GAAP (Generally Accepted Accounting Principles) – accounting rules and standards that companies are required to adhere to when they prepare financial statements and reports.Established by the Financial Accounting Standards Board (FASB) and authorized by the SEC5 Important Accounting PrinciplesThe Assumption of Arm’s Length Transaction:Two parties involved in an economic transaction arrive at a decision independently and rationally.The Cost Principle:Transactions are recorded at the historical cost at which they occurred.The Realization Principle:Revenue is recognized when transaction is completed, while cash may not be collected until a later time.The Matching Principle:Expenses related to generating any revenue are matched with the related revenue during the period in which revenue arerecognizedGoing Concern Assumption:It is assumed that a company will continue to operate for the foreseeable future.Advantages of US GAAP:W/O GAAP, there would be no standardization of financial reportsMakes it easier to compare results among different firms, and across time periods.Criticisms of US GAAP:It is too complicated and detail oriented, and leaves no room for accountants to use their judgment.It can easily be circumvented by sharp financial managers and accountants.Financial Statements:Income Statement- results of operation for a period of time (movie)Method and expenses are located on the statementMeasures profitability of a firm over a period of timeInclude both cash and credit sales- value of products and servicesNet Income= Diff between the Firm’s revenues and expensesBasic Structure is Revenues – Expenses = Net IncomeIncludes some non-cash itemsRevenue from making sales on creditExpenses from – depreciation of property, plant & equipment (PP&E)Amortization of some intangibles (patents, licenses)Some common subtotals along the way:Operating profit (EBIT)= Revenue – operating expensesEarnings before taxes= operating – interestBalance sheet – company’s financial position at a point in time (snap-shot)This financial statement identifies all the assets and liabilities of a firm at a point in time (like a snapshot)Total Assets = Total Liabilities + Stockholders’ EquityLeft side – all assets the firm owns & uses to generate revenuesRight side- shows how those assets are financed with money that the firm has borrowed from creditors (liabilities), and with shareholders’ investment (equity)Liquidity – ability to convert to cash easily with min. riskEquity is last entitled to “residual”Statement of Cash FlowsNet Working Capital = Current Assets – Current LiabilitiesNet Operating Working capital (NOWC) = Current Assets – (Current Liabilities – Notes Payable)FIR 3410 1st Edition Lecture 5Current Lectureo GAAP (Generally Accepted Accounting Principles) – accounting rules and standards that companies are required to adhere to when they prepare financial statements and reports.- Established by the Financial Accounting Standards Board (FASB) and authorized by the SEC- 5 Important Accounting Principles- The Assumption of Arm’s Length Transaction:o Two parties involved in an economic transaction arrive at a decision independently and rationally.- The Cost Principle:o Transactions are recorded at the historical cost at which they occurred.- The Realization Principle:o Revenue is recognized when transaction is completed, while cash may not be collected until a later time. - The Matching Principle:o Expenses related to generating any revenue are matched with the related revenue during the period in which revenue arerecognized- Going Concern Assumption:o It is assumed that a company will continue to operate for the foreseeable future.- Advantages of US GAAP:- W/O GAAP, there would be no standardization of financial reports- Makes it easier to compare results among different firms, and across time periods.- Criticisms of US GAAP:- It is too complicated and detail oriented, and leaves no room for accountants to use their judgment. - It can easily be circumvented by sharp financial managers and accountants.- Financial Statements:- Income Statement- results of operation for a period of time (movie)o Method and expenses are located on the statemento Measures profitability of a firm over a period of timeo Include both cash and credit sales- value of products and serviceso Net Income= Diff between the Firm’s revenues and expenses Basic Structure is Revenues – Expenses = Net Income Includes some non-cash items Revenue from making sales on credit Expenses from – depreciation of property, plant & equipment (PP&E) Amortization of some intangibles (patents, licenses) Some common subtotals along the way: Operating profit (EBIT)= Revenue – operating expenses Earnings before taxes= operating – interest - Balance sheet – company’s financial position at a point in time (snap-shot)o This financial statement identifies all the assets and liabilities of a firm at a point in time (like a snapshot)o Total Assets = Total Liabilities + Stockholders’ Equity Left side – all assets the firm owns & uses to generate revenues Right side- shows how those assets are financed with money that the firm has borrowed from creditors (liabilities), and with shareholders’ investment (equity) Liquidity – ability to convert to cash easily with min. risk Equity is last entitled to “residual”- Statement of Cash Flows- Net Working Capital = Current Assets – Current Liabilities- Net Operating Working capital (NOWC) = Current Assets – (Current Liabilities –