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SUBJECT: ACCOUNTING
GRADE 11
CHAPTER: PARTNERSHIPS
LESSON: GAAP
LESSON OVERVIEW (KNOWLEDGE AREAS)
1. Introduction
2. Need for GAAP
3. Accounting Principles
LESSON
GAAP may be defined as the body of knowledge, consisting of the written and unwritten rules or
concepts, which guide accountants in their financial reporting duty. This body of knowledge has
been built up over the years and has been changed in nature in order to adapt to the changing
needs of society and the economy. Indeed, GAAP is still in a state of flux, with the Institute of
Chartered Accountants worldwide constantly adding to this body of knowledge through the
issuing of statements of accounting practice which dictate, or at least, recommend, the methods
to be adopted by accountants in certain situations.
As the business world became more sophisticated over the ages, a problem started to develop.
Various businesses would prepare their financial reports in a variety of different ways, which
made comparison between different organisations extremely difficult. This had very serious
consequences. For example, a businessman/woman who wished to invest in certain businesses
found it impossible to decide, when comparing two businesses, on the one that was more
profitable. Also, the lack of accounting rules opened the door for disreputable individuals to
“window-dress” their financial statements and make them look better than they actually were.
As a result the reliability of the figures contained in financial statements were brought into
severe question.
Furthermore, financial statements were also becoming more and more complicated so that
people who had not studied Accounting as a subject found it very difficult to understand it.
These are problems that are constantly facing accountants even today. In South Africa, the
Institute of Chartered Accountants has followed the lead of the other major nations, and has
issued a number of statements of accounting policies, taxation, extraordinary items, stock
valuation etc. Nevertheless, there is still a deep body of knowledge and “unwritten rules” which
have been developed since the times of Luca Pacioli.
These written and unwritten rules provide the framework of reference to accountants today, to
assist them in deciding how financial information should be reported. The purpose of these
rules is to make financial statements:
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understandable
useful
relevant
reliable
timely
verifiable
neutral
comparable and consistent
We have already covered some of the rules which provide the basis for GAAP, possibly without
naming them. Let us now look at the more important concepts in greater detail.
1.
The “business entity” concept.
This was possibly the first concept we encountered when starting our study of Accounting in the
previous years. According to this concept, the financial affairs of a business must be kept
separate from the financial affairs of the owner.
For example, Liam Brady who already has a personal bank account in his own name,
decides to start up a business and call it LB Hypermarket. It is necessary for him to open
up a separate bank account in the name of LB Hypermarket.
There are two main reasons for this rule:
1.
2.
The business has a “life” distinct from its owner. It is possible for Larry King to sell LK
Hypermarket should he wish to do so.
The financial progress of the business must be separated from the personal finances of the
owner.
For example, Liam Brady receives a birthday present of R4 000 from his wife. If the
business transactions were not separated from personal transactions, then Liam Brady
would not be able to calculate the profit of the business without considerable difficulty.
Remember that even though the business entity rule applies to all forms of business
enterprise’s, the owner is still not protected from losing his personal possessions should the
business become insolvent (in the case of sole proprietorships and partnerships).
As far as financial reporting is concerned, financial statements will be prepared for LB
Hypermarket, without taking into account Liam Brady’s personal assets.
Should he so desire, Liam Brady can prepare a separate set of financial statements to cover his
personal financial position.
2. The “historical cost” concept.
This concept covers the valuation of assets that have been purchased by the business. The
general rule is that assets are to be valued at historical cost i.e. at the amount that was originally
paid for them.
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LB Hypermarket values Land and Buildings in 2010 at R70 000 even though on the same
date they could have sold the property for ten times that amount.
The reason for this rule is that, if accountants were allowed to place any subjective value on
such items as Land and Buildings, this would open the door for manipulation of financial results
to suit their own purposes e.g. they might wish the financial results to look better or to look
worse, depending on the circumstances. Furthermore, property values tend to fluctuate from
one year to the next and one is not really sure of the monetary value of items such as Land and
Buildings until the asset is actually sold.
Financial statements will be prepared for LB Hypermarket with all assets shown at
historical cost irrespective of opinions as to their current worth.
However, accountants throughout the world do realise that in these times of high inflation, the
historical cost may be inappropriate, and have constantly been discussing ways of overcoming
this problem, such as Inflation Accounting or Replacement Cost Accounting but have not yet
reached consensus. So the historical cost rule is still one of the cornerstones of financial
reporting. Exceptions are sometimes made to this rule in special circumstances, which will be
studied at a much later stage.
3.
The “going-concern” concept.
The concept is based on the assumption that financial statements are to be prepared for a
business that will continue operating for the foreseeable future. For example, LB Hypermarket
is assumed to be continuing business for the next few years and this might have implications in
the valuation of its assets. If LB Hypermarket were to close down in one weeks’ time, they
might be forced to value their assets at less than the book values as they would not receive an
appropriate price for their assets in the event of a forced, quick sale, i.e. the “liquidation” values
might be different from the “book values.”
As far as financial reporting is concerned, all fixed assets, investments and current assets
are valued in accordance with the historical cost rule and not on what the business would
be likely to receive for those assets should they be sold at short notice.
Note that there are certain types of businesses where financial statements might not be
prepared on the basis of the going-concern concept. These are usually businesses which have
a limited life span e.g. mining companies.
4. The “matching” concept.
There are two aspects to this concept:
1. Expenses and income must be reported in (matched to) the correct time period, and
2. If an expense has been incurred with the effect of producing income, then the two items
must be matched against each other in the same set of financial statements.
