/need of business entity concept
The business entity concept of accounting is of great importance because of the following
reasons:
The business entity concept is essential to separately measuring the performance of a
particular business in terms of its profitability and cash flows.
It helps in assessing the financial position of each and every business separately on a
particular date.
It becomes difficult and impossible to audit the records of a business if they are intermingled
with those of different entities or individuals.
The concept ensures that each and every business entity is taxed separately.
Example 3:
Mr. Sam owns a company. He uses two different credit cards: one for the payment of business
expenses and one for the payment of personal expenses. He pays $200 for the electricity bill for
his company using his personal credit card. According to the business entity concept of
accounting, the electricity bill for the business should have been paid using the company’s credit
card. The payment of $200 using a personal credit card would therefore be considered a
contribution of additional capital by Sam.
2. Monetary Unit Principle:
Definition and explanation
The monetary unit assumption (also known as the money measurement concept) states that
only those events and transactions are recorded in the books of accounts of a business that can
be measured and expressed in monetary terms. Information that cannot be expressed in terms
of money is useless for financial accounting purposes and is therefore not recorded in books of
accounts.
Example 1
The CEO of Fine Enterprise delivers a lecture to the company’s employees in a special meeting.
This lecture can be helpful in raising the employees’ morale and completing the current projects
on time.
Since the value of the lecture cannot be expressed in terms of money, it cannot be recorded in
the company’s books of accounts.
Example 2
Fast Transport Company has five trucks. One of its trucks was seriously damaged in a road
accident and is being repaired.
The company can only account for the amount of insurance or any expenses that it actually has
to pay to get the truck in working condition, but it cannot record the loss of revenue caused by
the time the truck takes to be repaired.
3. Time Period Principle:
Definition and explanation
The time period assumption (also known as the periodicity assumption and accounting time
period concept) states that the life of a business can be divided into equal time periods. These
time periods are known as accounting periods, for which companies prepare their financial
statements to be used by various internal and external parties and stakeholders.
Normally, an accounting period consists of a month, quarter, six months, or a year, depending on
the needs of the business entity and its stakeholders.
Importance of time period assumption
The time period assumption enables both trading and non-trading organizations to stop and see
how successful they have been in achieving their core objectives during a particular period of
time and where the room for improvement still exists.
Example 1
Meta Company provides services worth $2,500 to Beta Company during the first quarter of the
year. Beta will pay the cash to Meta for these services next quarter. According to the time period
assumption, if Meta prepares its financial statements at the end of the first quarter of the year, it
must include this service revenue of $2,500 in its income statement for the first quarter.
Example 2
Meta Company incurs expenses of $1,200 during the first quarter of the year. The cash for these
expenses will be paid next quarter. The time period assumption requires Meta to disclose these
expenses on the income statement for the first quarter of the year.
4. Revenue recognition principle
Definition and explanation
Revenue should not be recognized by an entity until it is (i) earned and (ii) realized or realizable
(i). When revenue is referred to as earned?
In a sales transaction, the revenue is referred to as earned when the seller satisfies its
performance obligation by delivering the related goods or services to the buyer, along with all
benefits and rights according to the terms of sale.
The revenue is referred to as “realized” when goods are sold or services are provided in
exchange for cash or claims to cash (i.e., accounts receivable). It is referred to as “realizable”
when goods or services are provided in exchange for a noncash asset that is readily convertible
into cash without incurring any additional costs.
Examples
1. Gibson Guitar Company places an order for a certain type of wood with Eastern Wood Company
on January 25, 2015. Eastern ships the wood to Gibson on February 5, 2015. On the same date,
Gibson intimates Eastern that it has received the wood. Gibson makes the full payment to
Eastern for this order on February 20, 2015. According to the revenue recognition principle,
Eastern should record the revenue on February 5, 2015, when the wood is received by Gibson,
not at the time of the placement of the order or the time when cash is received.
2. On December 25, 2024, John Marketing Consultants receives $1,500 cash from SD Corporation.
This is an advance receipt of cash for which the consultancy services are to be provided on
January 8, 2025. On January 8, 2025, the relevant consultancy services are provided by John
Marketing Consultants to SD Corporation. According to the revenue recognition principle, John
Marketing Consultants should recognize the revenue on January 8, 2025, not on December 25,
2024, when the cash is received from SD Corporation.
5. Matching Principle:
Explanation: Expenses must be matched with the revenues they helped generate in that period.
Expenses that can be directly traced to related revenue fall under this category, for example,
inventory expenses. Suppose Atlanta Inc, is a trading company. It has imported 10,000 units of
kitchen appliances from Pakistan at $100 per unit. During the current year, it has managed to sell
only 6,000 units of those appliances at $125 each.
