Generally Accepted Accounting Principles (GAAP) is the standard framework of guidelines for financial accounting. It includes the standards, conventions, and rules accountants follow in recording and summarizing transactions, and in the preparation of financial statements.
One key aspect of GAAP is an emphasis on the term "general", since not all accounting exercises employ the same method and generate the same results. GAAP accommodates variation in applied accounting methods as long as the methods generally adhere to its set of broadly-defined principles.
GAAP also creates an environment in which financial reporting results can vary depending on purpose. One company may produce different reports for the same fiscal year, all completed within GAAP, for different audiences or different purposes, and all of these reports can be considered correct.
A company may report financial performance considered acceptable by the accounting firm producing the review, yet upon closer investigation, irregularities may be revealed. This may require a restatement of all or part of the report. Recently (2006 - 2007), well known corporations such as Apple and Research In Motion had to restate parts of their financial reports in which adherence to certain "best practices" was questionable.
Financial accounting information must be assembled and reported objectively. Third-parties who must rely on such information have a right to be assured that the data are free from bias and inconsistency, whether deliberate or not. For this reason, financial accounting relies on certain standards or guides that are called "Generally Accepted Accounting Principles" (GAAP).
Principles derive from tradition, such as the concept of matching. In any report of financial statements (audit, compilation, review, etc.), the preparer/auditor must indicate to the reader whether or not the information contained within the statements complies with GAAP.
To achieve basic objectives and implement fundamental qualities GAAP has four basic assumptions, four basic principles, and four basic constraints.
One key aspect of GAAP is an emphasis on the term "general", since not all accounting exercises employ the same method and generate the same results. GAAP accommodates variation in applied accounting methods as long as the methods generally adhere to its set of broadly-defined principles.
GAAP also creates an environment in which financial reporting results can vary depending on purpose. One company may produce different reports for the same fiscal year, all completed within GAAP, for different audiences or different purposes, and all of these reports can be considered correct.
A company may report financial performance considered acceptable by the accounting firm producing the review, yet upon closer investigation, irregularities may be revealed. This may require a restatement of all or part of the report. Recently (2006 - 2007), well known corporations such as Apple and Research In Motion had to restate parts of their financial reports in which adherence to certain "best practices" was questionable.
Financial accounting information must be assembled and reported objectively. Third-parties who must rely on such information have a right to be assured that the data are free from bias and inconsistency, whether deliberate or not. For this reason, financial accounting relies on certain standards or guides that are called "Generally Accepted Accounting Principles" (GAAP).
Principles derive from tradition, such as the concept of matching. In any report of financial statements (audit, compilation, review, etc.), the preparer/auditor must indicate to the reader whether or not the information contained within the statements complies with GAAP.
- Principle of regularity: Regularity can be defined as conformity to enforced rules and laws. This principle is also known as the Principle of Consistency.
- Principle of sincerity: According to this principle, the accounting unit should reflect in good faith the reality of the company's financial status.
- Principle of the permanence of methods: This principle aims at allowing the coherence and comparison of the financial information published by the company.
- Principle of non-compensation: One should show the full details of the financial information and not seek to compensate a debt with an asset, a revenue with an expense, etc.
- Principle of prudence: This principle aims at showing the reality "as is" : one should not try to make things look prettier than they are. Typically, a revenue should be recorded only when it is certain and a provision should be entered for an expense which is probable.
- Principle of continuity: When stating financial information, one should assume that the business will not be interrupted. This principle mitigates the principle of prudence: assets do not have to be accounted at their disposable value, but it is accepted that they are at their historical value (see depreciation).
- Principle of periodicity: Each accounting entry should be allocated to a given period, and split accordingly if it covers several periods. If a client pre-pays a subscription (or lease, etc.), the given revenue should be split to the entire time-span and not counted for entirely on the date of the transaction.
Assumptions
- Business Entity: assumes that the business is separate from its owners or other businesses. Revenues and expenses should be kept separate from personal expenses.
- Going Concern: assumes that the business will be in operation indefinitely. This validates the methods of asset capitalization, depreciation, and amortization. Only when liquidation is certain this assumption is not applicable.
- Monetary Unit principle: assumes a stable currency is going to be the unit of record. The FASB accepts the nominal value of the US Dollar as the monetary unit of record unadjusted for inflation.
- The Time-period principle implies that the economic activities of an enterprise can be divided into artificial time periods.
Principles
- Cost principle requires companies to account and report based on acquisition costs rather than fair market value for most assets and liabilities. This principle provides information that is reliable (removing opportunity to provide subjective and potentially biased market values), but not very relevant. Thus there is a trend to use fair values. Most debts and securities are now reported at market values.
- Revenue principle requires companies to record when revenue is (1) realized or realizable and (2) earned, not when cash is received. This way of accounting is called accrual basis accounting.
- Matching principle. Expenses have to be matched with revenues as long as it is reasonable to do so. Expenses are recognized not when the work is performed, or when a product is produced, but when the work or the product actually makes its contribution to revenue. Only if no connection with revenue can be established, may cost be charged as expenses to the current period (e.g. office salaries and other administrative expenses). This principle allows greater evaluation of actual profitability and performance (shows how much was spent to earn revenue). Depreciation and Cost of Goods Sold are good examples of application of this principle.
- Disclosure principle. Amount and kinds of information disclosed should be decided based on trade-off analysis as a larger amount of information costs more to prepare and use. Information disclosed should be enough to make a judgment while keeping costs reasonable. Information is presented in the main body of financial statements, in the notes or as supplementary information
Constraints
- Objectivity principle: the company financial statements provided by the accountants should base on objective evidence
- Materiality principle: the significance of an item should be considered when it is reported. An item is considered significant when it would affect the decision of a reasonable individual.
- Consistency principle: accounting procedures should follow industry practices.
- Prudent principle: when choosing between two solutions, the one that will be least likely to overstate assets and income should be picked.
