Generally Accepted Accounting Principles (GAAP)

What Does Generally Accepted Accounting Principles Mean?

Generally accepted accounting principles (GAAP) refer to a common set of accepted accounting

principles, standards, and procedures that companies and their accountants must follow when
they compile their financial statements. GAAP is a combination of authoritative standards (set by
policy boards) and the commonly accepted ways of recording and reporting accounting
information. GAAP improves the clarity of the communication of financial information.

GAAP may be contrasted with pro forma accounting and with the IFRS standards, which are
both considered to be non-GAAP.

GAAP

Understanding GAAP

GAAP is meant to ensure a minimum level of consistency in a company's financial statements,

which makes it easier for investors to analyze and extract useful information. GAAP also
facilitates the cross-comparison of financial information across different companies.

These 10 general principles can help you remember the main mission and direction of the GAAP
system.

1.) Principle of Regularity

The accountant has adhered to GAAP rules and regulations as a standard.

2.) Principle of Consistency

Professionals commit to applying the same standards throughout the reporting process to prevent
errors or discrepancies. Accountants are expected to fully disclose and explain the reasons
behind any changed or updated standards.

3.) Principle of Sincerity

The accountant strives to provide an accurate depiction of a company’s financial situation.

4.) Principle of Permanence of Methods

The procedures used in financial reporting should be consistent.

5.) Principle of Non-Compensation

Both negatives and positives should be fully reported with transparency and without the
expectation of debt compensation.
6.) Principle of Prudence

Emphasizing fact-based financial data representation that is not clouded by speculation.

7.) Principle of Continuity

While valuing assets, it should be assumed the business will continue to operate.

8.) Principle of Periodicity

Entries should be distributed across the appropriate periods of time. For example, revenue should
be divided by its relevant periods.

9.) Principle of Materiality / Good Faith

Accountants must strive for full disclosure in financial reports.

10.) Principle of Utmost Good Faith

Derived from the Latin phrase “uberrimae fidei” used within the insurance industry. It
presupposes that parties remain honest in transactions.

Compliance

GAAP must be followed when a company distributes its financial statements outside of the
company. If a corporation's stock is publicly traded, the financial statements must also adhere to
rules established by the U.S. Securities and Exchange Commission (SEC).

GAAP covers such things as revenue recognition, balance sheet item classification and

outstanding share measurements. If a financial statement is not prepared using GAAP, investors
should be cautious. Also, some companies may use both GAAP and non-GAAP compliant
measures when reporting financial results. GAAP regulations require that non-GAAP measures
are identified in financial statements and other public disclosures, such as press releases.

The hierarchy of GAAP is designed to improve financial reporting. It consists of a framework for

selecting the principles that public accountants should use in preparing financial statements in
line with U.S. GAAP. At the top of the GAAP hierarchy are statements by the Financial
Accounting Standards Board (FASB) and opinions by American Institute of Certified Public
Accountants (AICPA). The next level consists of FASB Technical Bulletins and AICPA Industry
Audit and Accounting Guides and Statements of Position. On the third level are AICPA
Accounting Standards Executive Committee Practice Bulletins and positions of the FASB
Emerging Issues Task Force (EITF). Also included are Topics discussed in Appendix D of EITF
Abstracts. On the lowest level are FASB implementation guides, AICPA Accounting
Interpretations, AICPA Industry Audit and Accounting Guides and Statements of Position not
cleared by the FASB. Also included are practices that are widely recognized.

Accountants are directed to first consult sources at the top of the hierarchy and then proceed to
lower levels only if there is no relevant pronouncement at a higher level. The FASB's Statement
of Accounting Standards No. 162 provides a detailed explanation of the hierarchy.

GAAP vs. IFRS

GAAP is focused on the practices of U.S. companies. The Financial Accounting Standards

Board (FASB) issues GAAP. The international alternative to GAAP is the International
Financial Reporting Standards (IFRS) set by the International Accounting Standards
Board (IASB). The IASB and the FASB have been working on the convergence of IFRS and
GAAP since 2002. Due to the progress achieved in this partnership, the SEC, in 2007, removed
the requirement for non-U.S. companies registered in America to reconcile their financial reports
with GAAP if their accounts already complied with IFRS. This was a big achievement, because
prior to the ruling, non-U.S. companies trading on U.S. exchanges had to provide GAAP-
compliant financial statements.

