What if every company prepared its financial statements according to its own rules? It would be a nightmare and nearly impossible to get any meaningful information from the statements. You wouldn't know which data was correct or whether that stellar performance from management was exaggerated.
This is why professional accounting associations have established accounting assumptions to use when preparing financial statements. The purpose is to create a consistent basis that managers, stockholders and analysts can use to evaluate a company's financial statements and performance.
Financial statements are expected to be reliable, verifiable and objective. They should be consistent and follow the same principles that make them comparable over time.
Role of GAAP in Accounting
The Financial Accounting Standards Board is in charge of developing accounting principles. These principles are presented as Generally Accepted Accounting Principles or GAAP.
The purpose of GAAP is to standardize and regulate accounting definitions, assumptions and methods. It defines how financial information should be reported and creates consistency for comparisons from year-to-year. The application of GAAP means analysts, investors and management can make reasonably confident conclusions when comparing one company to another or statistics for its industry.
The Securities and Exchange Commission has the governmental authority over financial reporting for companies with publicly-traded stock.
Fundamental Accounting Assumptions
The following assumptions form the basis for GAAP and establish a foundation for reliable and consistent information:
Accrual: Accrual principles require that activities are recorded as they occur and revenue and expenses are related. Revenues are earned and recorded at the time of sale. This means that revenue from a sale is valid when the buyer takes possession of the product or the service has been performed. However, it is not the moment when cash is transferred from the buyer to the seller.
Expenses are recorded when the business accepts the goods or services from another company, not when payment is made for the goods or services.
Accrual principles require the recording of revenues along with their related expenses. For example, if your company manufactures and sells a bicycle, the expenses (invoices) for the steel, wheels, cables and chains would be recorded when the bicycle is sold. The accrual-basis method of accounting matches revenues and expenses, and presents an accurate picture of the company's profit.
Consistency: Using consistent methods of accounting is essential because it gives management the confidence that the information is correct and can be relied on to draw conclusions and make informed decisions. Consistent accounting methods make it easier to compare the performance of companies in the same industry, but there are some exceptions.
Consider the perfectly legitimate methods of accounting for inventory: LIFO and FIFO. One company might use the last-in-first-out method while another company in the same industry could use the first-in-first-out method. Both methods are acceptable but can give entirely different results. Also, companies can sometimes switch from one method to the other. Users of this financial information must be aware of the differences in accounting for inventory and consider these adjustments when evaluating performance.
Reliability and objectivity: The data used to prepare financial reports must use only transactions that can be proven with supporting documents. The information must be factual and verifiable, ideally by an outside third party.
Monetary unit assumption: Economic activity should be expressed in a single monetary unit of currency. The effects of inflation are ignored, and the purchasing power of the dollar is assumed to remain the same. The dollar cost of a transaction from 1960 has the same value as one recorded in 2018. The monetary unit is usually determined by the country where the company has its principal operations.
Time period: Financial reports should cover a uniform and consistent time period. The reporting periods could be monthly, quarterly or annually. If this approach is not followed, financial reports across different periods will not be comparable.
Business entity assumption: The economic data in financial reports is restricted to the operations of the company. The activities of the business are not intermingled with the personal transactions of the owner. While a sole proprietorship and its owner are considered a single entity for legal purposes, the business is reported as a separate entity for accounting purposes.
Going concern: Accountants present the value of the information as if the business were going to remain a "going concern" and will continue to operate indefinitely in the future. The company does not have the necessity nor the intention to cease operations. The numbers would be different if it looked like the company was going out of business and cease to exist.
Accordingly, the depreciation expenses for fixed assets are spread over their useful life. If the firm were not expected to continue, the cost of a fixed asset would be expensed in full in the year of acquisition.
Accountants are required to express an opinion as to the long-term survivability of the company. If the accountant determines that the business will not be able to continue operating, the accountant must disclose this viewpoint.
Historical cost: The cost principle requires the use of historical costs of assets on the books. This is the amount spent when an item was originally acquired. These values are not adjusted for changes in market prices, inflation or estimated resale values. An analyst looking for the current value of a company's long-term assets would have to employ a third-party appraiser to get this information.
Full disclosure: While GAAP covers most reporting methods of accounting information, other information that is important and relevant to the performance and condition of the company must be disclosed. This information is usually reported in the notes to the financial statements. As an example, suppose the business is named in a lawsuit for a large amount of money. At the time of the financial statements, the outcome of the lawsuit and its effect on the company is not clear. This situation would be disclosed in the notes to the financial statements.
Conservatism: Whenever two acceptable accounting principles give different answers, conservatism requires that the accountant use the method that reports a lower income or a lesser asset amount. This approach prevents the presentation of overly optimistic financial statements and gives users the confidence that the reports are based on solid information.
For example, an accountant will report the potential losses from a lawsuit but not the potential gains. Another example is when inventory is marked lower than the original cost but not written up for an increase in market value.
Accounting Standards Establish Credibility
Accounting assumptions provide structure on how financial transactions are reported. GAAP are the principles used to regulate and standardize accounting methods and definitions. Because of this consistency analysts and stockholders can evaluate financial statements with the confidence they are accurate, reliable and comparable across different periods. Management will have the confidence that the information will be a foundation for sound decision-making.
Consistent accounting principles create a sense of order thereby limiting or eliminating the potential for chaotic and undecipherable financial statements. Business transactions have become more complex over the years and standardized accounting methods are needed to present useful financial information to all stakeholders as well as the public.
James Woodruff has been a management consultant to more than 1,000 small businesses. As a senior management consultant and owner, he used his technical expertise to conduct an analysis of a company's operational, financial and business management issues. James has been writing business and finance related topics for work.chron, bizfluent.com, smallbusiness.chron.com and e-commerce websites since 2007. He graduated from Georgia Tech with a Bachelor of Mechanical Engineering and received an MBA from Columbia University.