Generally Accepted Accounting Principles

Generally Accepted Accounting Principles (GAAP) are a set of rules, guidelines, and principles that U.S. companies of all sizes and across industries adhere to. In the U.S., these accounting standards have been established by the Financial Accounting Standards Board (FASB) and the American Institute of Certified Public Accountants (AICPA).

For companies that follow GAAP, these principles are at the core of all of their accounting transactions. Businesses use them to organize and summarize financial information into accounting records.

What Is GAAP?

GAAP is a set of accounting standards used in the United States to help publicly-traded companies create their financial statements. These standards 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 generally accepted accounting principles.

Who Developed GAAP?

While the Financial Accounting Standards Board specifies overall GAAP, the Governmental Accounting Standards Board (GASB) specifies GAAP for U.S. state and local government entities.

Not all companies have to follow generally accepted accounting principles. In the U.S., the Securities and Exchange Commission (SEC) requires publicly traded companies to follow GAAP. Private companies, state and local governments, and nonprofit organizations may choose to use GAAP or be required to follow its accounting principles by lenders, investors, or regulators.

Many small businesses issue financial statements that don’t adhere to GAAP guidelines when reporting financial information. These alternatives are known as “other comprehensive basis of accounting” (OCBOA) methods, and they include cash basis accounting, modified cash basis, income tax basis, and regulatory basis.

Outside of the U.S., most public companies follow International Financial Reporting Standards (IFRS) rather than U.S. GAAP.

Principles of Accounting

One way to understand the GAAP requirements is to look at the 10 principles of accounting. These basic accounting principles were created by the American Institute of Accountants (AIA) following the Wall Street Crash of 1929. The goal was to ensure publicly-traded companies were following consistent accounting methods and help investors compare financial results from company to company and from year to year.

The AIA initially recommended 5 basic principles, but additional ones were added to the list over the years. They’re the foundation of all accounting standards in the U.S. and elsewhere, including GAAP standards.

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 a 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. While the value of an asset might rise or fall with 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 company’s 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, revenue 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 a service has been performed, the company recognizes revenue from the sale. This is regardless of whether the money changes hands 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, the 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 a lower asset value.

For example, potential lawsuits may be regarded as losses and are reported but potential gains from other sources are not.

10 Principles of GAAP

While GAAP includes a number of official accounting rules and standards, there there are 10 principles that can help you understand the mission of GAAP.

These are separate from the 10 accounting principles listed above, but there may be some overlap between the two lists.

1. Principle of Regularity

The principle states that the accountant has to follow all GAAP rules and regulations. In other words, you can’t pick and choose which GAAP rules to follow.

2. Principle of Consistency

The accountants should enter all transactions and prepare all financial reports consistently throughout the financial reporting process. By applying similar standards in the reporting process, accountants can avoid errors or discrepancies.

If a company changes the way it records or presents financial documents, the accountants are expected to disclose and explain the reasons behind the changes.

3. Principle of Sincerity

As per this principle, the accountant should provide an accurate and honest depiction of the business’s current financial situation.

4. Principle of Permanence of Method

The focus of this principle is that there should be 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. In other words, the financial statements shouldn’t compensate (offset) a debt with an asset or expenses with revenues.

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 suitable time periods, such as quarterly or annually.

9. Principle of Full Disclosure

While creating financial reports, accounting professionals must strive to disclose all situations, circumstances, and events that are relevant to financial statement users.

10. Principle of Utmost Good Faith

This principle states that all parties involved in reporting financial data are expected to act honestly and in good faith.

While the GAAP principles are primarily used by large companies, if you hope to someday take your company public, you may want to start following GAAP accounting methods early on.

International Accounting Standards (IASs) were issued by the antecedent International Accounting Standards Council (IASC), and endorsed and amended by the International Accounting Standards Board (IASB). The IASB will also reissue standards in this series where it considers it appropriate.

International Accounting Standards (IASs) were issued by the antecedent International Accounting Standards Council (IASC), and endorsed and amended by the International Accounting Standards Board (IASB). The IASB will also reissue standards in this series where it considers it appropriate.