Every industry has a set of guidelines that helps standardize how work is completed, directs professional decision making and allows governing bodies to oversee professional behavior. The guidelines for accounting professionals are called the "Generally Accepted Accounting Principles," or GAAP. In this article, you will learn the basics of GAAP.
What are GAAP principles?
GAAP are the guidelines for recording and reporting financial information. GAAP gives accounting professionals a standard to compare financial documents from different companies and industries. Any corporation that is publicly traded on the stock market must use these rules to file financial statements to the U.S. Securities and Exchange Commission (SEC).
Lenders and creditors also prefer documents that comply with GAAP and most financial institutions require annual financial statements using these standards when they issue business loans.
GAAP generally requires accrual-based accounting, which means that events are recorded in the accounting period they occurred rather than when money is exchanged. This distinction is important for several of the principles.
Here are the assumptions and principles of GAAP:
- Economic entity assumption
- Principle of regularity
- Principle of consistency
- Principle of sincerity
- Monetary unit assumption
- Full disclosure principle
- Time period assumption
- Cost principle
- Going concern principle
- Revenue recognition principle
- Matching principle
- Principle of conservatism
- Materiality principle
Economic entity assumption
Every economic entity must have separate financial records. Economic entities include governments, businesses, churches, school districts and other social organizations. While accounting information from different entities can be combined in financial reporting, each transaction or event must be recorded by a specific entity. For example, if there are several subsidiaries connected to a corporation, each subsidiary must have its own financial records. Business records should also be kept separate from the owner's personal finances.
Principle of regularity
The accounting professional uses GAAP rules and regulations as a standard for financial reporting.
Principle of consistency
Accounting professionals use the same standards throughout the reporting process to prevent errors and discrepancies. Any changes or updates to the reporting standards need to be explained in the footnotes of the financial statements.
Principle of sincerity
The accounting professional is dedicated to accurate and impartial reporting.
Monetary unit assumption
Accounting records should only include quantifiable transactions. This means that the only entries into the accounting records should be clearly-defined assets or liabilities, which are recorded using a stable currency. Businesses in the U.S. use the U.S. dollar to record these transactions.
Full disclosure principle
This principle requires that financial statements include information regarding incomplete transactions, pending lawsuits or other events that may have a significant impact on a company's financial standing. Accounting professionals use footnotes on financial statements to provide this information and to describe the company's policies for recording and reporting business transactions.
Time period assumption
Business transactions can be complicated and their effects can be long lasting. Businesses create arbitrary time periods to help in reporting transactions. These time periods might be over a day, a week, a month, a quarter, a year or any other period of time. The period of time being reported must be listed in the heading for the financial statement.
Related: Q&A: What Does "Fiscal Year" Mean?
In accountancy, "cost" is the amount of money spent when an item is originally purchased. This means that any amounts on a financial statement are called "historical cost amounts". This also means that asset amounts are not adjusted for any type of increase in value, like inflation or rising market value.
Going concern principle
This principle is based on the assumption that the company will be active for the foreseeable future. This allows liabilities and assets to be listed as short term and long term. Long-term liabilities and assets are those that will not be acted on—either paid or sold, respectively—for at least a year.
Revenue recognition principle
Revenue is earned and reported when a product is delivered or when the service is completed, regardless of the timing of cash flow. This means that delivery revenue is recorded when the delivery is made, not when the deal is struck or the payment is received. If a service is paid for in advance, the money is not counted as revenue until the service is completed.
This principle requires that expenses be recorded with the revenue that they help produce. This means that commissions are recorded when the sale is made—not when the commission is paid—and that wages are recorded when the employee completed the work—not when they are paid. Since advertising cannot be matched with a specific revenue, advertising expenses are recorded in the period when the ad is run.
Principle of conservatism
Accounting professionals need to use their judgment when they record estimated transactions. This principle requires that the less optimistic estimate be recorded if there are two equally-likely estimates. Using this kind of estimation ensures that the accounting professional does not underestimate losses or overestimate gains.
This principle states that any principle may be ignored if the amount is insignificant. The logic here is that there is a point at which following the GAAP principle would be overly burdensome or inconsequential. There is not a set limit when an amount is immaterial, so the accounting professional must use their judgment on when to apply materiality. Most financial records are rounded to the nearest dollar or nearest thousand, depending on the size of the company.
The hierarchy of GAAP
There is a hierarchy of GAAP so that accounting professionals know which accounting principles to use when they are preparing GAAP-compliant financial statements. Accounting professionals will reference the most definitive documents first and work toward less official documents if they can't find the appropriate principle for their situation. Here is the hierarchy of GAAP:
- Statements by the Financial Accounting Standards Board and Accounting Principles Board, along with opinions from the American Institute of Certified Public Accountants
- FASB Technical Bulletins and AICPA Industry Audit and Accounting Guides and Statements of Position
- AICPA Accounting Standards Executive Committee Practice Bulletins, FASB Emerging Issues Task Force and topics discussed in Appendix D of EITF Abstracts
- FASB implementation guides, AICPA Accounting Interpretations, AICPA Industry Audit and Accounting Guides, Statements of Position that haven't been cleared by the FASB and widely-accepted accounting practices