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Generally Accepted Accounting Principles (GAAP) Explained

GAAP Accounting Principles

Generally Accepted Accounting Principles (GAAP) Explained

Accountants adhere to generally accepted accounting principles when recording and compiling financial statements. GAAP regulates the accounting profession to ensure ethical practices.

Definition Of GAAP

What Is GAAP? GAAP is a group of acceptable accounting procedures, principles, and standards that accounting firms and accountants must observe during financial reporting.

Types Of GAAP Accounting Principles

The four fundamental GAAP principles that accounting firms observe are:

  • Revenue Recognition Principle
  • Matching Principle
  • Full Disclosure Principle
  • Measuring Principle

Revenue Recognition Principle

The revenue recognition principle, also known as rev-rec, identifies the particular conditions in which a company recognizes revenue and dictates how it should account for it. According to rev-rec, a company should recognize revenue when they’ve provided clients with products or services.

Once the firm renders the goods or services and expects to receive payment from the buyer, rev-rec determines when to recognize revenue.

This principle using accrual accounting states that revenues are recognized when earned and realized, not necessarily when funds are received.

Realizable means you’ve provided the client with the services and goods, but you expect payment at a later date. Earned revenue accounts for services or products that have been provided.

Matching Principle

This principle is almost similar to the revenue recognition principle save for the fact that it deals with expenses. The matching principle states that the firm should record its expenses in the same period it earns the corresponding revenue.

The matching principle tells us when to recognize expenses—this must be in the same period a company uses it to generate revenue.

Full Disclosure Principle

The full disclosure principle requires companies to report the events, circumstances, and situations behind the financial statements that affect user decisions. Financial statements use footnotes to relay these details and describe the policies your firm applies to report and record business transactions.

Financial statements should provide details about your company’s past performance. Although incomplete transactions, pending lawsuits, or other circumstances may impact your firm’s financial status, you must disclose such details.

The users should see everything and know how you calculate the numbers.

Measuring Principle

The measuring principle is an informal method for determining the minimum price of securities for traders to establish entry and exit points.

According to the measurement principle, accounting data is based on real value, not its appraisal value or what we think it’s worth or cost.

For instance, if you buy a piece of land for $15,000, but its actual value is $20,000 at the time of purchase, and its value appreciates to $30,000 five years later, your books will still show that it costs $15,000 (original purchase price).

Who Developed GAAP?

Generally Accepted Accounting Principles was created by the Financial Accounting Standards Board (FASB).

The United States Securities and Exchange Commission (SEC) approves these standards, and accountants must follow them when collating or drafting financial statements.

Importance Of GAAP

  • GAAP makes reading, interpreting, and conveying financial reports more transparent and protects investors from misleading or fraudulent information.
  • Although adherence to GAAP is not legally required, it benefits businesses—investors trust firms with GAAP-compliant financial reports since they are more certain about their financial data validity.
  • A certified public accountant (CPA) audit can inspect for GAAP compliance on a firm’s financial statements; the external auditor confirms and certifies the procedures and details on a company’s records and determines any irregularity.

Note: Countries outside the US may adopt the International Financial Reporting Standards (IFRS) instead of GAAP.

How GAAP Are Used

These principles were set to improve accounting practices when accountants collate financial reports. GAAP guarantees consistency in financial statements making it easier for investors to access reliable financial details put together by accountants with ethical practices.

The ten principles outlined in GAAP include:

1. Consistency

Accountants must adhere to the GAAP procedures and standards consistently.

2. Continuity

When a professional values an asset in a financial statement, it must assume the business continuity—accountants must presume the business has no end date.

3. Regularity

The principle of regularity requires accountants to follow GAAP rules and standards and refrain from misconduct in financial reporting.

4. Good Faith or Full Disclosure

Accountants must fully disclose every company’s aspect when compiling financial statements.

5. Time Specificity/Principle of Periodicity

It states that financial entries should be dispensed at the specific time allocated to them. The release of financial reports should also line up with the start and end date assigned to them.

6. Matching Principle

This means that the accounting approach used in financial reporting should be uniform, whether debit or credit.

7. Sincerity

An accountant has to be accurate when depicting a company’s financial status in a financial statement. Companies that conduct some of their transactions using foreign currencies must disclose this and convert the sum to an acceptable currency.

8. Non-compensation Principle

This principle means that financial reporting should be done without expecting any compensation.

