Generally Accepted Accounting Principles (GAAP) is a set of Assumptions, Principles, and Constraints put in place by the Financial Accounting Standards Board (FASB). The goal of GAAP is to provide assurance that financial information provided by corporations is giving a true picture of the financial health of that corporation.
GAAP applies to US companies. There are also global standards called International Financial Reporting Standards meant to provide ruling principles for all businesses. The US has not at this time adopted those standards. GAAP and IFRS have many similarities and some differences.
To learn more about the International Accounting Standards Board (IASB) and International Financial Reporting Standards (IFRS), check out this article:
GAAP is broken out into three areas known as Assumptions, Principles, and Constraints.
Assumptions:
- Business Entity—a business is separate from its owners and revenue and expenses are kept separate for business and personal.
- Going Concern—assumes that the business will continue on into the future.
- Monetary Unit—assumes a stable currency, in the US that monetary unit is the US Dollar
- Time-period principle—assumes economic activities can be divided into time periods (a month, a quarter, a year)
Principles:
- Historical Cost Principle: assets and liabilities are recorded at acquisition cost, not Fair Market Value (FMV).
- Revenue Recognition Principle: revenue is recorded when earned, not when cash is received.
- Matching Principle: expenses should be matched with related revenues. Matching Principle and Revenue Recognition are the basis for Accrual accounting.
- Full Disclosure Principle: a company should share the important pieces of information (like financial statements) but balance what is disclosed on the cost of preparing and presenting that information. For example, the financial statements should give full information on the financial health of the business, but there may be other items that need explanation. Rather than clog up the financial statements with details would also include footnotes explaining some items. An example might be a disclosure that a lawsuit against the company has just been filed. We wouldn’t put that in the financial statements because we don’t know what’s going to happen yet.
Constraints:
- Objectivity Principle: financial statements should be based on objective evidence—we have invoices to match our revenue, we have bills and cancelled checks to match our expenses.
- Materiality Principle: Is the item being reported of significance? Would it make a difference in the decision of a reasonable person. Example: a one cent difference on a bank reconciliation is not material, but a $100,000 difference is. This can vary depending on the size of a business. What’s material for a small business may not be for a large business.
- Consistency Principle: the company must use the same accounting principles and methods from accounting period to accounting period. We can’t use accrual basis this month and switch to cash basis next month.
- Conservatism Principle: if we have two choices, we choose the one with the less favorable outcome. Should we recognize this expense in the last month or the current month? Which has the least favorable impact on our profits? That’s the one we choose. This works really well when deciding whether or not to eat a donut.
- Cost Constraint: The benefits of reporting financial information should outweigh the costs of supplying it.
The Final Rule: If following one or more of these principles means we would be misstating material information or providing misleading information, we don’t follow GAAP. We “depart from GAAP” and disclose why we don’t comply. That would be a rare occurrence.
For more background on GAAP, watch this video:
For more about how GAAP impacts Financial Statements, check out this article:
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