GAAP, or Generally Accepted Accounting Principles, is the standard system of running accounting operations and preparing financial statements. Each country has its own version of GAAP; this article covers the United States. The Securities and Exchange Commission (SEC) requires that any publicly traded company must use GAAP. In practice, virtually every non-governmental organization in the United States uses it, whether public, private, or nonprofit, a small business or a large one, in its reports.
Who's In Charge
Since 1973, the Financial Accounting Standards Board (FASB) has developed GAAP. It combines rules from various organizations as the primary standards, including the FASB Standards and Interpretations; the American Institute of Certified Public Accountants (AICPA) Accounting Research Bulletins; and the Accounting Principles Board Opinions, as well as other FASB and AICPA standards and prevalent industry practices. FASB, however, does not regulate compliance; this is the AICPA's area.
Assumptions, Principles, and Conventions
Economic Entity Assumption
A business is its own separate entity, regardless of ownership, and for accounting purposes, operates in independence of everything else. Whether a business is owned by stockholders or as a sole proprietorship, the owners' individual financial transactions are separate.
Stable Monetary Unit Assumption
All transactions are described as dollar transactions, regardless of whether they actually took place in dollars (e.g. they could have been transacted in another currency or in stock). Furthermore, the value of the dollar does not change. (Essentially, this ignores inflation)
Time Period Assumption (aka Periodicity)
Each entry applies to a specific, named time frame or frames and information is reported periodically.
Historical Cost Principle
All transactions are recorded at actual cost at the time the transaction took place. If an organization bought land that was worth $1 million but turned out to have a value of $800,000, it is recorded as $1 million. Similarly, if the land was worth $1 million when it was purchased but appreciated in value to $2 million, it is still recorded in all transactions at $1 million. (Again, the system ignores inflation.)
Full Disclosure Principle
All information required to understand an organization's financial standing must be included in the financial statement or in the notes. For example, if the organization is likely to accept a major offer to purchase assets; is party to a major lawsuit as a plaintiff or defendant; or owns a patent that is likely to increase significantly in value, these facts must be included, usually in the notes.
Going Concern (aka Continuity) Principle
This simply assumes that a business will remain in business, unless stated otherwise. This allows for depreciation of certain expenses over time, for example, and that assets are recorded at historical value, as noted above, rather than at the value they'd receive if sold.
Matching Principle
By this principle, every expense item has a revenue item and vice-versa. For example, if an organization purchases furniture, it appears as an expense and as revenue in accounts payable.
Revenue Recognition Principle
Revenue is counted when it is earned, not when it is received. Since many companies pay their bills within 30 days (net 30) of receiving the goods or services, this means that revenue statements and cash flow statements are rarely synchronized.
Full Disclosure Principle
All the information needed to make decisions related to the organization (e.g. to invest) are include in the financial statements.
Materiality Convention
This allows for accountants to use their judgment over whether a certain amount is significant to a report. For example, a statement from Microsoft or Citibank might round some items to the nearest hundred thousand or even million dollars, while one from a small business might not round at all or might round to the nearest dollar.
Conservatism Convention
If there are two equally viable projections or two equally viable ways of calculating a figure, the accountant must select the one that indicates a lower gain or revenue to the organization.
Cost-Benefit Relationship Convention
If the cost of reporting an item is greater than the benefit of reporting it, that item may be omitted.
Industry Practices Convention
If an industry has standard accounting practices that differ from GAAP, then the accountant should follow those instead of GAAP.
GAAP Complete Set of Statements
In GAAP, the Statement of Financial Position (SOFP), Statement of Activity (SOA), and Statement of Cash Flows are considered the complete set of financial statements.
