GAAP Accounting Standards
It is important to understand why in investor would want to learn GAAP (Generally Excepted accounting principles) instead of another form of reporting. The SEC (Security Exchange Commission) requires publicly traded corporations to use GAAP accounting. This is an important distinction because there are multiple ways and agencies that companies report to. For example, for the tax returns business report to the IRS or companies located in Europe report in IFRS which is an international standard similar to GAAP.
Think of GAAP more as a framework for the rules that accountants follow. I go over some of these in detail but what they are is accounting best practices. Most of these rules were put in place to protect stakeholders. From a finance standpoint, you are a stakeholder if you are an investor so they are designed to protect you.
This is an important accounting concept as well as a legal concept. What this means is that the business is a separate entity from the owners, so the cooperation you own technically functions as an individual who can sue or get sued. This is good for a few reasons but one thing that this does is protect the owners from getting sued. The cooperation can get sued and you can loose your investment; however, you will not lose your personal assets. The lawyers understand who has the money and will go after the accounting firm that did the audits before they go after you as an individual.
The lawyers understand who has the money and will go after the accounting firm that did the audits before they go after you as an individual. The largest fraud case in recent history was Enron which was audited by Author Anderson. Since Author Anderson was the auditor of Enron they were taken out when Enron went down because they were participating in the fraud. The government and stakeholders went after Anderson and they are no longer around today.
The basics of this principle is that the company will have an indefinite life. We all know that cooperations come and go but is it really possible for a cooperation to live forever? I would use some of the blue chip stocks that make up the S&P 500 as examples. Marriott International was started in 1922 or Coke was founded in 1868. These cooperations have exceeded the average human life so it is possible for a cooperation to have a very long life.
Monetary Unit Principle
This is the assumption that the US dollar is a stable currency. There are theories around the US dollar telling us otherwise, but the truth is that the US dollar is a stable currency. It does, however, change value when you think of currency pairs such as the CAD and USD which fluctuate in value when you look at them together.
Time Period Principle
This assumes that the business can divide the year into artificial time periods. This is an import concept in accounting because dates and times hold great meaning on judging how “well” or “not so well” a business does. From investing, I have learned that these time periods can be whenever the company decides. There are a lot of companies that follow the calendar year that match how their business is operated. This can be anytime the company wants to report though and will seem random.
As an example, this is the quarter end dates for Walmart. They don’t follow a calendar and are simply made up by the corporate officers.
For publicly traded companies there are two rules that they follow that deal with revenue recognition. There is the matching principle and what accountants call the accrual method of accounting. Accrual accounting and the matching principle put revenues and expenses in the same period they occur. This is to give the users a better understanding of the financial statements.
This means that the prices on the books are actually the purchase price. By an asset, I mean company equipment, vehicles or property that the business owns. Then the asset follows a depreciation schedule to write down the cost over its useful life. This subject was confusing to me when I first started as a student in accounting because the historical price, less depreciation, has nothing to do with the amount a business can sell the asset for. In reality, this has nothing to do with the price or value currently of the asset. (Fair Value) This value is adjusted when the company sells the asset or disposes of it.
This means that a business should report to their stakeholders (Investors, Creditors, Owners) enough information to give them a good idea of how the business is performing; however, this has to be an amount that is financially reasonable.
To break this down a little the business should disclose relevant information to their stakeholders. There is a term used in accounting call material. The important thing is that the reporting must be material to the size of business. For large S&P 500 companies, this could be anything under a million dollars isn’t material. Look at the financial statements for these companies and they round their numbers to the closest million.
This means that a company uses the same accounting methods from period to period. To keep this basic I won’t be able to use examples that involve more complex subjects of accounting. It is important to understand that this is so the statements can be compared with accounting period to period. This is like comparing apples to apples instead of apples to oranges.
Being conservative means using prudence when reporting information by choosing the less favorable outcome. This is a really important concept because there are a lot of estimations done in accounting. When there are multiple outcomes the worst outcome should be disclosed and the most probable outcome should be reported.