What are GAAP?

GAAP or Generally Accepted Accounting Principles is a common set of accounting principles, standards, and procedures that the Finance Accounting Standards Board issues. When accountants compile their financial statements for public companies in the United States, they must conform to the GAAP rules.

GAAP combines authoritative standards set by the policy boards and the commonly accepted ways of recording and reporting accounting information. It aims to improve clarity, consistency, comparability, and communication of financial information.

It also helps govern the world of accounting by establishing general rules and guidelines and focuses on standardizing and regulating accounting definitions, assumptions, and methods across all industries. GAAP covers the topics like revenue recognition, balance sheet classification, and materiality.

To better understand GAAP, you need to understand the basic principles of accounting.

Main Principles of Accounting

1. Economic Entity Principle

According to the economic entity principle, a business entity’s recorded activities and any other business activities should be kept separate from the recorded activities of its owners and any other business entities.

This means that you should keep different accounting records and bank account for each entity and not mix the assets and liabilities of its owners or business partners with them. In addition, each business transaction must be specifically associated with an entity.

2. Monetary Unit Principle

The monetary unit principle means that you can only record business transactions expressed in terms of currency. That is why a company cannot track non-quantifiable items like employee skill levels, customer service quality, or engineering staff ingenuity.

The monetary unit principle also presumes that the value of the unit of currency in which transactions are recorded remains relatively stable over time.

3. Time Period Principle

The time period principle states that a company should report the financial results of its operations over a standard time period, which is usually monthly, quarterly, or annually.

Once the length of each reporting period has been determined, record transactions within each period per GAAP or International Financial Reporting Standards. A high level of consistency in reporting for the same periods is necessary to produce financial statements compared to the previous years’ results.

4. The Cost Principle

The cost principle requires assets to be recorded at their respective cash values at the time they were purchased or acquired. You cannot increase the amount recorded for the asset to reflect increases in market value or inflation, nor can you update it to reflect any depreciation. 

The recorded assets can include short-term and long-term assets, liabilities, and any activity, and these assets are always recorded at their original cost.

5. Full Disclosure Principle

The full disclosure principle states all information in an entity’s financial statements that would affect a reader’s understanding of those statements should be included. 

It is common to only disclose information about events that are likely to have a material impact on the entity’s financial position or financial results to reduce the amount of disclosure. Mainly, the financial records will track the depreciation or increasing value of the acquired assets, but the cost principle will remain constant. 

Furthermore, the cost principle is also known as the historical cost principle. Regardless of how much an asset appreciates or depreciates over time, the asset’s original cost is the value kept as the cost principle at the time of its acquisition.

6. Going Concern Principle

The going concern principle assumes that an entity will remain in business for the foreseeable future. On the other hand, this means that the company will not be forced to halt operations and liquidate its assets shortly at what may be very low fire-sale prices. 

By making this assumption, the accountant is accepted in forgoing the recognition of certain expenses until a later period, when the entity is presumably still in business and making the best use of its assets. An entity is considered a going concern in the absence of significant information to the contrary. 

An example of such contradictory information is an entity’s inability to meet its obligations as they come due to the lack of significant asset sales or debt restructurings. If this is not the case, an entity would be acquiring assets with the intent of closing its operations and reselling the assets to a third party.

7. Matching Principle

The matching principle is based on the cause-and-effect relationship between spending and earning. It requires that all business expenses be recorded in the same period as related revenues. In other words, it formally recognizes that businesses must spend money to generate revenue. 

The accrual accounting is based on this principle which specifies how and when a company’s balance sheet is adjusted if there is no cause-and-effect relationship leading to future related revenue; the expenses can be recorded immediately without changing entries.

8. Revenue Recognition principle

The revenue recognition principle states that you should only record revenue when earned, not when the related cash is collected. It means recognizing revenue as soon as services have been rendered and completed, even if the payment from the customer is not expected for several weeks. The accrual basis of accounting incorporates this concept. 

9. Materiality Principle

The materiality principle states that the accounting standard can be ignored if the net impact on the financial statements is so minor that a user of the statements would not be misled. If an item is immaterial, you are not required to implement the provisions of an accounting standard under generally accepted accounting principles (GAAP). 

Because this definition does not provide definitive guidance in differentiating material information from immaterial information, determining whether a transaction is material requires judgment. This concept varies based on the size of the entity. 

10. Conservatism Principle

The conservatism principle is a general concept of recognizing expenses and liabilities as soon as possible when the outcome is uncertain, but only recognizing revenues when they are sure to be realized and received. 

Hence this is why when given a choice between several outcomes with equal probabilities of occurrence, you should realize the transaction resulting in a lower amount of profit or, at the very least, the deferral of profit. 

Similarly, if a choice of outcomes with similar probabilities will impact an asset’s value, recognize the transaction resulting in a lower recorded asset valuation.

Main GAAP Principles

After going through the above, we can summarize that the ultimate goal of GAAP is to ensure that a company’s financial statements are: complete, consistent, and comparable. As a result of these principles, it becomes easier for the investors to analyze and extract useful information from its financial statements, including trend data of that period of time. 

Following are the principles of GAAP:

1. Principle of Regularity

This principle makes it essential that you, as an accountant, use a system for reporting. So don’t just make it up as they go along.

2. Principle of Consistency

The consistency principle states that you should follow it consistently throughout subsequent accounting periods once you adopt an accounting principle or method. If the new version improves the reported financial results, you can only change an accounting principle or practice. If such a change is made, fully document its effects and include this documentation in the financial statements’ note.

3. Principle of Sincerity

This principle means that the accountant preparing the report isn’t trying to mislead anyone. All the financial information and analysis are presented as fairly and accurately as possible.

4. Principle of Permanence of Methods

Financial reporting procedures should be consistent, allowing for a comparison of the company’s financial information.

5. Principle of Non-Compensation

This principle means that one should show the full details of the financial accounting information and not seek to compensate a debt with assets, revenue, or expenses.

6. Principle of Prudence

This accounting principle seeks to depict reality as it is, and no attempt should be made to make things appear prettier than they are. Usually, the revenue should be recorded only when specific, and a provision should be made for a probable expense.

7. Principle of Continuity

When making reports, an accountant should assume that the company will continue operating in the same manner. The assumptions about the future should be consistent with what occurred in the past for this principle to be upheld.

8. Principle of Periodicity

This principle states that the accountant should report financial data at consistent and accepted time intervals. You should not compare a quarter to the last two weeks of the year and shouldn’t make up a five-month period for reporting either. Hence it’s best to maintain a consistent and periodic approach. Months, quarters, and years are all viable options to work with.

9. Principle of Materiality

All the financial information should be presented in a GAAP-compliant report. This principle is supposed to ensure that your accountant does not skip accounts or debts or omit information that misleads readers.

10. Principle of Utmost Good Faith

This principle states that you should not lie no matter what regarding the financial matters and transactions being made.

GAAP Principles – Very Essential and Useful

GAAP principles help businesses maintain consistency in financial information presentation, reduce the risk of misrepresentation, and avoid fraud. GAAP was established to protect the rights of stakeholders, including investors. 

It holds companies accountable for their financial reporting activities, providing greater assurance to all the parties involved. As a result, companies present accurate and fair financial information by adhering to GAAP guidelines as a standard of operation.