What Are the Generally Accepted Accounting Principles?
The Generally Accepted Accounting Principles (GAAP) are a set of rules, guidelines and principles companies of all sizes and across industries in the U.S. adhere to. In the U.S., it has been established by the Financial Accounting Standards Board (FASB) and the American Institute of Certified Public Accountants (AICPA).
Irrespective of the type of company, the GAAP is at the core of all of the company’s accounting transactions. It is used by businesses to organize and summarize the financial information into accounting records.
What this article covers:
What Is GAAP?
GAAP is a set of rules used for helping publicly-traded companies create their financial statements. These rules form the groundwork on which more comprehensive, complex, and legalistic accounting rules are based.
GAAP covers a wide array of topics such as financial statement presentation, liabilities, assets, equities, revenue and expenses, business combinations, foreign currency, derivatives and hedging and non-monetary transactions.
Financial accounting information is based on historical data. To facilitate comparisons, the financial information must follow the generally accepted accounting principles.
While the overall GAAP is specified by the Financial Accounting Standards Board, the Governmental Accounting Standards Board (GASB) specifies GAAP for state and local government. Compliance with GAAP as well as SEC is required by publicly traded companies.
What Are the Principles of Accounting?
The best way to understand the GAAP requirements is to look at the ten principles of accounting.
1. Economic Entity Principle
The business is considered a separate entity, so the activities of a business must be kept separate from the financial activities of its business owners.
2. Monetary Unit Principle
The monetary unit assumption means that only transactions in U.S. dollar amounts can be included in accounting records. It’s important to note that accountants ignore the effects of inflation on the recorded dollar amounts.
3. Time Period Principle
The business activities may be reported in short, distinct time intervals which may be weeks, months, quarters, a calendar year or fiscal year. The time interval has to be identified in the headings of the financial statements such as the income statement, statement of cash flow and stockholders’ equity statement.
4. Cost Principle
The cost principle mentions the historical cost of an item. This refers to cash or cash equivalent that was paid to purchase an item in the past. This asset amount is adjusted for inflation. The historical cost is reported on the financial statements.
5. Full Disclosure Principle
All information that is relative to the business and is important to a lender or investor must be disclosed in the content of the financial statements or in the notes to the statements. This is the reason that numerous footnotes are attached to financial statements
6. Going Concern Principle
This accounting principle refers to the intent of a business to carry on its operations and commitments into the foreseeable future and not to liquidate the business.
7. Matching Principle
The matching principle requires that businesses use the accrual basis of accounting and match business income to business expenses in a given time period.
For example, the commissions for sales should be recorded in the same accounting period that sales income was made (and not when they were paid).
8. Revenue Recognition Principle
Under the accrual basis of accounting, the revenues must be reported on the income statement in the period in which it is earned. This means that as soon as a product is sold, or the service has been performed, the revenues are recognized. This is regardless of whether the money is received or not.
9. Materiality Principle
The materiality principle refers to the misstatement in accounting records when the amount is insignificant or immaterial. Because of the materiality principle, financial statements usually show amounts rounded to the nearest dollar.
10. Conservatism Principle
If accountants are unsure about how to report an item, conservatism principle calls for potential expenses and liabilities to be recognized immediately. It directs the accountant to anticipate the losses and choose the alternative that will result in less net income and/or less asset amount.
For example, potential lawsuits may be regarded as losses and are reported but potential gains from other sources are not.
What Are the 10 Principles of GAAP?
There are ten principles that can help you understand the mission of the GAAP standards and rules.
1. Principle of Regularity
The principle states that the accountant has complied to the GAAP rules and regulations.
2. Principle of Consistency
The accountants should enter all items in exactly the same way that it has been fixed. By applying similar standards in the reporting process, accountants can avoid errors or discrepancies.
If the standards are changed or updates, the accountants are expected to fully disclose and explain the reasons behind the changes.
3. Principle of Sincerity
As per this principle, the accountant should provide the correct depiction of the financial situation of a business.
4. Principle of Permanence of Method
The focus of this principle is that there should be a consistency in the procedures used in financial reporting.
5. Principle of Non-Compensation
The full details of the financial information should be disclosed including negatives and positives. This should be done without the expectation of debt compensation by an asset or revenue by an expense.
6. Principle of Prudence
The financial data representation should be done “as it is” and not based on any speculation.
7. Principle of Continuity
The principle assumes that the business will continue its operations in the future.
8. Principle of Periodicity
The accounting entries are distributed across the suitable time periods.
9. Principle of Full Disclosure
While creating the financial reports, the accountants must strive for full disclosure.
10. Principle of Utmost Good Faith
This principle states presupposes that the parties remain honest in transactions.
While the GAAP principles are used by large companies while reporting their financial information, if you believe your small business may eventually be subject to GAAP, you may want to adopt the standard early on.