Generally accepted accounting principles (GAAP) – an overview

The Wall St. crash of 1929, as well as its aftermath, made very obvious the amount of manipulation and fraud taking place when it came to financial reporting. One of the main lessons learned from this infamous event was that there was a much greater need for accounting standards that were more effective and far reaching. Since then, there has been ongoing attempts made to standardize accounting and bring about a more uniform way of bookkeeping. This has led to the emergence of the GAAP – generally accepted accounting principles. Simply put, these are the authoritative standards and rules that govern financial accounting and reporting by businesses.

The overall goal is to provide an overview of the company’s financial performance over a certain time period, as well as its current financial position. Businesses across the globe follow general standards and guidelines when it comes to preparing financial statements. These standards vary from country to country, and each respective nation will then have both a private accounting sector and some state-led regulators, which come together in order to give an oversight of these. This then means that each country will have standards, methods, and regulations specific to them. In general, GAAPs can be seen as more of an umbrella term to cover the more overall universal principles.

In total, there are more than ten GAAPs that all together make up the generally accepted accounting principles. These are split into the three categories of assumptions, principles and constraints:

Assumptions:

1. Business entity: a company is a separate body from its owners and any other businesses. Also known as the economic entity assumption, it clarifies that all commercial activities are detached from the running of the business.
    
2. Monetary unit: the unit of record used is a stable currency. In this case only amounts in US dollars can be recorded and included. The currency is then unadjusted for inflation.
    
3. Periodicity: this means that the activities of the company can be reported into measured time periods; weeks, months, quarters, or years. Companies based in the US are required to file quarterly (10-Q) as well as annual (10-K) reports (Bear in mind, that not all companies align their fiscal years with calendar years).
    
4. Going concern: it is assumed that the business intends to continue operating for at least the foreseeable future and will not be going into liquidation.

Principles:

5. Historical cost principle: resources and assets should be recorded at the amount that they were purchased at; and not relative to inflation. Historical, in this context, refers to the time in the past that the payment was paid.
   
   
6. Revenue recognition principle: this refers to the point in time that income is earned, and not when it is received. The principle is in line with accrual basis accounting, and is therefore not influenced by cash flow.
   
   
7. Matching principle: arguably one of the key components of accounting is consistency. As far as is possible, expenses have to be matched with income of the same period. This ensures that there can be a more accurate assessment of profitability versus performance, i.e. how much needs to be spent in order to make financial gain, e.g. Cost of Goods Sold – the expense of a sale should be recorded in the same period as the sale was made.
   
   
8. Full disclosure principle: all information that is relevant is included in the statement. These details can be either in the main body of the statement or else in the accompanying footnotes, etc.

Constraints:

1. Materiality: the idea behind this constraint is that, when it comes to accounting, certain issues are considered trivial and therefore disregarded. Those that are seen as important are known as material items, and have the potential to influence the economic decisions of those who view the statement. Given that materiality depends both on the intended audience of the financial statement, as well as its intended purpose, this principle is seen as a sort of gray area in accounting, where professional judgement should be used.
   
   
2. Conservatism: This principle relates to the issue of potential earnings and expenditure. It emphasizes erring on the side of caution, i.e. conservatism, and for that reason one should recognize possible expenses and liabilities immediately – irrelevant of whether you are uncertain if they will actually occur or not. At the same time, potential revenue should not be officially acknowledged until it is actually received. In other words, when confronted with two solutions, it is advised that you opt for the one that is less favorable.
   
   
3. Consistency: the word ‘consistency’ here is in relation to the accounting principles and methods being used – they should remain the same from statement to statement.
   
   
4. Cost: this particular constraint states that the cost of providing information must be considered alongside the advantages that can come from using that information. The benefits of creating such financial statement should certainly outweigh the cost of supplying it.
   
   
5. Objectivity: all information contained within the accounts should be based on objective evidence – opinions, intentions, desires, biases, etc. from within the company should not have any influence.

Globally there is also a push to bring about greater uniformity when it comes to financial statements. Growing globalization means there is a need for a common language to allow company accounts to be interpreted and understood all around the world, by people from many different business and accounting backgrounds. It is for this reason that the International Financial Reporting Standards (IFRS) have emerged. These were established by the International Accounting Standards Board (IASB) and continue to be maintained by this particular organization. 

Small and medium-sized enterprises will sometimes lean towards following more simplified standards, in addition to any specific requirements advocated by their respective lenders and/or shareholders. Some countries have local, country-specific accounting principles which are then applied to regular companies, whilst larger and/or listed companies are expected to conform to IFRS. The idea of this is then that these financial statements can be compared internationally. It is however interesting to note that since 2005, all listed and grouped companies within the EU have been required to use the IFRS.

However it must also be remembered that the GAAP is not legally binding, but instead should be seen as a set of guidelines to follow. Although their overall purpose is to improve the transparency of financial statements, they do not actually guarantee that the aforementioned statements are error-free, or indeed that they are not purposely missing certain information.

When it comes to the USA, such developments are less clear and evident.  Even though the U.S. Securities and Exchange Commission (SEC), an independent arm of the federal government, continues to push for a continued support for a uniform set of high quality, globally accepted standards and methods for accounting, progress itself has unfortunately been much slower. This is also despite the fact that the SEC has recognized and stated that IFRS is the best placed option for achieving exactly this. Publicly traded companies in the US are instructed to adopt these standards and principles for the creation of their statements. Private businesses are not required to follow them, though many still choose to.

It can’t be stressed enough the fact that these are ‘generally accepted’ accounting principles, standards, and methods. While there is no doubt that they help to bring about more transparency and understanding when it comes to financial statements, this does not necessarily guarantee that they will ensure that the respective financial statements will be free of mistakes or miscalculations. Such errors or omissions could be purely accidental or else have the intention of misleading the likes of potential investors.

Please note the legal disclaimer relating to this article.