What are Generally Accepted Accounting Principles (GAAP)?

June 9, 2010

1. Generally Accepted Accounting Principles (GAAP)

GAAP is a set of Generally Accepted Accounting Principles that are used during the preparation of financial statements.

It is through GAAP that the principles behind accounting theory and reporting are established. Most industries in the United States are expected to conform to GAAP principles when preparing and distributing financial information. These guidelines are determined and reviewed by the Financial Accounting Standards Board (FASB) as a means to standardize and present financial information. Through this standardization, corporate financial information can more readily be reviewed and interpreted by investors, banks and other potential creditors. GAAP places all companies on a level playing field by ensuring that any financial information presented is uniformly consistent, relevant, feasible and objective.

In the US, GAAP usually refers to US GAAP as promulgated by FASB. However, other sets of GAAP exist. For example, iGAAP is sometimes used when talking about International Financial Reporting Standards (IFRS). GAAP can also be referred to in terms of a locality using this set of accounting standards, for instance, German GAAP.

2. Basic assumptions behind US GAAP

Economic Entity Assumption: Assumes that business functions and records are kept separate from the owner's private and personal financial transactions.

Going Concern Assumption: Assumes that a business is to be in operation for a long time.

Monetary Unit Assumption: Assumes that money provides an appropriate basis for accounting measurement and research.

Time Period Assumption: Assumes that a business will divide its financial reporting records into artificial time periods. Most companies typically use quarterly and annual time periods for reporting purposes.

3. Principles behind US GAAP

Cost Principle: This principle requires that assets and liabilities be recorded at their acquisition price. Note, however, that recently a fair market value has been playing a significant role in valuing assets and liabilities.

Revenue Recognition Principle: This principle requires revenue to be recorded when it is earned and realized or realizable.

Matching Principle: This principle states that expenses must be recorded in the same period as the revenues associated with those expenses.

Disclosure Principle: This principle requires all companies to fully disclose information that may impact decisions of users of financial information.

4. Constraints of US GAAP

Materiality: Whether a particular transaction must be recorded strictly in accordance with GAAP depends on its materiality. An item is material when its omission or inclusion would influence or change the judgment of a reasonable person. If an item is not material, then its recording may deviate from GAAP without jeopardizing usefulness of the financial statements.

Cost-Benefit Relationship: In establishing GAAP, it is important to consider the costs it will take for companies to prepare such information and the benefits that users will derive from it.

Industry Practices: Financial statements of companies in certain industries do not follow the accounting standards fully. This should be taken into consideration because that particular industry may have its peculiarities where deviations from GAAP are warranted.

Conservatism Principle: When in doubt about accounting treatment of certain transactions, a company should choose the treatment which will not overstate assets and revenues and will not understate liabilities and expenses.

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