Explaining_Basic_Accounting_Concepts_and_Business_Structures

Explaining Basic Accounting Concepts and Business Structures COM 537 / Financial Accounting 2010 Explaining Basic Accounting Concepts and Business Structures The first basic concept that a person would need to know when studying accounting is GAAP. GAAP, or generally accepted accounting principles, is a common set of standards that the accounting profession developed that is accepted and practiced by all users of financial accounting statements and reports (Kieso & Warfield, 2007, p. 5). The major source organizations of GAAP are: American Institute of Certified Public Accountants (AICPA), Accounting Principles Board (APB), and the Financial Accounting Standards Board (FASB). The AICPA is a National organization of practicing CPA’s. A committee of the AICPA is the APB or the Accounting Principles Board whose purposes are to advance the written expression of accounting principles, determine appropriate practices, and narrow the areas of difference and inconsistency in practice. The demise of the APB resulted in the creation of the Financial Accounting Standards Board (FASB). Its mission is to establish and improve standards of financial accounting and reporting for the guidance and education of the public. (Kieso & Warfield, 2007, pp. 7 & 8) “The FASB standard of GAAP is called ‘The Hierarchy of Generally Accepted Accounting Principles,’ which defines the meaning of GAAP and identifies the sources of accounting principles and the framework for selecting the principles to be used in the preparation of financial reports” (Kieso & Warfield, 2007, p. 12). The hierarchy is: • Category A (most authoritative): FASB Standards, Interpretations, and Staff positions; APB Opinions; and AICPA Accounting Research Bulletins, • Category B: FASB Technical Bulletins (no longer issued), AICPA Industry Audit and Accounting Guides, and AICPA Statements of Position, • Category C: FASB Emerging Issues Task Force and AICPA AcSEC Practice Bulletins, • Category D (least authoritative): AICPA Accounting Interpretations, FASB Implementation Guides, and widely recognized industry practices. The Hierarchy of Generally Accepted Accounting Principles is important because it sets the standard of accounting in the United States. If there were no standard to use, every user of accounting principles would have to develop their own system of accounting which would lead to incomparable financial statements (Kieso & Warfield, 2007, p. 12). The second basic concept to understand accounting is to use quality information to make the best decisions. Relevance and reliability are two primary qualities users need for better information. Relevant information has “predictive or feedback value” of outcomes “presented on a timely basis” (Kieso & Warfield, 2007, p. 6). Reliable information is “verifiable, is a faithful representation, and is reasonably free of error and bias” (Kieso & Warfield, 2007, p. 6). Comparability and consistency are secondary information qualities. Comparability helps users “to identify real similarities and differences between companies” (Kieso & Warfield, 2007, p. 7). Consistent application of accounting standards from period to period is important in useful decision making. The third basic concept in accounting is accrual based accounting versus cash based accounting. Accrual basis accounting is different than cash basis accounting because both systems report revenue and expenses in different accounting time periods. Also, accrual based accounting follows two important guiding principles which are the revenue recognition principle and the matching principle. A cash based accounting system does not follow these principles and is prohibited under GAAP (Kimmel, 2007, p. 158). In a cash based accounting system, revenue is recorded only when cash is received and expenses are recorded only when cash is paid. This can be misleading in the financial reports because the revenues may not match up to the expenses in the same period. On the other hand, in accrual based accounting revenues are recorded when they are earned (the revenue recognition principle) and not when they receive the cash. Expenses are recognized when incurred (the matching principle) and not when they are paid (Kimmel, 2007, p. 160). When discussing business structures in accounting, there are three basic choices a business can have: sole proprietorship, partnership and a corporation. Sole proprietorships and partnerships outnumber corporations five to one, in the US, but most of the revenues earned are from corporations (Kimmel, 2007, p. 5). There are advantages and disadvantages for each choice. The sole proprietorship is a business that is owned by one person. A partnership is when two or more people own a business. Proprietors and partnerships receive lower taxes, but are personally liable for all debts owed. “A corporation is a separate legal entity for which evidence of ownership is provided by shares of stock” (Kimmel, 2007, p. 27). One advantage is that the stocks are easy to sell which means transfer of ownership is much easier than the other forms of business. The taxes are higher, but there is no personal liability for debts owed (Kimmel, 2007, p. 4).