Generally Accepted Accounting Principles (GAAP) - Explained
What is GAAP?
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Table of ContentsWhat are Generally Accepted Accounting Principles?Who Created GAAP?How are Generally Accepted Accounting Principles Used?GAAP vs. IFRS
What are Generally Accepted Accounting Principles?
Generally accepted accounting principles (GAAP) is an embodiment of rules and standards that are acceptable and practiced in the accounting industry. GAAP contains a set of accounting standards, principles, and procedures that accountants and accounting companies must follow.
What are the Types of GAAP Accounting Principles?
There are four main principles of GAAP that we follow throughout all of accounting. If it doesn't follow one of these four principles, then it's really not following accounting.
- Measurement Principle
- Revenue Recognition Principle
- Matching Principle
- Full Disclosure Principle
All of these are discussed below.
What is the Measurement Principle?
So the first one we're going to talk about is what's called the measurement principle. The measurement principle states that accounting information is based on actual value and not what we think it's worth, not what it's appraised for, not what it actually cost us.
So, if you purchase a piece of land for ten thousand dollars, but it's actually valued at fifteen thousand dollars at the time of purchase, and you have it still five years later and it's appreciated up to twenty five thousand dollars, it's still going to be on your books at ten thousand dollars (the original purchase amount).
What is the Revenue Recognition Principle?
The second one is called the revenue recognition principle or rev-rec. This principle states that revenue must be recognized one when the goods and services are provided to the customer.
So, I have rendered the product or the service and at the moment expected payment to be received from the customer. This principle it's telling you when you have to recognize revenue when the product is delivered or the service rendered.
What is the Matching Principle?
The matching principle is pretty much the same as the revenue recognition principle except it's dealing with expense. This principle states that the company must record its expenses in the same period used to generate the revenue.
So, just like in the revenue recognition principle tells us when we have to recognize revenue, the matching principle tells us when we have to recognize expense. This just has to be in the same period that which we used it.
What is the Full Disclosure Principle?
The full disclosure principle states that a company must report the details behind the financial statements that would impact users decisions. These disclosures are often found in the footnotes of the statement.
So, throughout this material, we will refer to different methods or different ways of doing things, procedures. When you're choosing what method to use, you have to state in your financial statements that this is the method I use and this is how we get the numbers or this is the percentage that I use or this is the percentage that I estimate.
You're giving everything a value. This way, the end user can see how these numbers are calculated. We want to tell everything to to everyone.
Who Created GAAP?
GAAP is a standard framework that was developed by professionals in the accounting industry (Financial Accounting Standards Board or FASB). Commonly accepted accounting practices were also included in the framework.
The United States Securities and Exchange Commission (SEC) adopts these standards and accountants are mandated to follow these principles when arranging or collating financial statements.
Financial reporting must be tailored to reflect GAAP, otherwise, it might be unacceptable. IFRS standards and pro forma accounting are non-GAAP.
How are Generally Accepted Accounting Principles Used?
GAAP was designed to improve accounting practices especially when accountants compile financial statements. GAAP ensure consistency in financial reports which makes it easier for investors to access useful and reliable financial information as compiled by accountants with ethical practices. There are 10 general principles states in GAAP, they are the principles of;
- Time Specificity
This is also called principle of periodicity, it entails that financial entries should be distributed at the specific time assigned to them. Also, the release of financial statements should align with the start and end date pertaining to them.
This principle binds accountants to adhere to the regulations and standards of GAAP and also desist from irregularities in financial reporting.
Professionals must consistently practice the standards and procedures outlined in GAAP.
When an accountant values an asset in a financial report, it must assume the continuity of the business. This means the accountant must assume the business will have no end date.
- Good Faith or Full Disclosure
This entails that accountants make full disclosure of every aspect of a company while compiling financial reports.
This means that an accountant must be accurate while depicting the financial status of a company in a financial report. Businesses that conduct some of their operation in foreign currencies need to convert the amount to the accepted currency and disclose this.
- Permanence of Methods to Matching Principle
This entails that the accounting procedures used in financial reporting (either debit or credit) should be consistent.
This is also a GAAP principle that states that an accountant must present fact-based data at all times and not present speculated data.
- Principle of Non-compensation
This means financial reporting should be made without any expectation for compensation.
- Honesty/Utmost Good faith
All parties involved in financial transactions must exhibited the good trait of honesty. Accounting companies and professionals are expected to comply with the principles and standards states in GAAP. Financial statements and reports, when issued, must also comply with these principles.
GAAP vs. IFRS
IFRS standards are considered non-GAAP.
This is because IFRS standards are set by the IASB (International Accounting Standards Board) while the Financial Accounting Standards Board (FASB) sets GAAP.
As an international alternative to GAAP, IFRS is the accounting standard used in more than 110 countries while GAAP remains the benchmark for accounting practices in the United States.
Diverse strategies have been put in place by both IASB and FASB to merge IFRS and GAAP. The results from this combination is the removal of certain requirements placed on non-US companies registered with the SEC in the US.
Despite the convergence of IFRS and GAAP, there are still some differences that are noticeable in these two accounting concepts. These differences include:
- Costs of development under GAAP are to be charged to expense as they are incurred, but these costs can be amortized under IFRS.
- LIFO (Last In First Out) which is a practice that allows goods that are produced last to be sold out first is prohibited under IFRS while it can be used under GAAP.
- Write downs: This is the reduction in the value of an asset. The amount of write-down of an inventory cannot be changed even if the market value increases under GAAP but write-downs amounts can be reversed under IFRS.
- What is Accounting? – Financial Accounting
- Who are Users of Accounting Information? – Financial Accounting
- What are Generally Accepted Accounting Principles? – Financial Accounting
- Accounting Assumptions
- Accounting Constraints
- Accounting Conservatism - Financial Accounting