If LB Hypermarket stipulates that their year end is 28 February, then all transactions occurring
up to and including that date must be reflected in the financial statements for that year
irrespective of whether the transaction has resulted in the exchange of cash or not.
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For example, LB Hypermarket sells goods on credit for R8 000 on 28 February 2010. Even
though LB Hypermarket has not yet received the cash for those sales, the amount is still
to be recorded in the Income Statement for that accounting period. Furthermore, the cost
of those sales must also be recorded in the same financial period so that the gross profit
is correctly calculated.
One of the main reasons for adopting this concept is to ensure that financial statements are
comparable from one year to the next and from one business to another.
If businesses were allowed to reflect income in the income statement only when the cash
is received, there would be an opportunity to manipulate the reported profit by delaying
the deposit of cash until after the year-end; similarly, if the expenses are reflected only
when they are paid, then profit can be manipulated by either delaying or advancing the
payment for that expense.
Let us consider the following example.
LB Hypermarket place a large advertisement in the local newspaper during February
2010 at a cost of R3 000. This amount will not be paid until 25 March 2010 when an
account will be received from the newspaper. However, as a result of the advertisement,
the business makes additional gross profit of R20 000 during February on the increased
volume of goods, which it has sold, for cash. If the matching concept were not applied,
the profit for the year ended 28 February 2010 would be R20 000 greater, but the R3 000
would only appear in the financial statements of the following year. It is therefore
necessary to make an entry to record the R3 000 in the accounting period in which the
advertising expense is incurred rather than in the period in which it was paid. This will
then reflect the profits as increasing by R17 000 (i.e. R20 000 less R3 000).
5. The “prudence” concept
This concept is often termed the “doctrine of conservatism”. In terms of this concept,
accountants will report on financial results in a conservative, possibly even a pessimistic,
manner. In other words, an accountant will not anticipate any revenue, which has not been
earned beyond all doubt, but he will provide for any possible loss even if he is not entirely sure
of the exact monetary amount.
The accountant realises that there are many individuals who will rely on the financial statements
prepared by him/her in the making of business decisions. If the profit is overstated (i.e.
anticipated revenue does not materialise), it may cause financial loss if someone had relied on
optimistic financial statements. The accountant has therefore traditionally been inclined to
understate, rather than overstate, profits in the event of uncertainty.
For example, LB Hypermarket has been told that a customer will be suing them for R13
000 for medical costs as a result of defective food stuff which s/he had bought from them
and eaten. The accountant would be inclined to report this as a loss in the financial
statements even though the matter has not yet been finalised.
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If, however, LB Hypermarket are told that they will make a R40 000 profit on the sale of
certain land, then the accountant will be inclined not to report this profit until the transfer
of the land has been concluded.
ENRICHMENT
This concept sometimes leads to exceptions being made to other rules, e.g. the historical
cost rule. Where LB Hypermarket has purchased stock of stationery at the historical cost
of R3 500 and this stock has now become obsolete, the old stock can only be sold at 50%
below the original cost price. In this case the accountant might be inclined to value the
stock in the financial statements at the net realisable value of
R1 750.
6. The concept of “materiality”
The word “material” can have several meanings, but the dictionary definition which applies to
Accounting is the following: “that which matters, which is considerable, which is important”.
Think of how the word is used in the following sentence: “That information is material to my
decision.”
The concept of materiality therefore covers the accounting treatment of items which are of
importance to the readers of the financial statements. The material items must be specifically
shown in the financial statements, while the immaterial items need not be highlighted.
This concept has been covered by us several times before. For example, in preparing the Cash
Payments Journal we allocated Interest on Overdraft to a special account and did not post the
amount to the Bank Charges account. This is because the figure is important in making
decisions about a business e.g. would the interest have been lower had a loan been taken out
instead of an overdraft?
We covered another example in the Creditors Journal where we allocated certain small,
miscellaneous expenses to the Sundry Expenses account rather than post them to separate
accounts.
One of the main reasons for adopting this concept is to assist the reader of the financial
statements in his/her understanding of the figures provided. If, for example, all the items which
comprise “Sundry Expenses” were to be reflected separately, then the Income Statement would
be unnecessarily long and the reader would have to search through the mass of figures in order
to arrive at the figures that are relevant to him/her.
In subsequent chapters we will see a further application of this concept of materiality where we
attempt to make the Balance Sheet as simple as possible while, at the same time show detailed
information by way of notes to the Balance Sheet.
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Exercise 1
1. What is meant by GAAP?
2. Briefly explain what is meant by each of the following fundamental accounting concepts:
(a) The Business Entity Concept.
(b) The Historical Cost Concept.
(c) The Going-Concern Concept.
(d) The Matching Concept.
(e) The Prudence Concept.
(f) The Concept of Materiality
Homework
Match each concept mentioned in the left hand column with an example of its application in the
right hand column.
CONCEPTS
(a) Business Entity Concept
APPLICATION
(1) Damages payable to a client will be finalised
next year. An estimated amount of R9 000 is
recorded this year.
(b) Historical Cost Concept
(2) Interest on overdraft is shown as a separate
amount in the Income Statement.
(c) Going-Concern Concept
(3) An owner of a business wins R1 000 in a
competition. This is not reflected in the Income
Statement of the business.
(d) Matching Concept
(4) Whenever a debtor settles an account,
discounts should be recorded at the same time.
(e) Prudence Concept
(5) Land and Buildings are shown in the Balance
Sheet at R25 000 even though an estate agent
says that they could be sold for R100 000.
(f) Concept of Materiality
(6) Trading stock is shown in the Balance Sheet at
R8 000 even though the business would get
only R5 000 if the stock was sold at a flea
market the next day.