ACCT 101 – Professor Farina
Lecture Notes – Chapter 1
Introducing Accounting in Business
GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP)
What is GAAP?
In the United States, GAAP is a set of rules and standards that guide accountants as to when and how to properly
record transactions and prepare financial statements. GAAP is not like the laws of physics. GAAP is designed to
meet the needs of society. GAAP is always evolving as the economic environment changes. Also, GAAP only refers
to rules of accounting in the United States. Different countries have different rules for different purposes.
Broad GAAP
There are a few broad GAAP principles that provide general guidance and that apply to all types of transactions.
These are fundamental accounting rules. These are like general traffic laws. Some of these are discussed below.
Specific GAAP
Specific GAAP rules offer specific direction for important kinds of specific situations. As you continue your study of
accounting and learn how to record specific types of transactions, you will be learning specific GAAP rules.
Examples of some specific GAAP rules are:
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how uncollectible accounts receivable should be recorded
acceptable methods for calculating inventory cost
how interest should be calculated on certain kinds of debt
Where does GAAP come from?
There is no single source or listing of GAAP. There are a number of different sources, some more important than
others.
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Official Pronouncements: An official pronouncement is a formal and authoritative document issued by the
Financial Accounting Standards Board (FASB), which is the highest standard-setting authority in
accounting. The FASB is an independent organization that derives its authority from the Federal Securities
and Exchange Commission and the fact that all state licensing boards for accountants accept the FASB
pronouncements as highest authority. The pronouncements of the FASB are called Statements of Financial
Accounting Standards (SFAS). An SFAS prescribes how certain kinds of transactions must be recorded and
presented. It is the highest authoritative directive.
FASB Technical Guides: The next level below an SFAS is a technical guide, usually dealing with narrow or
very specific subject matter.
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Examples:
----FASB Technical Bulletins
----AICPA (American Institute
----EITF (Emerging Issues Task Force) Positions and Recommendations
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Industry Practice: Industry practice is a source of GAAP. Historically, some industry practices have achieved
wide acceptance over many years. Sometimes this has created conflict and a lack of consistency within
GAAP, because the practices serve the purposes of different groups. This process continues today, to a
diminished degree.
Other Accounting Literature: Research publications by educators, journal articles, textbooks, professional
association publications, and AICPA technical practice aids are examples of this source of GAAP. These are
the least authoritative GAAP sources.
FOUR IMPORTANT BROAD GAAP PRINCIPLES
Reliability principle
An important qualitative characteristic of information is that it must be reliable.
In order for this to happen, accountants must follow the reliability principle. This principle requires that accountants
record only that information into the accounting system which can be verified by objective evidence.
Examples of objective evidence are documents such as receipts, invoices, canceled checks, bank statements, and
verified measurements such as physical counts of merchandise inventories.
Estimates are often required in the accounting process.This is an especially tricky and difficult problem. To conform
to the reliability principle in these situations, the accountant must take extra effort to demonstrate that the estimate is
free of bias, was made by a qualified and completely independent person, and conforms as closely as possible to
known objective evidence.
Cost principle
The “cost principle” is also called the “historical cost principle.”
The cost principle requires that all transactions be recorded at original (historical) cost. They must also be stored in
the records and presented on the financial statements at historical cost. Historical cost is what was paid or charged for
something.
Example: Land purchased for $50,000 10 years ago and worth $200,000 today is shown on the
balance sheet at a cost of $50,000.
Exceptions to historical cost: there are certain exceptions to the cost principle. One of those is
accounting for investments in stocks. Current GAAP requires investments to be recorded at cost, but
adjusted to market value.
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Revenue recognition principle
The “revenue recognition principle” requires that accountants only record revenue when it is earned.
As a general rule, revenue from the sale of goods or services is considered earned when all three of
the following conditions are satisfied:
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The seller has delivered the correct service or product.
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The amount of revenue is measurable.
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The buyer can reasonably be expected to pay.
The revenue recognition principle is particularly important because many businesses are often too
eager to prematurely record revenues in order to show net income at a higher number. The revenue
recognition principle is the accountant’s guideline when confronting these situations.
Matching principle
Businesses must incur expenses in order to generate revenue. The “matching principle” requires
accountants to identify which expenses have helped to generate revenues, and then “match” those
expenses with revenue in the same accounting principle.
We will learn more about this when you study adjusting entries.
TIP: Don’t confuse “cost” with expense.” The word “cost” means the expenditure of money or
other resources to acquire an asset. For example, if a business spends $3,500 to purchase supplies, it
has expended money and the cost is $3,500. If the cost is used up in the process of generating
business revenues, then the cost becomes an “expense.” So, if $500 worth of the supplies is used up,
then $500 of the cost becomes $500 of “Supplies Expense.”
In practice, the words “cost” and “expense” are often used interchangeably, and you have to be
careful about their intended meanings.
ACCOUNTING ASSUMPTIONS
Basic conditions
Underlying assumptions are the most basic conditions that must exist before GAAP can be applied.
If these conditions do not exist, accounting as we know it cannot be used. Underlying assumptions
are the “foundation” of the operating guidelines.
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MODIFYING CONSTRAINTS
Modifying constraints are rules that are used to make sure that GAAP rules are applied sensibly, and
not in some arbitrary way that would result in undesirable outcomes.
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Materiality: GAAP need not be followed if an item is immaterial. Information is
material if it can effect a decision made by a user of the financial statements. For
example, the purchase of a pencil sharpener by Cerritos College may be charged to
expense, rather than recorded as equipment (asset), as the amount of the purchase is not
significant.
Conservatism: When two alternatives equally satisfy GAAP requirements, select the
least favorable alternative.
 Cost/benefit: The cost of providing specific information should not exceed the benefits
to the users of it.
 Monetary unit assumption: Transactions are expressed in monetary amounts (i.e., the
US dollar).
 Time period assumption: accounting reports are prepared according to time periods.
For example the income statement is prepared annually, or quarterly.
 Going-concern assumption: The business issuing financial statements is expected to
continue operating indefinitely.
 Business entity assumption: A business is accounted for separate from its owners.
SARBANES-OXLEY (SOX)
Congress passed SOX to curb financial abuses of publicly-held companies. SOX makes it a
violation of law if such companies do not apply stringent financial and internal controls.
Chief Executive Officer s and Chief Financial Officers now must sign statements
accompanying the annual report to stockholders that internal controls are effective. These
officers face imprisonment, and fines, if found to have signed these statements falsely.
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RULES OF DEBIT AND CREDIT FOR CORPORATIONS
CATEGORY
Assets
Liabilities
Equity
ACTION
Increase
Decrease
DEBIT
X
CREDIT
X
Increase
Decrease
X
X
Capital Stock:
increase
X
Retained Earnings:
Increase
X
Retained Earnings:
Decrease
X
Dividends: Increase
X
Revenues
Increase
Expenses
Increase
X
X
The Capital Stock account shows investments by the owners, now called stockholders or
shareholders.
The Retained Earnings account accumulates all net income earned, less all dividends paid,
since the business started operations.
The Dividends account takes the place of the Owner, Drawing account used by sole
proprietorship business.
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