GAAP: Understanding It and the 10 Key Principles

In short, generally accepted accounting principles (GAAP) are a set of commonly followed accounting standards and rules for financial reporting. The standards include definitions, concepts, principles, and industry-specific rules. In other words, GAAP is a collection of concepts and best accounting practices accepted throughout the industry. The most notable principles include the revenue recognition principle, matching principle, materiality principle, and consistency principle.

• However, some reason that the GAAP creates opportunities for great inconsistency and unintended opacity, where transparency is sought.
• Each will have a balance sheet, income statement, and cash flow statement, for instance.
• Realizing the need to reform the APB, leaders in the accounting profession appointed a Study Group on the Establishment of Accounting Principles (commonly known as the Wheat Committee for its chairman Francis Wheat).
• This is why you have to go through the extra effort to complete your bookkeeping for foreign transactions.
• Of course, you could always hire a professional to handle all of your accounting needs, but it’s also a good idea to have a fundamental understanding to get a better picture of your financial situation.
• The principle states that the accountant has to follow all GAAP rules and regulations.

According to the cost constraint principle, the cost of reporting financial information should be less than the benefit derived from that financial information. In other words, providing financial information in accordance with GAAP should not cause an undue financial burden. In other words, it’s always important to read the fine print, even — or maybe especially — in your financial statements. Yet another difference between these two accounting standards is in how they classify liabilities.

Frequently Asked Questions About GAAP

The FASB and IASB want to merge their standards because they share the goal of pursuing accounting integrity. While each financial reporting framework aims to provide uniform procedures and principles to accountants, there are notable differences between them. GAAP compliance makes the financial reporting process transparent and standardizes assumptions, terminology, definitions, and methods. External parties can easily compare financial statements issued by GAAP-compliant entities and safely assume consistency, which allows for quick and accurate cross-company comparisons. Although it is not required for non-publicly traded companies, GAAP is viewed favorably by lenders and creditors.

• GAAP aims to improve the clarity, consistency, and comparability of the communication of financial information.
• They guarantee a measure of consistency in the accounting reports among all businesses.
• Even for those who create financial documentation or do research for privately held corporations, any outside investor or auditor will expect GAAP compliance in any special project or presentations.
• The business is considered a separate entity, so the activities of a business must be kept separate from the financial activities of its business owners.
• The business activities may be reported in short, distinct time intervals which may be weeks, months, quarters, a calendar year, or a fiscal year.
• The objectivity principle is, in part, the reason many companies will have an independently audited set of financial statements produced on a routine basis.
• For example, employee wages should be documented in the week they performed work, not the week when they actually receive their paycheck.

By applying similar standards in the reporting process, accountants can avoid errors or discrepancies. The matching principle requires that businesses use the accrual basis of accounting and match business income to business expenses in a given time period. Profit and loss statements, also called income statements, encompass a date range. All financial statements have to indicate the time period for the activity reported in order for them to be meaningful to those reviewing them.

Key Differences

The International Financial Reporting Standards (IFRS) is the most common set of principles outside the United States. IFRS is used in the European Union, Australia, Canada, Japan, India, and Singapore. These standards may be too complex for their accounting needs, and hiring personnel to create GAAP definition reports can be expensive. As a result, the FASB works with the Private Company Council to update GAAP with private company exceptions and alternatives.

Even though your accountant is a trusted business advisor, you are ultimately responsible for your business’s financial information. We believe everyone should be able to make financial decisions with confidence. Revenue is earned and recognized upon product delivery or service completion, without regard what is gaap to the timing of cash flow. Suppose a store orders five hundred compact discs from a wholesaler in March, receives them in April, and pays for them in May. The wholesaler recognizes the sales revenue in April when delivery occurs, not in March when the deal is struck or in May when the cash is received.

Basic concepts

That is, since good faith, honesty, and general truthfulness are required by the GAAP, and thus by the SEC, investors have recourse in case a company’s financial operations are misrepresented. Publicly held companies that are traded on public equity markets must adhere to GAAP standards as a condition of their being listed by the SEC. Their compliance lends consistency to all quarterly, annual, and other financial documents. This consistency helps analysts, investors, and creditors understand, process, and trust the news they find in these filings on the company website.