What are Generally Accepted Accounting Principles?
Generally Accepted Accounting Principles, popularly known as GAAP, are a strategically compiled collection of accounting principles, standards, and rules that must be followed by the management of every company during the compilation of their financial statements.
GAAP not only obliges a company over certain common rules, but it also acts as a guide for the accountants to systematically record and report the accounting information and maintain consistency while drafting the financial statements of the company.
Need of Generally Accepted Accounting Principles (GAAP)
1. There are various beneficiaries and users of the financial statements presented by a company other than the management itself like shareholders and investors, governments or taxation departments, customers and suppliers, etc.
2. GAAP is used for simplified reporting of the financial information about a company that provides better understandability and improved clarity for all the associated parties.
3. In order to provide a set of standards applicable to every corporate organization that can generate comparable, transparent, and fair information, GAAP was introduced by The Financial Accounting Standards Board (FASB).
4. Financial statements, including balance sheets, income statements, and cash flow statements compiled using GAAP, are able to represent the true economic picture of a company.
5. Without GAAP, companies become free to manipulate financial information and the probability to accounting frauds will highly increase. The best example of committing an accounting fraud was of Enron, where it hides its liabilities and inflated its earnings.
Generally Accepted Accounting Principles (GAAP)
GAAP system of accounting introduces ten basic principles that clarify the objective of accounting standards while compiling financial statements
1. Principle of Regularity: The management of every company has to comply with the rules and regulations imposed by GAAP under general accounting practices.
2. Principle of Consistency: The accountants of an entity must consistently follow the same accounting methods and procedures from period to period. E.g. a company that depreciates its fixed assets using the written down value (WDV) method at 10% per annum. The company should consistently follow the WDV method for depreciation in future years also.
3. Principle of Sincerity: The management must sincerely compile the financial information that reflects the reality of the company’s financial status. The financial statements should represent the true economic and financial health of the company.
4. Principle of Permanence of Methods: The accounting standard aims to provide logical and consistent financial information that allows both intra-company (period to period) and inter-company comparative analysis.
5. Principle of Non-Compensation: The accountants must disclose full details of the financial accounting information and do not get indulged in any manipulative practices like compensating a debt with an asset, compensating revenues with expenses, etc.
6. Principle of Prudence: The management of the entity should present the fact-based financial picture, i.e. the reality “as it is” without any speculation, and not make things look prettier than what they are.
7. Principle of Continuity: It is also called going concern assumption because a business is established assuming it will operate for an indefinite period of time. The importance of the principle lies in the fact that if a business is going to liquidate in the near future, then it should revalue its assets and liabilities at the market or actual amount.
8. Principle of Periodicity: Every accounting entry must be allocated to a specific period as per the guidelines mentioned in the following points:
- Matching Concept: The concept says that revenues of a particular period must be matched with their corresponding expenditures in order to represent the exact real profits for the period.
- Accrual basis of Accounting: The concept says that record all the revenues and expenditure that actually incurred in a particular period irrespective of cash flows. In other words, record income is earned and expenses if incurred and not when cash has been received/spent.
9. Principle of Materiality: The principle states that financial statements should include significant or material information and avoid reporting non-material information. In other words, reporting some transactions can be ignored using rules of an accounting standard if the net impact of such transactions is negligible while compiling financial statements. However, proper disclosure in footnotes might be required as per rules.
10. Principle of Utmost Good Faith: The principle requires the transacting parties to act honestly without misleading each other or withholding critical information from one another. It is the most fundamental principle in the insurance industry, and this should be the minimum standard that applies to everyone while making financial transactions.
GAAP vs IFRS
GAAP or US GAAP is mainly practiced by companies of the USA, while International Financial Reporting Standards (IFRS) has been used by more than 110 countries across the globe. The global acceptance of IFRS is due to its principle-based logical system that represents the economics of financial transactions in a better way than GAAP.
FASB has been working with the help of IASB for convergence of GAAP into IFRS since 2002. In 2007 the obligation for non-US companies registered in America to report in GAAP had been withdrawn by the Securities and Exchange Committee (SEC) of the USA if they are compiling their financial statements under the IFRS system.
Key Differences between GAAP vs IFRS
The Basis of Comparison Between GAAP vs IFRS
|Issued by the Financial Accounting Standards Board (FASB) of the USA.||Issued by the International Accounting Standards Board (IASB).|
|Cost Method||LIFO is allowed.||LIFO is prohibited.|
|Cost of Development||Charge as and when they incurred.||The large cost can be capitalized and amortized over multiple periods.|
|Writedowns||Not allowed to reverse even if the market value of asset or inventory written off increases.||The reverse is allowed as per rules.|
Conclusion – Generally Accepted Accounting Principles
GAAP is just a collection of rules and standards that provides guidelines and methods to compile the financial transaction of a company into financial statements for a particular period. It adds clarity and transparency for outside parties and imposes an obligation for the management of the company. However, GAAP does not guarantee error-free reporting; therefore, investors should act wisely while reading financial statements before investing.
This has been a guide to the Generally Accepted Accounting Principles. Here we also discuss the need and different principles of GAAP. You may also have a look at the following articles to learn more-