Generally Accepted Accounting Principles (GAAP)

Did you know?

Pro members can track their course progress and get access to exclusive downloads, quizzes and more!

Find out more

Already got an account? Log in here.

Generally Accepted Accounting Principles (GAAP) are the rules and accounting concepts that are generally accepted in the United States.

Rules and procedures are very important in accounting to ensure that there is consistency in reporting. The US GAAP is a set of rules and accounting practices that were jointly developed by the Financial Accounting Standards Board (FASB) and the Government Accounting Standards Board (GASB). They are applicable to both governmental and non-profit organizations as well.

Any publicly traded company in the United States releasing its financial statements are required by the US law to follow the accounting rules and practices as set in the GAAP standard. An alternative to US GAAP is the IFRS, which were developed by the International Accounting Standards Board (IASB) and is more prevalent in countries operating outside the United States. IFRS can be found being used in the European Union, South America and even Asia.

History of GAAP

The history of corporations has generally been scarred with wrongful, deceitful, and downright fraudulent financial reporting. One of the reasons for the infamous 1929 stock market crash was the less than forthright reporting by the listed companies resulting in the Great Depression.

During this period, the federal government realized that there was a need for a common and consistent accounting standard for financial reporting to protect the interests of the investors. They started working with the different financial accounting groups in the United States to establish standard and practices for accurate and consistent financial reporting.

GAAP was established by the passing of legislation like Securities Act 1933 and Securities Exchange Act of 1934. Since then, GAAP has undergone a process of gradual reform and evolution to become what it is today. It is widely accepted as the best practices across different industries in the country.

Importance of GAAP

Some of the advantages of using GAAP are:

  • They are set a set of rule and procedures that need to be followed when preparing the financial statements. This means more standardization and transparency in financial reporting. This makes it easier for the investors, creditors, and other stakeholders to comprehend the financial statements and compare them with those of other companies.
  • Nonprofit and governmental entities are also brought under the scope of US GAAP since the law requires them to report their financials using this accounting standard. Therefore, they also have to be honest and accountable as well.
  • The US GAAP standard minimizes the chances of companies manipulating their financial statements to misrepresent the financial position of a company. The financial reports prepared under the accounting standards ensures that the true economic reality of the company is being represented.
  • Financial reports that are prepared under the accounting standard of US GAAP promote investor trust in the company. It also gives a sort of guarantee to someone who is looking to invest in the company.

The Basic Principles of US GAAP

The GAAP has 10 basic principles incorporated in it. These are:

Principle of Consistency

GAAP ensures that there are a set of accounting rules and procedures that can be applied consistently from one accounting period to another. Accountants follow these rules to prepare the financial statements which can then be comparabed with other periods or even other companies.

If a company decides to change an accounting method in a period, it must fully disclose this in its financial statements including the impact of change, date of change, and the rationale behind the change. If the company cannot justify the change, it will not be permitted to do so by the accounting standard.

Principle of Permanent Methods

This is somewhat related closely to the previous principle. The procedures used in the financial reporting should be consistent, thereby, allowing comparison of financial statements.

Principle of Non-Compensation

Every company is expected to provide full and transparent financial reporting including the positive and negative. In return, they should not be expecting any compensation of any kind.

Principle of Prudence

All reporting should be done on a factual and a reasonable basis that can be supported with evidence. There is no room for speculation in the financial statements of a company.

Principle of Regularity

This implies that all accountant must consistently adhere to the rules and regulations set out in the accounting standard of GAAP.

Principle of Sincerity

This implies that the accountants should be honest, fair, and accurate to the best of their abilities when preparing financial reports.

Principle of Good Faith

Anyone expected to be involved in the accounting and financial reporting process of a company is expected to be of honest and of the utmost good faith. If he suspects a company involved in fraudulent reporting, he should be ethical enough to report this to higher authorities and immediately disassociate himself from the process.

Principle of Materiality

There could be small errors including rounding off estimates that the company does not need to go into and investigate as the financial impact of this is very negligible.

Principle of Continuity

This principle states that all asset valuations in the financial reporting is under the assumption that the company is a going concern and that it would have continued operation going forward.

Principle of Periodicity

Financial reporting should pertain to a commonly accepted period like quarterly, semiannually, or annually. For instance, a quarterly profit and loss account will contain revenues pertaining to only that period.

Conclusion

GAAP was introduced to safeguard the interests of investors from the fraudulent and deceitful reporting behaviors that organizations used to practice a century ago. The emphasis of GAAP is on reliable, consistent, fair, and honest reporting so that the investors can make informed decisions. GAAP also promotes full disclosure reporting which implies inclusion material information in the footnotes of the financial reports, so that investors are not caught off guard by such events.

The financial reports prepared under GAAP promote a sense of trust within the investors and it ensures that financial statements they receive depict the true economic reality and financial position of a company.