Generally accepted accounting principles, or GAAP, are standards that encompass the details, complexities, and legalities of business and corporate accounting. The Financial Accounting Standards Board (FASB) uses GAAP as the foundation for its comprehensive set of approved accounting methods and practices.
The rules and guidelines that companies must follow when reporting financial data. The common set of accounting principles is the generally accepted accounting principles (GAAP). To remain listed on many major stock exchanges in the U.S., companies must file regular financial statements reported according to GAAP.
Accounting principles differ around the world, and countries usually have their own, slightly different, versions of GAAP. Since accounting principles differ across the world, investors should be aware of these differences and account for them when comparing companies in different countries.
The problem of differences in accounting principles does not much affect mature markets. Still, investors should be careful, since there is still leeway for the distortion of numbers under many sets of accounting principles
What Are the Basic Principles of Accounting?
GAAP incorporates three components that eliminate misleading accounting and financial reporting practices: 10 accounting principles, FASB rules and standards, and generally accepted industry practices.
These components create consistent accounting and reporting standards, which provide prospective and existing investors with reliable methods of evaluating an organization’s financial standing. Without GAAP, accountants could use misleading methods to paint a deceptive picture of a company or organization’s financial standing.
10 Principles of GAAP
There are 10 general concepts that lay out the main mission of GAAP.
The Continuing Concern Concept
The continuing concern concept assumes that a business will continue to operate unless it is known that such is not the case. The values of the assets belonging to a business that is alive and well are straightforward. For example, a supply of envelopes with the company’s name printed on them would be valued at their cost.
This would not be the case if the company was going out of business. In that case, the envelopes would be difficult to sell because the company’s name is on them. When a company is going out of business, the values of the assets usually suffer because they have to be sold under unfavorable circumstances. The values of such assets often cannot be determined until they are actually sold.
The Principle of Conservatism
The principle of conservatism provides that accounting for a business should be fair and reasonable. Accountants are required in their work to make evaluations and estimates, to deliver opinions, and to select procedures. They should do so in a way that neither overstates nor understates the affairs of the business or the results of operation.
The Objectivity Principle
The objectivity principle states that accounting will be recorded on the basis of objective evidence. Objective evidence means that different people looking at the evidence will arrive at the same values for the transaction.
Simply put, this means that accounting entries will be based on fact and not on personal opinions or feelings.
The source document for a transaction is almost always the best objective evidence available. The source document shows the amount agreed to by the buyer and the seller, who are usually independent and unrelated to each other.
The Time Period Concept
The time period concept provides that accounting takes place over specific time periods known as fiscal periods. These fiscal periods are of equal length and are used when measuring the financial progress of a business.
The Revenue Recognition Convention
It provides that revenue be taken into the accounts (recognized) at the time the transaction is completed. Usually, this just means recording revenue when the bill for it is sent to the customer. If it is a cash transaction, the revenue is recorded when the sale is completed and the cash received. It is not always quite so simple.
Revenue is taken into the accounts on this periodic basis. It is important to take revenue into the accounts properly. If this is not done, the earnings statements of the company will be incorrect and the readers of the financial statement misinformed.
The Matching Principle
The matching principle is an extension of the revenue recognition convention. The matching principle states that each expense item related to revenue earned must be recorded in the same accounting period as the revenue it helped to earn. If this is not done, the financial statements will not measure the results of operations fairly.
The Cost Principle
The cost principle states that the accounting for purchases must be at their cost price. This is the figure that appears on the source document for the transaction in almost all cases. There is no place for guesswork or wishful thinking when accounting for purchases.
The value recorded in the accounts for an asset is not changed until later if the market value of the asset changes. It would take an entirely new transaction based on new objective evidence to change the original value of an asset.
The Consistency Principle
The consistency principle requires accountants to apply the same methods and procedures from period to period. When they change a method from one period to another they must explain the change clearly on the financial statements.
The readers of financial statements have the right to assume that consistency has been applied if there is no statement to the contrary. The consistency principle prevents people from changing methods for the sole purpose of manipulating figures on the financial statements.
The Materiality Principle
The materiality principle requires accountants to use generally accepted accounting principles except when to do so would be expensive or difficult, and where it makes no real difference if the rules are ignored. If a rule is temporarily ignored, the net income of the company must not be significantly affected, nor should the reader’s ability to judge the financial statements be impaired.
The Full Disclosure Principle
The full disclosure principle states that any and all information that affects the full understanding of a company’s financial statements must be included with the financial statements. Some items may not affect the ledger accounts directly. These would be included in the form of accompanying notes.
Basic Accounting Principles and Guidelines
These 10 guidelines separate an organization’s transactions from the personal transactions of its owners, standardize currency units used in reports, and explicitly disclose the time periods covered by specific reports. They also draw on established best practices governing cost, disclosure, matching, revenue recognition, professional judgment, and conservatism.
Rules and Standards Issued by the FASB and Its Predecessor, the Accounting Principles Board (APB)
The FASB issues an officially endorsed, regularly updated compendium of principles known as the FASB Accounting Standards Codification. The compendium includes standards based on the best practices previously established by the APB. These organizations are rooted in historic regulations governing financial reporting, which the federal government implemented following the 1929 stock market crash that triggered the Great Depression.
Generally Accepted Industry Practices
All organizations do not follow the GAAP model. Rather, particular businesses follow industry-specific best practices designed to reflect the nuances and complexities of different business areas. For example, banks operate using different accounting and financial reporting methods than those used by retail businesses.
- GAAP is the set of accounting principles set forth by the FASB that U.S. companies must follow when putting together financial statements.
- GAAP aims to improve the clarity, consistency, and comparability of the communication of financial information.
- GAAP may be contrasted with pro forma accounting, which is a non-GAAP financial reporting method.
- The ultimate goal of GAAP is to ensure a company’s financial statements are complete, consistent, and comparable.
- There are 10 key concepts that guide the principles of GAAP.