Part I.
A. Generally Accepted Accounting Principles.
GAAP is not a fixed set of rules. It is a guideline or more precisely a group of objectives
and concepts that have evolved over 500 years from the basic concepts of Luca Pacioli set
forth in the 1400s. It governs how financial statements are prepared and presented in the
United States. The Financial Accounting Standards Boards (FASB), the American Institute
of Certified Public Accountants and the Securities and Exchange Commission (SEC)
provide guidance about acceptable accounting practices. Some of the reasons we use
GAAP are that any business that expects anyone from outside their company to look at
their financial data needs to use GAAP. Compliance with GAAP helps maintain
creditability with creditors and stockholders because it reassures outsiders that a company
financial reports accurately portray their financial position. Additionally anyone who reads
your financial statements will automatically assume they are prepared and comply with
GAAP. Another reason to use GAAP is that banks and finance companies often require
their clients to use GAAP or have audited financial statements. It would be cheaper in the
long run to prepare statements using GAAP than pay someone to audit them all the time.
Additionally investors who are accustomed to using financial information prepared
according to GAAP might balk if your statements dont meet their expectations, which
could lead to unhappy investors ultimately leading to a loss of profits. Finally the SEC
requires companies to comply with GAAP.
The basic point of the Generally Accepted Accounting Principles is to put everything in
one format so that every business is not doing things there own way and it makes it easier
for the investment community to read the business financial statements.
B. Historical Cost.
Historical cost is the actual purchase price plus incidental costs incurred in getting the
fixed asset in a condition and position ready for initial use. Under U.S. Generally Accepted
Accounting Principles (US GAAP), the historical cost principle dictates that most assets
and liabilities should be recorded at their historical cost. For example, a tract of land which
was purchased 50 years ago for $10,000 may be worth $1 million today, but it will be
recorded on the balance sheet at its historical cost of $10,000. The historical cost principle
is used because of its reliability and freedom from bias when compared to the fair market
value principle.
C. Accrual Basis vs. Cash Basis Accounting.
In accrual basis accounting, income is reported in the fiscal period it is earned,
