The common set of accounting principles, standards and procedures that companies use to compile their financial statements. GAAP are a combination of authoritative standards (set by policy boards) and simply the commonly accepted ways of recording and reporting accounting information.
PURPOSE OF GAAP
Adherence to generally accepted accounting principles serves five important purposes. These are:
(a) It increases the ability of users of financial statements to understand the accounting reports issued by different reporting entities.
(b) It provides reasonable degree of comparison between financial reports presented by entities since they adopt a standard framework of guidelines.
(c) It increases the confidence of investors, markets, and indeed the general public, that the financial statements issued by a reporting entity, faithfully represents its transactions.
(d) Preparers of financial statements have a set of guidelines which can be readily referred to in accounting and reporting their financial transactions.
(e) External auditors need GAAP to guide them in reporting on the truth and fairness or otherwise of the financial transactions of different entities.
In the previous sections of this chapter, we have interpreted GAAP as generally accepted accounting principles. GAAP could also be interpreted as generally accepted accounting practice. Some authors have argued that the term “principle” gives GAAP an unjustified measure of permanent since the concept changes in response to new developments in the business and economic environment.
The word “practice” perhaps better reflects the fact that accounting practice alters in response to changes in different social-economic environments, GAAP, therefore, goes beyond mere principles as they encompass contemporary accounting practices that are permissible within an accounting environment. By extension, international GAAP encompasses contemporary accounting practices that are “regarded as permissible by the accounting profession and regulators internationally” (Bonham, et al 2008).
The Accounting Standards issued by the International Accounting Standards Board (IASB) constitute the source of international GAAP.
FACTORS THAT DETERMINE THE ACCEPTABILITY OF AN ACCOUNTING PRACTICE
The following factors, outlined by Bonham et al (2008), members of Ernst & Young Global, provide useful guide in determining whether an accounting practice should be acceptable in a country’s GAAP, as well as international GAAP.
(a) Is the practice addressed in accounting standards or other official pronouncement?
(b) Is the practice addressed in accounting standards that deal with similar and related issues?
(c) If the practice is not addressed in accounting standards, is it dealt with in the standards of another country that could reasonably be considered to offer authoritative guidance?
(d) Is the practice consistent with the needs of users and the objectives of financial reporting?
(e) Does the practice have authoritative support in the accounting literature?
(f) Is the practice consistent with the underlying conceptual framework document?
(g) Does the practice meet basic criteria as to the quality of information required for financial statements to be useful to users?
(h) Does the practice fairly reflect the economic substance of the transaction involved?
(i) Is the practice consistent with the fundamental concept of ‘fair presentation?’
(j) Are other companies in similar situation generally applying the practice?
These are generally accepted principles used in the preparation of financial statements and are rarely disclosed because of their general acceptability. They are:
(a) Entity concept: This principle assumes that a company or corporation is a separate entity on its own; it can sue and be sued in a court of law.
(b) Going concern: The concept assumes that an organization will continue to operate for the foreseeable future. The balance sheet and profit and loss account assume no intention to liquidate or curtail its scale of operations.
(c) Realization concept: This concept recognizes revenue as soon as it is capable of objective measurement and the value of asset is reasonably certain.
(d) Matching concept: Under this concept, revenue or income and costs in a period are matched and dealt with in the profit and loss account of the period they relate.
(e) Double entry principle/concept: This concept assumes that every transaction should have two entries. In other words, where there is a debit entry, there has to be a corresponding credit entry for proper accountability.
(f) Consistency concept: This means that every like item within each accounting period should be treated the same way. This allows for easy comparison of accounts of an entity over a period of time.
(g) Prudence concept: This assumes that income is actually realized, not estimated. That is, revenue and profit should not be anticipated but recognized only when realized in cash or other assets. Prudence and realization concepts, are basic concepts in determining profit made.
(h) Periodicity: This concept assumes that transactions should be separated into particular periods for easy matching of revenue with expenses.
(i) Historical cost: This assumes that items should be stated at their original cost of purchase rather than realisable value.
ACCOUNTING METHOD AND POLICY
This is the medium through which accounting concepts are applied to financial transactions in the preparation of financial statements.
The methods adopted and applied by an organization in applying the fundamental accounting principles to its financial transactions are called the Accounting Bases. There are two bases used in the preparation of financial statements. They are
(a) The accrual basis ;
(b) The cash basis
Every organization or corporation has a policy used in the preparation of its accounts. Accounting policies are, therefore, the basic rules, principles, conventions and procedures adopted in the preparation and presentation of financial statements.