Some differences that still exist between both accounting rules include:

 LIFO Inventory - While GAAP allows companies to use the Last In First Out (LIFO) as
an inventory cost method, it is prohibited under IFRS.

 Costs of Development - These costs are to be charged to expense as they are incurred
under GAAP. Under IFRS, the costs can be capitalized and amortized over multiple
periods.

 Write-Downs - GAAP specifies that the amount of write-down of an inventory or fixed

asset cannot be reversed if the market value of the asset subsequently increases. The
write-down can be reversed under IFRS.

As corporations increasingly need to navigate global markets and conduct operations worldwide,
international standards are becoming increasingly popular at the expense of GAAP, even in the
U.S. As the chart below shows, in 2004, almost all North American companies reported their
earnings using GAAP metrics. By 2016 that number had fallen to less than half.

Notes

GAAP is only a set of standards. Although these principles work to improve the transparency in
financial statements, they do not provide any guarantee that a company's financial statements are
free from errors or omissions that are intended to mislead investors. There is plenty of room
within GAAP for unscrupulous accountants to distort figures. So, even when a company uses
GAAP, you still need to scrutinize its financial statements.
 GAAP

The phrase "generally accepted accounting principles" (or "GAAP") consists of three important
sets of rules: (1) the basic accounting principles and guidelines, (2) the detailed rules and
standards issued by FASB and its predecessor the Accounting Principles Board (APB), and (3)
the generally accepted industry practices.

If a company distributes its financial statements to the public, it is required to follow generally
accepted accounting principles in the preparation of those statements. Further, if a company's
stock is publicly traded, federal law requires the company's financial statements be audited by
independent public accountants. Both the company's management and the independent
accountants must certify that the financial statements and the related notes to the financial
statements have been prepared in accordance with GAAP.

GAAP is exceedingly useful because it attempts to standardize and regulate accounting

definitions, assumptions, and methods. Because of generally accepted accounting principles we
are able to assume that there is consistency from year to year in the methods used to prepare a
company's financial statements. And although variations may exist, we can make reasonably
confident conclusions when comparing one company to another, or comparing one company's
financial statistics to the statistics for its industry. Over the years the generally accepted
accounting principles have become more complex because financial transactions have become
more complex.

Basic Accounting Principles and Guidelines

Since GAAP is founded on the basic accounting principles and guidelines, we can better
understand GAAP if we understand those accounting principles. The following is a list of the ten
main accounting principles and guidelines together with a highly condensed explanation of each.

1. Economic Entity Assumption

The accountant keeps all of the business transactions of a sole proprietorship separate from the
business owner's personal transactions. For legal purposes, a sole proprietorship and its owner
are considered to be one entity, but for accounting purposes they are considered to be two
separate entities.

2. Monetary Unit Assumption

Economic activity is measured in U.S. dollars, and only transactions that can be expressed in
U.S. dollars are recorded.
Because of this basic accounting principle, it is assumed that the dollar's purchasing power has
not changed over time. As a result accountants ignore the effect of inflation on recorded
amounts. For example, dollars from a 1960 transaction are combined (or shown) with dollars
from a 2018 transaction.

3. Time Period Assumption

This accounting principle assumes that it is possible to report the complex and ongoing activities
of a business in relatively short, distinct time intervals such as the five months ended May 31,
2018, or the 5 weeks ended May 1, 2018. The shorter the time interval, the more likely the need
for the accountant to estimate amounts relevant to that period. For example, the property tax bill
is received on December 15 of each year. On the income statement for the year ended December
31, 2017, the amount is known; but for the income statement for the three months ended March
31, 2018, the amount was not known and an estimate had to be used.

It is imperative that the time interval (or period of time) be shown in the heading of each income
statement, statement of stockholders' equity, and statement of cash flows. Labeling one of
these financial statements with "December 31" is not good enough–the reader needs to know if
the statement covers the one week ended December 31, 2018 the month ended December 31,
2018 the three months ended December 31, 2018 or the year ended December 31, 2018.

