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.