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‘Know Thy Numbers’ Installment #2 – Accounting Principles in a Nutshell

Plain English Principles for the Business Owner & Investor about Accounting and Finance

The Importance of GAAP

Financial information in financial statements. Installment #3 describes financial statements in more depth. Before we get there, however, we want to make sure we are all on the same page with four basic terms and one key concept.

The concept is Generally Accepted Accounting Principles (“GAAP”).  It sets the standard for how financial statements are (or should be) reported (at least for U.S. companies). It is a set of basic accounting principles and concepts that guide accountants in their everyday work.

The four basic terms are: revenue, costs, assets, and liabilities.  Please don’t skip ahead – this is the bedrock of everything else you will read in this series.

1. Revenue

How much has your company made in sales? In other words, how much has your company received for its products or services?

This differs from income in that revenue doesn’t take any of your costs into account. Gross income is revenue minus the cost of goods sold. Net income is a further refinement, which also subtracts overhead expenses. In other words, net income (aka net profit) is the amount that remains after all expenses have been deducted from sales.

2. Costs

There are a few ways to look at costs, but we’ll stick to those that can be valued monetarily (and not, for example, the emotional cost of losing your hair to stress).

A cost can be expensed or it can be capitalized. The choice determines how the cost is treated on the company’s financial statements.

  • If you expense a cost, then it will be included on the income statement and subtracted from revenue to determine gross income.
  • If you capitalize a cost, then that cost will be accounted for on the balance sheet as an asset, with only depreciation for the asset showing up on the income statement.

As long as you follow GAAP guidelines, you may determine for yourself whether to capitalize or expense. Most companies, however, follow a rule of thumb that any cost over a certain dollar amount will be treated as a capital expense, with all lesser costs being treated as an expense.

One last point: sometimes, expenses are referred to as operating expenses, and sometimes a cost that is capitalized is called a “capital expense.” On the one hand, it’s sort of annoying that there are multiple terms for the same thing; on the other hand, it’s convenient to have a term for costs that are capitalized, so much so that that the term “capital expense” is commonly shorthanded to CAPEX.

3. Assets

Assets are tangible and intangible “things” that your company owns that can be sold and converted to cash. This can be anything, and there are many different asset classes. Valuing assets correctly and transparently is a subject unto itself.

4. Liabilities

A liability is an amount owed to someone, and includes any sort of borrowing (whenever you buy something on credit, for example, you are borrowing). Liabilities are commonly divided into current liabilities (those that have to be paid in less than a year) and long-term liabilities.

GAAP: Accounting Principles and Concepts You Should Know

GAAP – again, an acronym for “Generally Accepted Accounting Principles” – is a commonly recognized set of rules, guidelines, and procedures that govern corporate accounting and financial reporting in the United States.

GAAP was developed jointly by the Financial Accounting Standards Board and the Governmental Accounting Standards Board. All companies that publicly release financial statements, nonprofits and governmental entities must follow GAAP.

GAAP is (or should be) a cornerstone for how a privately owned company reviews and understands financial information. Even if you don’t want to follow GAAP you should understand that a lot of third parties may expect you to. These include potential lenders, investors, or buyers of your company.

What started with five broad principles recommended by an American Institute of Accountants’ special committee following the stock market crash of 1929 has evolved into thousands of GAAP pronouncements on accounting topics with an accumulated wisdom approaching 10,000 pages.

We’ll give you the 10,000-foot view.

Breaking Down the 12 Commandments | GAAP Accounting Concepts

GAAP is made up of three basic concepts: Assumptions, Principles and Constraints all of which have four tenets:

The 4 GAAP Accounting Assumptions
  1. Economic Entity Concept: In the assumptions’ corner (and notice they all have the word “assumes”), the economic entity concept assumes that the business is a single entity separate from its owners and other businesses, and personal transactions should be kept separate from the business transactions. In other words, every bird in its own nest. And this applies to sole proprietorship nests as well.
  2. Going Concern Concept: The going concern concept assumes that the entity will continue its normal operations in the future, or at least for another year (yes, this is an example of a recent “update”). If the ship is sinking, then the accountant must disclose that information.
  3. Monetary Unit Concept: The monetary unit concept assumes the entity is using a stable unit of currency to record its transactions (“Monopoly” money not allowed). It’s also important to remember that inflation is not reflected in financial statements, so a dollar is a current dollar.
  4. Time Period Concept: The time period concept assumes that the activities of the entity can be divided into specific periods of time for reporting purposes, so information can be reported daily, weekly, quarterly, etc.
The 4 GAAP Accounting Principles
  1. Historical Cost Principle: The historical cost principle tells us that the initial recording of financial transactions is done at their original cost. So, it’s not how much you think it should cost, it’s what it actually costs. And yes, there are some exceptions, of course, in those thousands of pronouncements that are continually being updated.
  2. Revenue Recognition Principle: The revenue recognition principle states that revenue must be recorded by the entity when it is earned. The key word here is “earned.” That means the revenue is recorded once the sale happens rather than when the check is cashed.
  3. Matching Principle: The matching principle states that expenses must be matched with the revenues that helped generate them and therefore are recorded in the same period the revenue was earned.
  4. Full Disclosure Principle: The full disclosure principle is exactly what it says. Everything is out in the open; nothing is hiding behind the curtain. Past, present and future material information is available for all to see.
The 4 GAAP Accounting Constraints
  1. Objectivity: Make sure you have evidence to back up the information (and yes, it must be verifiable evidence).
  2. Materiality: Second is materiality, which asks the question: How significant is the information? If it will affect the decision of the reader of your financial information, then it matters, and is therefore material.
  3. Consistency: Consistency means that you do it the same way every time (just this once, let’s not make it more complicated by doing it differently).
  4. Conservatism: Simply put, when in doubt, always – and we mean always – choose the less favorable outcome. In other words, when reporting an item, choose the alternative that leads to less net income, for example.

So, there you have it: GAAP in a nutshell.

What’s Next?

We discussed GAAP in this installment as a stop on our way to discussing financial statements, since financial statements ought to be in compliance with GAAP. With an introduction to the importance of GAAP out of the way, in the next installment of this series, we’ll go through an overview of financial statements.

[Editor’s Note: To learn more about this and related topics, you may want to attend the following webinars: EBITDA and Other Scary Words, Finance and Accounting 101 and The KPI – Cash Flow Modeling and Projections.]

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About Jonathan Friedland

Jonathan Friedland is an attorney and entrepreneur. He founded DailyDAC in 2010 and launched Financial Poise in 2013. For more information on his legal practice, click here.

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About Kristina Parren

Kristina Parren is an associate editor with Financial Poise. Since graduating from the University of Michigan in film and screenwriting, she has worked as a copywriter and grant writer across multiple industries, including healthcare, finance, manufacturing and travel. In addition to her work as an editor and copywriter, she is an avid wildlife conservation activist,…

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