BUS103: Introduction to Financial Accounting

GAAP's assumptions, principles, and constraints can affect income statements through temporary (timing) and permanent differences.

Learning Objective

• Apply the four basic GAAP principles when preparing financial statements

Key Points

• Items that create temporary differences due to the recording requirements of GAAP include rent or other revenue collected in advance, estimated expenses, and deferred tax liabilities and assets.
• Also there are events, usually one-time events, which create "permanent differences," such as GAAP recognizing as an expense an item that the IRS will not allow to be deducted.
• The four basic principles of GAAP can affect items on the income statement. These principles include the historical cost principle, revenue recognition principle, matching principle, and full disclosure principle.
  
  

Terms

• deferred
  Of or pertaining to a value that is not realized until a future date, e.g. annuities, charges, taxes, income, either as an asset or liability.
  
  
• fair market value
  An estimate of the market value of a property, based on what a knowledgeable, willing, and unpressured buyer would probably pay to a knowledgeable, willing, and unpressured seller in the market. An estimate of fair market value may be founded either on precedent or extrapolation but is subjective. Fair market value differs from other ways of determining value, such as intrinsic and imposed value.
  

Although most of the information on a company's income tax return comes from the income statement, there often is a difference between pretax income and taxable income. These differences are due to the recording requirements of GAAP for financial accounting (usually following the matching principle and allowing for accruals of revenue and expenses) and the requirements of the IRS's tax regulations for tax accounting (which are more oriented to cash).

Income statement
GAAP and IRS accounting can differ.

Such timing differences between financial accounting and tax accounting create temporary differences. For example, rent or other revenue collected in advance, estimated expenses, and deferred tax liabilities and assets may create timing differences. Also, there are events, usually one time, which create "permanent differences," such as GAAP, which recognizes as an expense an item that the IRS will not allow to be deducted.

To achieve basic objectives and implement fundamental qualities, GAAP has four basic principles:

• The historical cost principle: It requires companies to account and report based on acquisition costs rather than fair market value for most assets and liabilities.
• The revenue recognition principle. It requires companies to record when revenue is (1) realized or realizable and (2) earned, not when cash is received.
• The matching principle. This governs the matching of expenses and revenues, where expenses are recognized, not when the work is performed or when a product is produced, but when the work or the product actually makes its contribution to revenue.
• The full disclosure principle. This suggests that the amount and kinds of information disclosed should be decided based on a trade-off analysis, since a larger amount of information costs more to prepare and use. GAAP reporting also suggests that income statements should present financial figures that are objective, material, consistent, and conservative.