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GAAP Related Practice Question's

Three independent unrelated paragraphs follow. Each one contains some unsound reasoning. For this practice, identify the areas that are not in accordance with US GAAP or are not true and explain why the reasoning is incorrect. Complete the identification and explanation of each paragraph before proceeding to the next paragraph.

P1: One function of financial accounting is to measure an entity's net income for a given period of time. An income statement prepared in accordance with US GAAP will reflect the true net income. The idea is to match revenues with expenses. Revenues are inflow of cash and should be realized when recognized. Expenses are an outflow of cash and should be recognized when paid. Dividends declared reduce retained earnings, and dividends paid are an expense. Extraordinary items are shown separately at the bottom of the income statement. A good net income is about 5% of revenues for all entities.

P2: One function of financial accounting is to accurately present an entity's financial position at a point in time. The balance sheet is prepared using historical costs for all assets. Assets represent future benefits for the entity. Unearned revenues are assets and prepaid expenses are liabilities. Retained earnings will usually equal cash available for the entity. Goodwill may be set up any time by an entity with an offsetting entry to "equity." "Depreciation" is measured as declining value of certain assets. The term "capitalize" means set up as an asset. WorldCom was accused of allegedly expensing items that should have been capitalized.

P3: Accounting is an exact science because the financial statements, which are not related to each other, have no limitations. US GAAP is established by the FASB, which is part of the US government. International accounting standards are established by the United Nations. All standard setting bodies have been concerned with "off-balance-sheet-reporting," which means that assets are left off the balance sheet. All entities must be audited by an independent CPA, who takes responsibility for these financial statements.
While accounting concepts and tax rules may overlap, they are not necessarily the same.

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P1: One function of financial accounting is to measure an entity's net income for a given period of time. An income statement prepared in accordance with US GAAP will reflect the true net income. The idea is to match revenues with expenses. Revenues are inflow of cash and should be realized when recognized. Expenses are an outflow of cash and should be recognized when paid. Dividends declared reduce retained earnings, and dividends paid are an expense. Extraordinary items are shown separately at the bottom of the income statement. A good net income is about 5% of revenues for all entities.

An income statement will reflect true income or not is difficult to say. The income statement prepared in accordance with GAAP will reflect the income as per the accounting procedures applied and in that sense is an accounting income based on the accounting concepts.
The GAAP is based on accrual method of accounting as opposed to the cash method. In the cash method, revenues and expenses are recorded when cash changes hand. In the accrual method revenues are recorded when earned and expenses are recorded when incurred. The matching takes place only under accrual method since we need not wait for the cash. Under the cash method there is no matching as revenues and expenses would be recorded when paid and not when it is earned or incurred.
Dividends are not an expense as these are paid out of net income. Dividends do reduce ...

Solution Summary

The solution explains how the given situations are not in accordance with GAAP.

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