Principles of Financial Accounting: Introduction to Accounting - Generally Accepted Accounting, Principles GAAP vs. IFRS

What It Is

Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) are two sets of accounting standards used to prepare financial statements. GAAP is primarily used in the United States, while IFRS is used in over 140 countries. The main difference between the two is the approach to accounting for certain transactions, such as revenue recognition, inventory valuation, and financial statement presentation. If a company buys $10,000 of inventory under GAAP, it would be recorded as an asset, while under IFRS, it would be recorded as an expense.

Key Concepts & Formulas

• Matching Principle: Matches revenues with the expenses incurred to generate those revenues. Example: If a company sells $10,000 of goods in a month, it would match the revenue with the cost of goods sold (COGS) of $8,000.
• Materiality: A principle that requires financial statements to be presented in a way that is not misleading to users. Example: If a company has a small transaction of $1,000, it may not be material and can be omitted from the financial statements.
• Consistency: A principle that requires companies to use the same accounting methods and policies from one period to another. Example: If a company uses the FIFO method to value inventory in one period, it must use the same method in subsequent periods.
• Going Concern: A principle that assumes a company will continue to operate for the foreseeable future. Example: If a company has a large amount of debt, it may not be considered a going concern and may need to be liquidated.
• Accrual Accounting: A method of accounting that matches revenues with the expenses incurred to generate those revenues. Example: If a company provides services in December but bills the customer in January, the revenue would be recognized in December under accrual accounting.
• GAAP Formula: Gross Profit = Sales – COGS: This formula is used to calculate the gross profit of a company.
• IFRS Formula: Revenue = Sales – Returns: This formula is used to calculate the revenue of a company under IFRS.
• Debit/Credit Rule: A rule that states that debits equal credits in a transaction. Example: If a company purchases $10,000 of inventory, it would debit the inventory account and credit the cash account.
• Asset Turnover Ratio: A ratio that measures the efficiency of a company's use of assets. Example: If a company has $100,000 in sales and $50,000 in assets, the asset turnover ratio would be 2.

Journal Entry Examples

GAAP Journal Entry Example

Dr. Inventory $10,000 Cr. Cash $10,000

Explanation: The company purchases $10,000 of inventory, which is recorded as an asset. The cash account is credited because it is the source of the funds used to purchase the inventory.

IFRS Journal Entry Example

Dr. Cost of Goods Sold $10,000 Cr. Inventory $10,000

Explanation: Under IFRS, the cost of goods sold is recorded as an expense, and the inventory account is credited because it is the asset that is being reduced.

GAAP Journal Entry Example

Dr. Accounts Payable $5,000 Cr. Purchases $5,000

Explanation: The company purchases $5,000 of goods on credit, which is recorded as an increase in accounts payable. The purchases account is credited because it is the source of the funds used to purchase the goods.

Common Mistakes

• Mistake: Confusing debits and credits for expense accounts.
• Correction: Remember that debits increase assets and decrease liabilities, while credits decrease assets and increase liabilities. Use the mnemonic "ADE" (Assets, Drawings, Expenses) to remember this rule.
• Mistake: Not considering the materiality principle when preparing financial statements.
• Correction: Consider the size and significance of transactions when deciding whether to include them in the financial statements.
• Mistake: Not using the same accounting methods and policies from one period to another.
• Correction: Use the consistency principle to ensure that accounting methods and policies are used consistently from one period to another.

Exam Tips

• Tip: Remember that a debit increases assets AND expenses – remember 'ADE' (Assets, Drawings, Expenses).
• Tip: Be careful when reversing normal balances – remember that a debit increases assets and decreases liabilities, while a credit decreases assets and increases liabilities.
• Tip: Consider the materiality principle when preparing financial statements – if a transaction is small and insignificant, it may not be material and can be omitted.

Quick Practice

Problem 1

A company purchases $10,000 of inventory under GAAP. What is the journal entry?

Answer: Dr. Inventory $10,000 Cr. Cash $10,000

Explanation: The company purchases $10,000 of inventory, which is recorded as an asset. The cash account is credited because it is the source of the funds used to purchase the inventory.

Problem 2

A company provides services in December but bills the customer in January. What is the adjusting entry under accrual accounting?

Answer: Dr. Accounts Receivable $5,000 Cr. Service Revenue $5,000

Explanation: The company provides services in December, but the revenue is not recognized until the customer is billed in January. The accounts receivable account is debited because it is the asset that is being increased, and the service revenue account is credited because it is the revenue that is being recognized.

Problem 3

A company has a large amount of debt and is not considered a going concern. What is the effect on the financial statements?

Answer: The financial statements would show a decrease in assets and an increase in liabilities.

Explanation: If a company is not considered a going concern, it may need to be liquidated, which would result in a decrease in assets and an increase in liabilities.

Last-Minute Cram Sheet

• GAAP vs. IFRS: GAAP is used in the US, while IFRS is used in over 140 countries.
• Matching Principle: Matches revenues with the expenses incurred to generate those revenues.
• Materiality: A principle that requires financial statements to be presented in a way that is not misleading to users.
• Consistency: A principle that requires companies to use the same accounting methods and policies from one period to another.
• Going Concern: A principle that assumes a company will continue to operate for the foreseeable future.
• Accrual Accounting: A method of accounting that matches revenues with the expenses incurred to generate those revenues.
• Debit/Credit Rule: A rule that states that debits equal credits in a transaction.
• Asset Turnover Ratio: A ratio that measures the efficiency of a company's use of assets.
• Dividends are NOT an expense – they go directly to retained earnings.
• Revenues are recognized when earned, not when received.
• Expenses are matched with revenues, not capitalized.
• Assets are recorded at cost, not market value.