Introduction to Financial Accounting and GAAP

Accounting, a.k.a. “The Language of Business”, is a large and diverse topic. Subtopics include financial accounting, cost accounting, management accounting, internal auditing external auditing, international accounting, governmental and not-for-profit accounting and taxes. The subtopic that comprises the largest portion of an accountants academic program of study is financial accounting.

The purpose of financial accounting is basically to provide useful information to users who will use that information to make a decision, most commonly either an investment or a credit decision. To be useful information needs to be relevant and reliable. The most common means of conveying information to users is through the preparation of financial statements: 1. the income statement, 2. the balance sheet, 3. the statement of cash flows, and 4. the statement of shareholders’ equity.

The income statement presents the profitability of company over a period of time. The balance sheet presents the assets, liabilities, and owners’ equity at the end of the period of time used for the income statement. The statement of cash flows classifies all cash inflows and outflows during the time period into one of three categories: operating, investing, and financing. The statement of shareholders’ equity shows how the shareholders’ equity changed over the period.

Generally accepted accounting principles (GAAP) are a set of standards, methods, procedures, and guidelines companies follow in measuring and reporting financial information in the financial statements. GAAP comes from written sources as well as practices that have been used for a ling time that have become generally accepted. Although the Securities and Exchange Commission (SEC) has the legal authority to set accounting standards for companies, it has always delegated the majority of this responsibility to the accounting profession itself. The current accounting professional body that sets standards is known as the Financial Accounting Standards Board (FASB). The FASB issues standards called Statements of Financial Accounting Standards (SFAS). They can be found on the FASB web-site, http://www.fasb.org. As of May 2007 the FASB has issued 159 such statements.

All publicly traded companies listing their stocks on U.S. stock exchanges must have their financial statement audited by an external CPA firm that expresses an opinion as to whether the financial statements have been prepared in conformity with GAAP. The idea is to lend credibility to the financial statements by providing a third-party’s verification that the statements are presented fairly in conformity with high quality standards, GAAP!

Recent accounting scandals (WorldCom, Enron, etc), however, have given the accounting profession somewhat of a black eye and have rekindled the debate over whether principles-based, or more recently termed, objectives-oriented, standards should be set forth as opposed to rules-based accounting standards. A principles-based approach to standard setting stresses professional judgment, as opposed to following a specific list of rules.