9. Prudence

This means that an accountant must always present factual data—an accountant must never present speculative information.

10. Utmost Good Faith/Honesty

All individuals who are party to any financial dealings must be honest. All accounting professionals and firms must comply with the standards and principles.

Whenever management issues financial reports and statements, they must be in line with these principles.

GAAP Compliance

If a company trades its stock publicly, its financial reports must comply with the regulations set by the United States Securities and Exchange Commission. The commission mandates that for a company to remain publicly registered on the stock exchange, it has to file financial statements that are GAAP–compliant regularly.

Auditors are the ones who determine if a financial statement is GAAP-compliant. A  CPA (Certified Public Accounting) company should carry out the audit.

Even though this isn’t a requirement for companies that don’t trade publicly, creditors and lenders view GAAP favorably. Before issuing a business loan, many financial organizations require yearly GAAP-compliant financial reports as part of their loan covenants. Consequently, most firms in the U.S. adhere to GAAP.

GAAP has made comparing financial statements from different companies easier. Even comparing companies in the same sector would be challenging without GAAP. Investors should always be careful when dealing with financial reports that don’t comply with GAAP.

Some firms include both non-GAAP and GAAP procedures in their financial results. The GAAP rules dictate that non-GAAP measures be part of financial reports alongside other public disclosures like press releases.

GAAP aims to make financial reporting better. It comprises a structure for choosing the principles that public accountants should utilize when preparing financial reports per the United States GAAP. The ranking can be broken down in the following manner:

  • Accounting Principles Board and Accounting Research Bulletin opinions by the American Institute of Certified Public Accountants (AICPA) and statements by the Financial Accounting Standards Board (FASB).
  • AICPA Industry Audit and Accounting Guides and FASB Technical Bulletins and Position Statements.
  • Positions of the FASB Emerging Issues Task Force (EITF), AICPA Accounting Standards Executive Committee Practice Bulletins, and topics discussed in Appendix D of EITF Abstracts.
  • AICPA Accounting Interpretations, FASB implementation guides, Statements of Position not cleared by the FASB, and AICPA Industry Audit, widely followed and accepted accounting practices and Accounting Guides.
  • Accountants should consult the first ranking sources and only consult lower level rankings if higher levels don’t have relevant pronunciation. There’s a detailed explanation of the pecking order on FASB’S Statement on the standards of financial accounting no.162.

Advantages And Disadvantages

The implementation of GAAP in accounting reflects a firm’s complete financial standing. The regulation assists creditors, investors, and shareholders in maintaining a certain level of transparency. Therefore, these principles help companies retain the trust of shareholders and investors.

The principles also help lenders determine whether or not they can give credit to a company. This level of transparency hurts struggling companies.

GAAP makes a company’s accounting procedure more consistent and accurate. It also enables a comparative study of different firms according to their financial reports. Additionally, it’s easier to conduct an internal analysis to identify critical areas that need improvement.

As a result of these principles, those in management have a complete report of the firm’s expenses, investment, revenues, losses, and income.

Nevertheless, there are some disadvantages of GAAP that are hard to ignore. Preparing a financial statement is an uphill task. For small businesses, in particular, it can be tough to follow all the listed principles.

Additionally, as firms go international, they need to shift from GAAP to IFRS (International Financial Reporting Standards) as GAAP is only applicable in the United States.

Differences Between GAAP And IFRS

IFRS guidelines are seen as non-GAAP as the International Accounting Standards Board set them while FASB (Financial Accounting Standards Board) sets GAAP.

IFRS is an international alternative to GAAP and is used in over 110 countries, while GAAP is only used in the U.S.

Both FASB and IASB have come up with different techniques to merge GAAP and IFRS. This has led to the removal of some of the demands placed on non-US firms registered with the SEC.

The merging of GAAP and IFRS notwithstanding, there are some noticeable differences in these two concepts. These include:

  • The Last In First Out (LIFO) is allowed in GAAP, while in IFRS, it isn’t.
  • Writedowns—the decline in value of an asset—are reversible in IFRS, while in GAAP, they are irreversible.
  • In IFRS, the cost of development is amortized, while in GAAP, they are supposed to be charged to expenses since they’re incurred.

Bottom Line

GAAP provides a standard way to report and interpret accounting procedures and standards across all companies in the United States. GAAP plays an essential role in accounting, particularly in reading and comparing financial statements.

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