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In order to learn accounting, understand certain transactions, and analyze financial statements, it is important to take a step back and study the accounting principles that are underneath all of the debits and credits. Learning the accounting principles will not only help you understand basic accounting, it will help you analyze transactions in the future. Let’s take a basic look at how US accounting standard are made and who makes them.

In the world of financial accounting, there are many different rules, concepts, and guidelines that govern how companies should account for financial transactions and present their financial statements. These rules and concepts are called generally accepted accounting principles or GAAP. Every private company that issues financial statements to the public, must follow the rules of GAAP. This is useful because it maintains accounting consistancy through years and across companies. This way an investor can compare a 2011 balance sheet of one company to the 2011 balance sheet of another company. The numbers and ratios will be meaningful because both companies used the same methods and techniques to prepare and present their balance sheets. GAAP is created by a private, independent seven-member board called the Financial Accounting Standards Board.

FASB

Soon after the stock crash in 1929, Congress designed to take action to help prevent investors from being deceived by fraudulent financial statements. Congress passed the Securities Exchange Acts of 1933 and 1934. These acts established the Security Exchange Commission or the SEC and give it the power to create accounting standards in the United States. The SEC realized that it was in its and the accounting industry’s best interest to keep accounting standard setting private. Thus, the SEC has declined, with a few minor exceptions, to create accounting standards. Instead, the SEC has allowed private organizations the opportunity to regular the accounting industry with principles and standards. There have been a few different organizations since 1933 that have established US accounting standards including the American Principles Board. In 1973 however, FASB was designated to be the only organization to establish private sectors accounting principles and standards in the United States. FASB’s mission is to “establish and improve standards of financial accounting and reporting that foster financial reporting by nongovernmental entities that provides decision-useful information to investors and other users of financial reports.”

www.fasb.org

GAAP Objectives

While establishing GAAP, FASB was mainly concerned about the end users of financial statements. Who are the end users? End users include people like investors, banks, lenders who use third party financial statements to evaluate business decisions. For instance, an investor will look at a company’s financial statements in order to decide whether to invest. FASB wants to make consistent standards that help end users understand and use the company’s financial data. GAAP’s primary intent is not to help businesses. It is intended to help the end users. All of the objectives that FASB and the prior accounting standard setting bodies wanted to accomplish can be simplified to one main objective: to make financial statements universally understandable and usable for all of their users. Remember, GAAP only has to be used by private companies that issue financial statements. GAAP does not have to be used by a private company that makes internal financial statements.

Since FASB is concerned about financial statement usability, it had to define what makes a financial statement usable. FASB came up with the qualitative characteristics of accounting information to evaluate the usefulness of financial information.

Accounting Principles

Think of accounting principles as the rules for financial accounting. FASB established these principles based the three objectives that I mentioned earlier. These principles tell accountants and companies how to account for transactions and present financial statements. Here’s a small list of the main principles of accounting.

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Accounting consistency applies to the quality of accounting information because it allows end users to understand and compare financial statements. Think of it this way. If a company changed accounting treatment for its accounts receivable every single year, it would be difficult to compare the prior years’ accounts receivable balances with the current year. Since each year follows a different rule or standard, each year wouldn’t be able to be compared.

This means that both ratio analysis and trend analysis wouldn’t be available for investors and creditors to help gauge the company’s current performance. GAAP does allow companies to change accounting treatments when it is reasonable and justifiable. Companies are not allowed to change from one method to another in a current year then back to the previous method the following year. This would contradict the consistency concept.

Examples

– Todd’s restaurant sells gift certificates during the holidays every year. When these gift certificates are sold, Todd sometimes credits a sale and sometimes he credits a gift cards payable account. Todd decides what to credit at the end of the month when his income numbers come in. If he needs more income, he credits sales. This is a clear violation of the accounting consistency concept. By not accounting for the gift cards consistently, Todd makes the financial statements misleading.

– Assume our example above except now Todd has decided to change is method of accounting from using both sales and gift cards payable to only accounting for his gift cards in a payables account. This change in accounting method is perfectly fine. Todd is changing from a non-GAAP appropriate method to an approved method of accounting.

– Denise’s Fine Jewelry uses the FIFO method for valuing their inventory. Denise made the most profit this past year than any other year in her business. Unfortunately, now she will owe a large amount of taxes. To minimize her taxes, Denise wants to switch to the LIFO inventory method. This switch is fine as long as Denise continues to use the LIFO method into the future doesn’t switch back to the FIFO method.