As per the revenue recognition principle, the entire purchase cost of $1,000,000 would not be
expensed out in the current period. Instead, only the cost of units sold ($600,000 = $100 x 6,000
units) will be treated as the inventory expense and charged to the cost of goods sold account.
The cost of unsold units ($400,000 = $100 x 4,000 units) would be recognized as an asset on the
year-end balance sheet and will be expensed out as and when they are sold in the forthcoming
period(s).
6. Historical cost concept
The historical cost concept (also known as the cost principle of accounting) states that the assets
and liabilities of a business should be presented in accounting records at their historical cost.
Historical cost is the amount that is originally paid to acquire the asset and may be different from
the current market value of the asset. Let us assume, for example, that a medicine company
purchases a piece of land, paying $25,000 in cash. The company will enter $25,000 as the cost of
the land in its accounting records. In a booming real estate market, the fair market value of the
land five years later might increase to $35,000. Although the market price of land has
significantly increased, the amount entered in the balance sheet and other accounting records
would remain unchanged at the original cost of $25,000.
7. Full disclosure principle of accounting
According to this principle, the management of an entity is required to disclose all the relevant
and appropriate information (both financial and non-financial) in their financial statements that
could impact the decision-making ability of the users of those statements. Such information is
made available to stockholders and other users either on the face of financial statements or in
the notes to the financial statements.
Examples:
1. If we talk about a loan to a director provided by the company, the full disclosure principle
will require the managers of the company to disclose all the information related to that loan
arrangement, like the loan deed itself, the duration of the loan, any collateral liability
attached, the rate of interest the company is charging, etc. So in light of this data, potential
investors can make their decision about investing in the company with more ease.
8. Conservatism principle of accounting
One important and basic principle is the conservatism principle (also referred to as the prudence
concept of accounting). This principle states that business entities must record all likely expenses
and liabilities, whereas revenues and assets should only be recorded when there is a certainty
that they will materialize.
Example 1
One of the most relevant examples of the conservatism principle is in the case of impending
legal suits. Let’s say ABC Inc. is a software company that has filed a suit against XYZ Inc. for using
its patent technology. ABC has claimed damages of $500,000 for patent infringement. The case is
ongoing in a court of law.
Although ABC Inc. may have a strong case in its favor, under the principle of conservatism, it will
not record this amount as a gain in its books until it actually materializes with a favorable ruling.
The reason is that recording a sizeable gain before it is actually received (or becomes receivable
through the court decision) may be misleading for users of the company’s financial statements.
Example 2
Kim Company has outstanding debtors amounting to $50,000. It gets information that one of its
debtors owing $10,000 has filed for bankruptcy and is unlikely to repay the dues. Under the
conservatism principle, the company ought to provide for the entire $10,000 due from the
debtor, as there is a likelihood that he will default on the payment.
9. Going Concern assumption:
Explanation: Financial statements are prepared with the assumption that the business will
continue operating indefinitely. The entity is viewed as continuing in business for the foreseeable
future. Presentation of Financial Statements deems the foreseeable future to be a period of at
least 12 months from the end of the reporting period.
It is assumed that the entity has neither the intention, nor the need, to liquidate or curtail
materially the scale of its operations.
If management conclude that the entity has no alternative but to liquidate or curtail materially
the scale of its operations, the going concern basis cannot be used and the financial statements
must be prepared on a different basis (such as the ‘break-up’ basis).
There are many indicators that an entity may not be a going concern, such as:
inability to pay dividends to shareholders
major losses or cash flow difficulties that have arisen since the reporting date
adverse key financial ratios
indications of withdrawal of financial support from the bank or other financial institutions
negative operating cash flows
[Link] concept of accounting
The materiality concept of accounting states that all material items must be properly reported
in financial statements. An item is considered material if its inclusion or omission significantly
impacts the decision of the users of financial statements. Items that have very little or no impact
on a user’s decision are termed immaterial or insignificant.
The materiality concept also allows accountants to ignore other accounting principles or
concepts if an action does not have a significant impact on the financial statements of the entity.
For example, a company may charge its telephone bill to expense in the period in which the bill
is paid rather than in the period in which the telephone service is used. This treatment is a
violation of the matching principle of accounting. However, accounting for telephone or other
utility bills on a cash basis is very convenient because the monthly cost of the service used is not
known until the utility bill is received by the company. Under this cash basis approach, the
telephone bill charged to expense in the current month actually belongs to the previous month,
but the error in financial statements resulting from this action is likely to be immaterial.
Assumptions
01. Economic entity
02. Going concern
03. Monetary Unit
04. Time period
Principle
01. Cost principle
02. Full disclosure
03. Revenue
04. Matching
Constraints
01. Conservatism
02. Materiality