Disclosure of Accounting Policies
Accounting policies adopted by an organization or corporation in the preparation and presentation of financial statements are disclosed under one heading to provide an overview.
Use of Accounting Policies
Policies adopted by an organization are based on personal judgement and the suitability of presenting a true and fair view of the result of an organization. Therefore, there is a need for management to be careful and rational in their choice of accounting policies.
There are principles that should be used as a guide. These are:
(A) Substance over form: This principle states that generally the legal form of every transaction is a basis for recording its commercial status in the books of accounts, but there are instances whereby the legal status differs from the commercial status.
In such instances, the commercial status shall be recognized rather than the legal form. For example, in a finance lease agreement, the commercial status is recognized by including the assets acquired as part of the fixed assets of the lessee, despite the fact that legal title remains with the lessor.
(b) Objectivity: This principle states that an accountant should be fair and unbiased in the process of recording, collating, summarizing, analysing and interpreting financial transactions. This implies that accountants should be fair to all users of financial information and also treat transactions without emotion.
(c) Materiality: The principle holds that only items of material values are accorded strictaccounting treatment: that is, items with significant values.
(d) Prudence: Revenue and profits are not to be anticipated but recognized only when realized while known losses should be adequately provided for.
(e) Fairness: this is a product of the objectivity principle. It emphasizes the need for accountants not to be influenced by any user, but to prepare accounts based on acceptable principles.
Where fundamental accounting concepts are followed in the preparation of accounts, disclosure of such concepts is not necessary unless there is a departure from the fundamental accounting concepts.
However, when selecting accounting policies, rational judgement should be used: thus, the principles of substance over form, objectivity, fairness, and materiality can conveniently allow prudence to govern.
A reporting enterprise should disclose the basis used in the preparation of accounts if it is significant for the understanding and interpretation of a financial statement. The policies should also be disclosed as an integral part of the financial statements.
Accounting policies should be used consistently to facilitate comparison except where a different policy will better enhance or reflect net profit or loss of current or subsequent periods.
When there is a change in accounting policy, the nature, justification and the effect on current year’s profit or loss should be disclosed. Also, cumulative effect of the change on profit or loss of prior periods should be adjusted in the retained earnings.
ILLUSTRATION OF ACCOUNTING POLICIES
Basis of Accounting
Financial statements are prepared under the historical cost convention, except for some fixed assets which are included at their professional valuation.
Group profit and loss account and balance sheet include the accounts of the company and all the subsidiaries and the company’s share of profit after tax, less losses of associated companies.
Any excess of the cost of acquisition over the fair values of the net assets is recognised as an asset in the balance sheet as goodwill arising on acquisition.
Investments in subsidiary and associated companies are stated at the lower of cost or the company’s share of their net tangible asset value at the year end.
Land and buildings are stated at their professional valuation plus additions at cost. Other fixed assets are stated at cost.
Depreciation on a fixed asset is calculated to write-off the cost or valuation on a straight line basis over its expected useful life.
Stock and Work-In-Progress
Stocks are stated at the lower of cost and net realizable value after making adequate provision for obsolescence and damaged items. In the case of goods manufactured by the company, cost consists of direct labour, material and appropriate proportion of factory overhead.
Turnover represents the net value of goods and service invoiced or sold to third party, net of value added tax (VAT).
Contract in Progress
These are stated at the values of independence engineers’ certificate for work done but in respect of which payments were not received at the year end, plus estimated values made by officials of the company of the realizable value of work done not yet certified.
Foreign Currency Conversion
Transactions in foreign currencies are converted into naira at the prevailing rate ruling at the date the relevant invoices are received, while assets and liabilities denominated in foreign currencies are translated at the prevailing rate ruling on the balance sheet date.
Provision is made for deferred taxation by the liability method to take account of all timing differences between accounting treatment of certain items and their corresponding treatment for income tax purposes.
There are many alternative postulates, assumptions, principles and methods that could be used in preparing the financial statements of a reporting entity. These alternative methods impact on the financial position and operational results of corporate entities differently. To ensure a degree of comparison of financial reports, there should be minimum uniform standards and guidelines of financial accounting that different entities have to follow in financial reporting. These standards are referred to as Generally Accepted Accounting Principles (GAAP).