Generally Accepted Accounting Principles or GAAP are the set of accounting principles, concepts, and guidelines that guide the more detailed and comprehensive accounting rules, practices, and standards. There are ten major GAAP principles that have evolved over decades and serve as the foundation of accounting. In the US, every company that releases its financial statements to the public and companies that publicly trade on stock exchanges need to follow GAAP guidelines.
Table of Contents
- 1 Origin of GAAP Principles
- 2 10 GAAP Principles
- 3 Final Words
Origin of GAAP Principles
The origin of GAAP goes way back to 1929 and the stock market crash that led to the Great Depression. At the time, faith in the economy was at an all-time low. Thus, the government decided to rebuild the faith and the Securities and Exchange Commission (SEC) was formed. The SEC asked the American Institute of Accountants for help and this gave rise to the concept of GAAP.
Over time, many changes have been made to these accounting standards. Also, the governing boards have changed. Presently, the Financial Accounts Standard Board (FASB) decides the accounting principles under GAAP, but the Securities and Exchange Commission (SEC) still has enforcement powers.
GAAP covers a range of topics, such as revenue and expenses, assets and liabilities, financial statement presentation, equities, foreign currency, hedging, business combinations, derivatives, and non-monetary transactions. To understand GAAP, it is important to understand the ten GAAP principles.
10 GAAP Principles
Discussed below are ten major GAAP principles;
Single Entity Principle
The business as a single entity concept states that all financial records of the business should be separate from the owners or other businesses. A company must report the assets and liabilities of different subsidiaries separately and not mix with the books of another company. In the absence of this principle, the records of multiple entities would get mixed, making it unfeasible from the point of view of financial audit or tax purpose.
Monetary Unit Principle
There should be a specific unit of currency in which the company should record transactions. All the transactions in the financial statements should be in the same currency unit, be it the US dollar, Euro, Indian Rupee or any other currency. It would be wrong to record some transactions in one currency and some in another currency.
Specific Time Period Principle
Financial statements are always related to a specific time, usually towards the end of the financial accounting period. All three financial statements – Income, Balance Sheet and Cash Flow Statement have a start, as well as, the end date. It is done to ensure that stakeholders are aware of the time period for which the company is reporting numbers.
This principle, as the name suggests, states that a company should record both revenue and expenses when earned and not when it gets the cash. Therefore, the income statement of the company includes accrued income and expense. In case there is any doubt on the suppliers regarding the payment, the accountant should put the item under the allowance for doubtful accounts.
Going Concern Principle
As clear from the name, everyone expects a business to run eternally with no end date. It also means that the business must not to cease operations and liquidate the assets in the near future at very low fire-sale prices. Because of this principle, a company can defer certain expenses to a future date.
If an accountant believes that the company might no longer be a going concern, the accountant must detail the same in his or her assessment. In case of liquidation, the accountant must write-down the value of the assets to their liquidation value. A point to note is that the value of a going concern firm is perceived to be higher than the liquidation value. This is because, in the former, there are chances that the company would turn profitable.
Full Disclosure Principle
Every company must make full disclosure and ensure that all the details and financial numbers are open to the public. This principle ensures that companies do not hide any material information, which can impact the investment decision of the stakeholders. Also, this principle ensures that the companies do not indulge into any unethical operations and businesses. And, no financial information that should be in the public domain is hidden intentionally.
It is one of the most basic principles. And, requires a company to report an expense in the period in which it earns the corresponding revenue. The matching principle depends on the accrual basis of accounting and adjusting entries. In case, an expense is not directly related to the revenue, then it should be reported on the income statement when it expires or is used up. And, if the future benefit of a cost cannot be determined, it should be charged to expense immediately.
Principle of Materiality
As per this GAAP principle, it is important for the bookkeeper to think materialistically. An accountant should be able to differentiate between the important and not so important issues. Errors are inevitable in accounting. However, it is up to the bookkeeper to decide on whether the error is important enough to give more time to it, or can be ignored. For example, it is upto the accountant to decide if a $10 error can be ignored or not.
Principle of Conservative Accounting
The principle suggests that an accountant must record expenses as and when they occur. On the other hand, the accountant should only record income when there is actual cash flow. This principle helps while recording transactions that are uncertain.
Historical Cost Principle
As per this principle, a company should record the purchase the goods, services, or capital assets at the price they actually paid for it. On the balance sheet, companies keep showing the asset at the historical without adjusting for any fluctuation in the market value.
Though the objective of these GAAP principles is to improve transparency, there is no guarantee that the financial statements of the companies following these principles are free from errors and omissions (both intentional and unintentional). There have been plenty of cases where companies following GAAP distort figures to mislead investors. So even if a company follows GAAP, it is always better to scrutinize its financial statements.1