Explaining Basic Accounting Concepts and Business Structures I will explain the basic accounting concepts and business structures from the following topics: GAAP sources and hierarchy; Good accounting information using the qualities of accounting principles; Difference between Accrual based accounting and cash basis of accounting; Types of business structures and the features of each structure.
1. GAAP sources and hierarchy
Generally accepted accounting principles (GAAP) is the set of accounting principles, standards and procedures that companies use to prepare their financial statements. GAAP principles are the bases of financial reports and the guidelines of United States accounting practices. There are four categories of sources of GAAP hierarchy as follows:
Category (A): FASB Standards, Interpretations, and Staff Positions; APB Opinions; AICPA Accounting Research Bulletins. Category (B): FASB Technical Bulletins (no longer issued), AICPA Industry Audit and Accounting Guides, AICPA Statements of Position. Category (C): FASB Emerging Issues Task Force, AICPA AcSEC Practice Bulletins. Category (D): AICPA Accounting Interpretations, FASB Implementation Guides (Q and A), widely recognized and prevalent industry practices. The category (a) of the GAAP hierarchy has a higher authority than a FASB Technical Bulletin, which is in category (b).The hierarchy is important because it gives the out layer for companies to search for the specific accounting transactions. For example, if a specific transaction can not be covered in category (a), then companies will turn to categories (b) for selecting and applying appropriate accounting principles, then (c) and (d).
2. Good accounting information using the qualities of accounting principles Good accounting information should be understandable. If no one can not understand the accounting information presented, it becomes useless to lose all of the other qualities. The good accounting information should be Reliable and Relevant. Reliability means verifiable, representation faithfulness, and free of error and bias. If the accounting numbers are wrong, there is no any meaning to use the information. Relevance means predictive or feedback value presented on a timely basis.
The internal managerial accounting reports are different from the external financial reports. The relevant information is needed to prepare the different kinds of reports. The good accounting information should be Comparability and Consistency. The good information can be used to identify the differences and similarities between companies. The company consistently use the same accounting treatment for better auditing purposes.
3. Difference between Accrual basis accounting and cash basis of accounting
The revenue recognition principle and the expense matching principle are two key elements for Accrual basis accounting. Company uses accrual basis accounting to recognize income when goods are shipped or services are rendered, and to recognize expense when it is obligated to pay it. On the contrast, cash basis accounting recognizes the revenue and expenses when the cash is received and paid. The cash basis accounting is prohibited under GAAP because it does not record revenue and expense when earned and incurred. It will misstate the actual income and expenses incurred and can not reflect the real business operation during the accounting period.
4. Types of business structures and the features of each structure
There are three types of business structures-Sole Proprietorship, Partnership, and Corporation. Sole proprietorship is a business owned by one person. It is the simplest form of business ownership. The sole proprietor is in direct control of all affairs and entitled all profits and losses and is free to transfer his interest in the sole proprietorship at will. The disadvantage is that the sole proprietor would be fully responsible for all debts and obligations related to the business. The business would have difficulty in raising capital. Partnership is a business owned by two or more persons associate a partner. Partnership can bring broad resources and unique skills. All the partners share profit and losses, share the right to manage and make major business decisions, have unlimited personal liability for obligation of the partnership.
For tax advantage, the partnership does not pay federal income tax; rather, partners file their own individual tax return. Disadvantage is that partners are fully and personally liable for the debts if their partnership. Corporation is a legal entity distinct from its owners (called “shareholders” or “stockholders”) and manager. It is easy to raise fund. The major advantage of corporation is that the owners are not personally liable for the obligation. Stockholders are free to transfer their ownership interests. Corporation must pay income taxes on any profits that it makes, and stockholders generally do not have to pay income tax on its profits until they are distributed as dividends. The corporate tax rate generally is lower than the personal tax rate.