Accounting: The Language of Business (Part 6)

“Life is like a balance sheet. One wrong entry could change everything.” —Unknown

Introduction to Accounting and Business

(Part E)

by

Charles Lamson

Generally Accepted Accounting Principles

If the management of a company could record and report financial data as it saw fit, comparisons among companies would be difficult, if not impossible. Thus, financial accountants follow generally accepted accounting principles (GAAP) in preparing reports. These reports allow investors and other stakeholders to compare one company to another. 

To illustrate the importance of generally accepted accounting principles, assume that each sports conference in college football used different rules for counting touchdowns. For example, assume that the Pacific Athletic Conference (PAC 10) counted a touchdown as six points and the Atlantic Coast Conference (ACC) counted a touchdown as two points. It would be difficult to evaluate the teams under such different scoring systems. A standard set of rules and a standard scoring system help fans compare teams across conferences. Likewise, a standard set of generally accepted accounting principles allows for the comparison of financial performance and condition across companies.

Accounting principles and concepts develop from research, accepted accounting practices, and pronouncements of authoritative bodies. Currently, the Financial Accounting Standards Board (FASB) is the authoritative body having the primary responsibility for developing accounting principles. The FASB publishes Statements of Financial Accounting Standards and Interpretations to these Standards.

Because generally accepted accounting principles impact how companies report and what they report, all stakeholders are interested in the setting of these principles. For example, the setting of accounting standards for stock-based compensation or stock options has been especially controversial. Even the United States Senate has been involved in the debate. Many managers opposed an initial proposal by the FASB that would record the value of such options as a reduction of profits because doing so would negatively impact their financial results. The FASB issued a revised proposal, but investors, analysts, and other stakeholders criticized manager stock options in light of the poor financial performance of many companies and the financial failures of Enron, Tyco, and WorldCom. As the debate continues, some companies are voluntarily treating stock options as a reduction of profits.

Throughout this analysis, accounting principles and concepts are emphasized. It is through this emphasis on the "why" of accounting as well as the "how" that you will gain an understanding of the full significance of accounting. In the following paragraphs, we discuss the business entity concept and the cost concept.

Business Entity Concept

The individual business unit is the business entity for which economic data are needed.This entity could be an automobile dealer, a department store, or a grocery store. The business entity must be identified, so that the accountant can determine which economic data should be analyzed, recorded, and summarized in reports.

The business entity concept is important because it limits the economic data in the accounting system to data related directly to the activities of the business. In other words, the business is viewed as an entity separate from its owners, creditors, or other stakeholders. For example, the accountant for a business with one owner (a proprietorship) would record the activities of the business only, not the personal activities, property, or debts of the owner.

The Cost Concept

If a building is bought for $150,000, that amount should be entered into the buyer's accounting records. The seller may have been asking $170,000 for the building up to the time of the sale. The buyer may have initially offered $130,000 for the building. The building may have been assessed at $125,000 for property tax purposes. The buyer may have received an offer of $175,000 for the building the day after it was acquired. These later amounts have no effect on the accounting records because they did not result in an exchange of the building from the seller to the buyer. The cost concept is the basis for entering the exchange price, or cost, of $150,000 into the accounting records for the building.

Continuing the illustration, the $175,000 offer received by the buyer the day after the building was acquired indicates that it was a bargain purchase at $150,000. To use $175,000 in the accounting records, however, would record illusory or unrealized profit. If, after buying the building, the buyer accepts the offer and sells the building for $175,000, a profit of $25,000 is then realized and recorded. The new owner would record $175,000 as the cost of the building.

Using the cost concept involves two other important accounting concepts---objectivity and the unit of measure. The objectivity concept requires that the accounting records and reports be based upon objective evidence. In exchanges between a buyer and a seller, both try to get the best price. Only the final agreed-upon amount is objective enough for accounting purposes. If the amounts at which properties were recorded were constantly being revised upward and downward based on offers, appraisals, and opinions, accounting reports could soon become unstable and unreliable.

The unit of measure concept requires that economic data be recorded in dollars. Money is a common unit of measurement for reporting uniform financial data and reports. 

*WARREN, REEVE,& FESS, 2005, ACCOUNTING, 21ST ED., PP.12-13*

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