Accounting

Chapter 6: Highlights

1. Generally accepted accounting principles (GAAP) are the methods of accounting that firms use to measure the results of their business transactions, with a principal aim of measuring net income for a period and financial position at the end of a period.

2. Standard-setting bodies within each country currently set GAAP. The Financial Accounting Standards Board (FASB) sets acceptable accounting principles in the United States. The International Accounting Standards Board (IASB) promotes the establishment of more uniform GAAP worldwide.

3. In some situations, GAAP permits alternative methods for reporting a particular transaction. In such cases, standard-setting bodies recognize that the economic effects of certain transactions may differ across firms and that a single method may not provide the best measure of earnings and financial position.

4. Standard-setting bodies generally provide broad guidelines rather than detailed rules for applying their pronouncements because (a) economic differences may exist between firms, and (b) firms should have latitude to apply pronouncements to reflect these economic differences.

5. The flexibility and latitude of GAAP do have economic consequences to managers, investors, lenders, and others.

6. Controls exist to constrain the opportunistic actions of management. In its audits, a firm’s independent accountant makes judgments about the appropriateness of the accounting principles a firm selects and the reasonableness of the way the firm applies the accounting principles. Another control is the oversight provided by government regulators, such as the Securities and Exchange Commission (SEC) in the United States.

1. The term “quality of earnings” encompasses the following ideas:

a) the representative faithfulness of earnings as a measure of value added.

b) the ability managers have to use discretion in measuring and reporting earnings in their particular...