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Comparability is extremely important to the end users of financial statements. If financial statements can’t be compared with other statements, what good are they? You wouldn’t be able to compare a company’s performance from year to year let alone two competitors’ financial statements. Without being able to compare and benchmark financial statements, the accounting information would be pretty useless.

Without the concept of comparability, financial ratios would not exist. You wouldn’t be able to compare two companies’ financial information with ratio analysis because their financial information wouldn’t be compatible. It would be like comparing apples to oranges. You could get a rough estimate on the worth of the company, but an accurate comparison wouldn’t exist.

Examples

– Assume that company A uses the FIFO inventory method and company B uses the LIFO inventory method for valuing its inventory. All else being equal, company B’s financial statements would most likely show less income because of a higher cost of goods sold. Company A would conversely have a lower income but higher inventory. These two companies don’t have comparable financial statements. They use different methods of accounting. In order to compare these statements properly, you must convert one of their inventory methods to match the other.

– US GAAP and the International Standards or IFRS have many standards in common, but they also disagree on many common accounting practices. For instance, US GAAP allows for a different method of accounting for pension programs. This means that a US based company like GM won’t use the same accounting methods as a foreign-based company like Toyota. These two company pension liabilities and pension funding will be reported differently. This means the two companies are not comparable in this respect. Luckily, most foreign companies still report their statements on US exchanges using GAAP, although this is likely to change in the future as IRFS is more widely adopted.

– Currency is another form of comparability. Financial statements presented in different currencies can’t be compared at face value. They must be converted into the same currency in order to be compared meaningfully.

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If decision makers cannot trust what is on the financial statements, financial reporting in general is useless. That is why the FASB is so concerned with the reliability of financial statement information.

Examples

The FASB described three attributes that all reliable financial information has: verifiability, representational faithfulness, and neutrality.

Verifiability

Financial information is verifiable when multiple, independent measures are used to come up with the same result. In other words, auditors and other third parties can measure and evaluate the company’s financial statement accounts and end up with the same result. If the auditors can’t verify financial information, the auditors can’t issue an unqualified opinion.

Representational Faithfulness

Representational faithfulness simply means that the financial statements represent reality or what actually happened during the year. For example, if a company reported cost of goods sold of $100,000 when its cost was actually $159,000, the financial statements wouldn’t accurately reflect reality or what actually happened. In reality, this company incurred $159,000 of costs and must show that on their financial statements.

Neutrality

Finally, in order for financial statements to be reliability, they must be neutral. By definition, financial statements that are prepared by company management are somewhat biased because the management want to see the company improve. This means they are more likely to report increased performance and neglect to report unfavorable events. Neutrality requires that management prepare completely unbiased financial statements.

For example, a company with information about a probable lawsuit must report it on their financial statement notes. Withholding this information would make the financial statements unreliable to outside investors and creditors.

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FASB asked the question, “Will financial statement users’ decisions be affected by this information?” If the answer is no, then the information isn’t relevant and can be excluded from the financial statements. A small abnormal expense is a good example of irrelevant accounting information. If the company suffers a small causality loss because someone threw a brick through the factory-building window, an investor will still invest in the company. This is irrelevant information because it doesn’t affect the end user.

However, the company suffering a causality loss because the factory burned down to the ground is a relevant piece of accounting information. This information must be included in the financial statements because investors or lenders’ decisions might be affected by this information.

Examples

FASB also identified three main characteristics of relevant accounting information: predictive value, feedback, and timeliness. Financial information must have all of these characteristics in order to be considered relevant.

Predictive Value

Predictive value refers to the fact that quality financial information can be used to base predictions, forecasts, and projections on. Financial annalists and investors can use past financial statements to chart performance trends and make predictions about future performance and profitability.

Feedback Value

Quality information has a feedback value when it can confirm or correct previous expectations. In other words, users can examine financial information and confirm or adjust their predictions made on previous performance trends. Based on this feedback, users can make future decisions.

Timeliness

Timeliness is one of the most important factors in relevant information. Out of date information does not do investors or creditors any good when they are trying to make current and future decisions. Financial reporting must be timely and current in order to be used by investors and creditors.

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