1. Accounting Basics: Introduction
  2. Accounting Basics: History Of Accounting
  3. Accounting Basics: Branches Of Accounting
  4. Accounting Basics: The Basics
  5. Accounting Basics: The Accounting Process
  6. Accounting Basics: Financial Statements
  7. Accounting Basics: Financial Reporting

Generally Accepted Accounting Principles (GAAP)

A key prerequisite for meaningful financial statements is that they be comparable to those for other companies, especially firms within the same industry. To meet that requirement, statements are prepared in accordance with Generally Accepted Accounting Principles (or, more commonly, GAAP), which "encompasses the conventions, rules and procedures, necessary to define accepted accounting practice at a particular time."

In the wake of the crash of 1929, the first serious attempt to codify GAAP was made by the AICPA (then the American Institute of Accountants) working with the New York Stock Exchange, which culminated in the creation of a Committee on Accounting Procedure. The Committee's resources were limited and in 1959 the Accounting Principles Board (APB) was established within the AICPA to take over the rule-making function. The APB was superseded in 1972 by the Financial Accounting Standards Board (FASB), an independent, not-for-profit organization with a governing board of seven members—three from public accounting, two from private industry, one from academia and one from an oversight body. (For more on GAAP visit the U.S. GAAP website.)

Current GAAP in the U.S. (or U.S. GAAP) include rules from the FASB and these predecessors. Over time, standards are eliminated and amended as business conditions change and new research performed. Although in the U.S. the SEC has delegated the function of accounting rule-making to FASB, it is not the only source of GAAP. Research from the AICPA, best industry practices as defined by research and traditions, and the activities of the SEC itself all play a role in defining GAAP. (For more on the SEC read Policing The Securities Market: An Overview of the SEC.)

Accounting is how business keeps score. Accounting data is used internally as a tool for the business to determine if internal goals and budgets are being met. External users include potential creditors and investors. Accounting data must be uniform in order for it to be useful as the basis of financial analysis of a company.

Many accounting standards are firmly established, others continue to be debated vigorously among the players and a few are so highly controversial they get even people on the sidelines riled up. One example from the 2008 financial crisis is mark-to-market accounting, on which accountants, presidential candidates and pundits alike weighed in. Accounting standards setting then becomes part of the political process, and depending on the strength and commitment of the various forces, the rules are eliminated, amended or left alone.

Accounting and accounting standards will continue to evolve over time as business continues to evolve. Online businesses have issues that couldn’t have been imagined even a decade ago. Standards and rules need to keep up with the evolution of the companies whose results they are designed to measure.

Disclosure

Accounting disclosures are as important as the actual numbers. Besides the balance sheet, P&L and statement of cash flows, a great deal of information is provided in the notes to the financial statements. Some key financial information is put directly into the financial statements in parentheses (e.g. on the balance sheet and the number of shares authorized and issued for common stock). Footnotes contain often critical information that may be considerable and include tables.

The note to the readers that "the accompanying notes are an integral part of these statements" alerts them to the notes' importance and is warranted. But since they are at the bottom — and because they are often numerous, lengthy and, at times, impenetrable — more casual users ignore them. (To learn more, see Footnotes: Start Reading The Fine Print.) This is a critical mistake as the information contained in some footnotes is often key to fully understanding the financial statements and some of the assumptions that were used in compiling the numbers.

What's included in the notes? There's information on securities held, inventories, debt, pension plans and other key elements in determining the company's financial position. In addition, the notes will contain information about the company's accounting policies. Under GAAP, companies often do have discretion to use varying methods for valuing assets, and recognizing costs and revenue. This "Summary of Significant Accounting Policies" will appear as the first note to the statement or in a separate section.

There are other required disclosures external to the financial statements and notes, such as the Management Discussion and Analysis (MD&A), required by the SEC. In all, the list of required disclosures is long, detailed and complex. Although this exhaustive release of company information increases transparency, it does mean that financial statements become unwieldy. And the financial meltdown of 2008 —following the reforms implemented in the wake of the Enron scandals a few years before —had observers once again wondering whether, despite all the disclosures, the necessary information for decision-making is being included in financial statements. (For further reading read An Investor's Checklist To Financial Footnotes.)

Common footnotes include:

  • Notes that advise on significant accounting policies such as depreciation methods or how the company values its ending inventory.
  • Notes regarding events subsequent to the close of the accounting period presented. These can be significant depending upon the nature of the event(s).
  • Notes explaining intangible assets such as trademarks and the like.
  • Notes regarding employee benefits, often a significant cost for companies.

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