4. Cost Principle

From an accountant's point of view, the term "cost" refers to the amount spent (cash or the cash
equivalent) when an item was originally obtained, whether that purchase happened last year or
thirty years ago. For this reason, the amounts shown on financial statements are referred to
as historical cost amounts.
Because of this accounting principle asset amounts are not adjusted upward for inflation. In fact,
as a general rule, asset amounts are not adjusted to reflect any type of increase in value. Hence,
an asset amount does not reflect the amount of money a company would receive if it were to sell
the asset at today's market value. (An exception is certain investments in stocks and bonds that
are actively traded on a stock exchange.) If you want to know the current value of a company's
long-term assets, you will not get this information from a company's financial statements–you
need to look elsewhere, perhaps to a third-party appraiser.

5. Full Disclosure Principle

If certain information is important to an investor or lender using the financial statements, that
information should be disclosed within the statement or in the notes to the statement. It is
because of this basic accounting principle that numerous pages of "footnotes" are often attached
to financial statements.
As an example, let's say a company is named in a lawsuit that demands a significant amount of
money. When the financial statements are prepared it is not clear whether the company will be
able to defend itself or whether it might lose the lawsuit. As a result of these conditions and
because of the full disclosure principle the lawsuit will be described in the notes to the financial
statements.

A company usually lists its significant accounting policies as the first note to its financial
statements.

6. Going Concern Principle

This accounting principle assumes that a company will continue to exist long enough to carry out
its objectives and commitments and will not liquidate in the foreseeable future. If the company's
financial situation is such that the accountant believes the company will not be able to continue
on, the accountant is required to disclose this assessment.
The going concern principle allows the company to defer some of its prepaid expenses until
future accounting periods.

7. Matching Principle

This accounting principle requires companies to use the accrual basis of accounting. The

matching principle requires that expenses be matched with revenues. For example, sales
commissions expense should be reported in the period when the sales were made (and not
reported in the period when the commissions were paid). Wages to employees are reported as an
expense in the week when the employees worked and not in the week when the employees are
paid. If a company agrees to give its employees 1% of its 2018 revenues as a bonus on January
15, 2019, the company should report the bonus as an expense in 2018 and the amount unpaid at
December 31, 2018 as a liability. (The expense is occurring as the sales are occurring.)
Because we cannot measure the future economic benefit of things such as advertisements (and
thereby we cannot match the ad expense with related future revenues), the accountant charges
the ad amount to expense in the period that the ad is run.

8. Revenue Recognition Principle

Under the accrual basis of accounting (as opposed to the cash basis of accounting), revenues are
recognized as soon as a product has been sold or a service has been performed, regardless of
when the money is actually received. Under this basic accounting principle, a company could
earn and report $20,000 of revenue in its first month of operation but receive $0 in actual cash in
that month.
For example, if ABC Consulting completes its service at an agreed price of $1,000, ABC should
recognize $1,000 of revenue as soon as its work is done—it does not matter whether the client
pays the $1,000 immediately or in 30 days. Do not confuse revenue with a cash receipt.
9. Materiality

Because of this basic accounting principle or guideline, an accountant might be allowed to

violate another accounting principle if an amount is insignificant. Professional judgement is
needed to decide whether an amount is insignificant or immaterial.

An example of an obviously immaterial item is the purchase of a $150 printer by a highly

profitable multi-million dollar company. Because the printer will be used for five years,
the matching principle directs the accountant to expense the cost over the five-year period.
The materiality guideline allows this company to violate the matching principle and to expense
the entire cost of $150 in the year it is purchased. The justification is that no one would consider
it misleading if $150 is expensed in the first year instead of $30 being expensed in each of the
five years that it is used.
Because of materiality, financial statements usually show amounts rounded to the nearest dollar,
to the nearest thousand, or to the nearest million dollars depending on the size of the company.

10. Conservatism

If a situation arises where there are two acceptable alternatives for reporting an item,
conservatism directs the accountant to choose the alternative that will result in less net income
and/or less asset amount. Conservatism helps the accountant to "break a tie." It does not direct
accountants to be conservative. Accountants are expected to be unbiased and objective.

The basic accounting principle of conservatism leads accountants to anticipate or disclose losses,
but it does not allow a similar action for gains. For example, potential losses from lawsuits will
be reported on the financial statements or in the notes, but potential gains will not be reported.
Also, an accountant may write inventory down to an amount that is lower than the original cost,
but will not write inventory up to an amount higher than the original cost.