Purpose of Generally Accepted Accounting Practice - Essay Example

? Generally Accepted Accounting Practice I. Introduction/Background Information.  Generally Accepted Accounting Principles or GAAP is the collection of the commonly set of rules of accounting standards used for financial reporting. The purpose of GAAP is to ensure transparency and uniformity of financial reporting among business organizations. There is however no one fix rule among all GAAP standards across industries and countries and they usually vary from one industry/country to another. In the United States, it is the Financial Accounting Standards Board (FASB) that sets the GAAP standards for private firms while it is the IASB sets principles for international accountants (Horngren et al, 2008). Compliance with GAAP is mandatory by every business operating in the USA. Corporations that are public companies are closely monitored by the Securities and Exchange Commission (SEC) to ensure their compliance to GAAP. II. GAAP and description of the accounting principles In the GAAP there exists accounting principles which also serves as measurements of conventions that are significant which are cost recording, revenue recognition and the matching principle. The recognition principle states that a company records revenues in its accounts only when it has earned and realized the revenue (Horngren et al, 2008 p.703). Revenues therefore cannot be recognized if it has not been earned. A second important convention is the matching principle which states that revenues must be linked to the expenses associated with them. Accountants apply the matching principle by identifying the revenue recognized during a period and by linking the expenses to the recognized revenue directly ( Horngren, 2008 p.703). The Cost Principle This GAAP accounting principle states that the recording of cost must be at their fair market price. Fair market price is determined by the amount reflected on documents accompanying the goods and/or services to ensure objectivity and accuracy of accounting when purchases are made. The effect of this costing principle on assets is that its value will not change until the market value of the asset changes. To effect this change in the books according to GAAP principle, a new require a new transaction as an evidence to effect the change of the value of the asset. In cases where objective evidence is not available to ascertain cost, the transaction can instead be recorded at its fair market value as determined by a third party appraiser (McKeown, 1973). The Revenue Recognition Convention The recognition principle states that a company records revenues in its accounts only when it has earned and realized the revenue (Horngren, 2008 p.703). Revenue cannot be recognized if it has not been earned. This principle states that revenue must only be completed and recorded into a company’s books when the transaction is already completed. This means that revenue will only be recorded once actual payment is received. On occasions when transactions involve huge projects which take a very long time to finish such as construction of buildings, revenue is done an accrual basis whereby it will bill its client on periodic basis on the amount of work that has been done or completed and recognize the revenue even if there is still work in progress (Klueh, 2009). Recognizing revenue correctly is important to the accuracy of the financial statements because earning is a critical aspect of a financial statement which can affect the company’s many stakeholders. The Matching Principle A second important convention is the matching principle which states that revenues must be linked to the expenses associated with them. Accountants apply the matching principle by identifying the revenue recognized during a period and by linking the expenses to the recognized revenue directly (Horngren, 2008 p.703). This can be likened to the revenue recognition principle whereby expenses related to the revenue that were earned during a certain accounting period must be reflected in the books of the company. This is important because failing to record cost along with its revenue at a specific accounting period would remove the objectivity and fairness of measuring the operation of a company. For example, expenses that were not recorded when the sale was made would inadvertently bloat the net income by not deducting the costs associated to realize that revenue. III. Selected company’s application of GAAP in cost recording, revenue recognition,  and matching of expenses and revenues.  To illustrate how companies apply the principles of GAAP in cost recording, revenue recognition, we can cite a construction company for illustration as it has been previously mentioned already. We could choose Koch Industries as an example being the largest construction in the US. Let us say that Koch Industries was contracted to construct a 100 storey building which could take three years to finish. As stated, Koch does have to reflect revenue only after three years because that would severely affect the liquidity of the company. It has to bill its client periodically to bankroll the revenue and defray its operational expenses. Thus in the revenue recognition convention, it could bill its client periodically according to its progress. In this case, Koch may bill the client for the completion of phase or whatever scheme that both parties agreed on how to bill the client. It does not have to be at the end of the project. Billing the client periodically would also help facilitate the matching principle of recording the cost associated with the revenue. For example, upon completion of a portion where the client is billed, the materials used in that portion will be already recognized as cost because the corresponding revenue has been recognized already. The price of such construction materials will be determined based by their acquisition price as indicated in the documents of purchase. IV. Description of recent accounting standard(s) and pronouncement(s) that affect  the selected company’s financial statements.  The internationally renowned accounting firm Deloitte reported that the implementation of the Sarbanes Oxley Act made the SEC ponder to transition the US accounting standard away from GAAP and going towards the internationally-used International Financial Reporting Standards (IFRS): “A ‘roadmap’ has been proposed which acknowledges that IFRSs have the potential to become the global set of high-quality accounting standards and which sets out seven milestones that, if achieved, could lead to mandatory adoption from 2014”  (Komar, 2013). The reason for this proposal could be attributed for IFRS universality compared to GAAP whose interpretation of rules and standards could vary from one industry or country to another which could make interpretation of financial statements relative and difficult. V. Assertions of internal controls described in the notes to the financial statements.  The assertions of internal controls in the notes to the financial statements help the financial statement more credible to the party who is interested with such financial statements. The accounting scandal wrought by Enron and Andersen Consulting whereby the two organizations connived to misrepresent their financial statements raised doubts among many stakeholders about the integrity of many financial statements. Also, the assertion of internal controls described in the notes of financial statements are consistent with the provision of Sarbanes-Oxley Act which requires auditors under the pain of criminal liability to indicate any critical findings and controls instituted for greater transparency and objectivity. In addition, the audience of such audited financial statements must also be given financial literacy training on how to interpret such assertion notes (SEC, 2009). VI. Conclusion GAAP intends to make the reporting of financial statements objective, accurate, fair and universal so that the parties who are consumers of financial statements may be adequately informed of their economic decisions based on the figures presented by the financial statements. Without the guiding principles of GAAP, such reporting of financial statement may become vulnerable to relativity and misinformation defeating the purpose of a financial statement. References Horngren, T., Sundem, G., Stratton, W., Burgstahler, D., and Schwartzberg, J. (2008) Introduction to Management Accounting: Chapters 1-17, [University of Phoenix Custom Edition (14th) e-text]. Prentice Hall Upper Saddle River, New Jersey. Retrieved from University of Phoenix, ACC561-Accounting. Klueh, K. C. (1992). Making GAAP relevant. Best's Review, 93(5), 40-40. Retrieved from http://search.proquest.com/docview/201114543?accountid=35812 Komar, A. (2013). Generally Accepted Accounting Principles. Retrieved from http://gogreenplus.org/nuts-and-bolts-guide/performance-nuts-and-bolts-guide/financial-practices/generally-accepted-accounting-principles/ MCKEOWN, J. C. (1973). Comparative Application of Market and Cost Based Accounting Models. Journal Of Accounting Research, 11(1), 62-99. US Securities and Exchange Commission (2009). Study of the Sarbanes-Oxley Act of 2002 Section 404 Internal Control over Financial Reporting Requirements. Retrieved at http://www.sec.gov/news/studies/2009/sox-404_study.pdf Read More