As creatively numeral accounting is, there is no surprise that it follows certain rules and principles, right?
Well, believe it or not, for companies around the world to evaluate each other’s financial statements, which determine their financial position, a commutability had to be thought of.
It eventually came in the form of GAAP (Generally Accepted Accounting Principles). To further understand, keep reading, as you’ll found out how the principles of GAAP in accounting came to be.
What is GAAP in accounting?
In response to the 1929 stock market crash, the federal legislation of GAAP (generally accepted accounting principles) was established in 1933 with the Securities Act of 1933 and the Securities Exchange Act of 1934. It is what the Financial Accounting Standards board (FASB) uses as foundation for the accounting practices.
GAAP in accounting is the standardized set of rules and guidelines that are to be accepted and respected when achieving any sort of financial accounting. It is also used as a standard rule that should not be confused with the international version referred to as IFRS (International Financial Reporting Standards).
It was enforced by the US securities and Exchange Commission to supervise public or publicly traded companies.
Yet, not every organization ought to use GAAP. For example, companies that are in the private sector can omit this rule, but some still choose to follow it.
Also, if any changes and updates of rules or regulations of the principles are to be made, it is the sole responsibility of the independent boards to deal with such matter and not the government.
GAAP uses the method of accrual accounting, which is the annual financial report of your balance sheet, income statement and cash flow.
Now that we have defined what GAAP is, let us now see why it is important.
Why GAAP is used in accounting?
Firstly, it is used because US law requires the public release of financial statements.
And, because globalization is the inventor of international businesses, companies, different rules and regulation and certainly different languages, a commonality had to be reached.
Said to be the universal language of business, GAAP is used to help companies provide financial statements and account data that could be read, understood by people in other countries.
For example, what if you were an American investor looking to invest in a foreign business, like a Chinese company? Or, if the Chinese company was looking for Western investors?
How would the investor know if it is worth the investment, if he can’t read nor understand the company’s financial statements, which detail a company’s financial situation?
Which is why GAAP’s implementation is essential in accounting. Business owners can understand each other and fraud, misinformation or misinterpretation would mostly be prevented.
What is the goal of GAAP?
GAAP accounting is what companies follow to prepare their financial statements.
As many job sectors and industries exist, GAAP is used to give a consistent, common ground and understanding to methods, definitions and more in accounting.
Else, without it, accountants could apply disingenuous calculations, ways to give a false perception of their company such as, obviously, their financial standing, situation or how much they are making to most likely evade taxes.
What are the GAAP assumptions?
There are 3 GAAP assumptions: economic entity, monetary unit and time period:
The economic entity assumption: is the separation between business transactions from the company’s boss personal transactions that the accountant should keep.
The monetary unit assumption: ensures that the accountant submits every transaction in the same currency, even if it is an international company.
The period assumption: is the preparation of income statement at the end of the supposed belief of a company’s economic life or businesses' activities. It is believed to be divided into short time intervals, known accounting periods.
What Are the Principles of GAAP?
GAAP has four principles known as:
Cost: calls for the cost recorded to be the actual cost of an asset or item you have purchased, and not that of the market values or adjustments for inflation so that the inventories and any other item bought is correctly displayed in the ledger for accounting. This principle is to avoid any estimations of late purchase and cost recording.
Revenue: The same goes for this revenue recognition principle. The revenue recognition principle is served as a basis for accrual accounting, which is to record revenue and expenses and recognize them on income statements, the moment the transaction takes place. It is to record the revenue at the exact time you have earned it, as opposed to when you’ve received payments. Its goal is to prevent payment delays that could lead to accounting miscalculations and errors.
Matching: This principle is for expenses to be recorded at the exact time that revenues are earned. To understand this, there are two lines, revenue and cost of goods sold (COGS), on the income statement that must be matched. And how to do it?
For example, a product was purchased in cash in 2019, but was not sold until the following year. In 2020, the product is sold and then delivered to the customer. The time and year to take into account here, is 2020 because it is when you will have received your revenue.
Disclosure: A full disclosure includes every information concerned with the financial statements. However, because it entails divulging quite a bit of information, to simplify the reader’s understanding and lessen judgements, it is common to only deal with and disclose information that will affect the financial statements’ results or financial position of your business.
But, the information should still be sufficient for executives’ decision process concerning the business. In addition, in the disclosure, you must always report current and existing accounting policies, as well as any changes to those policies from the policies priorly stated in the financials of a previous year.
What are the GAAP constraints principles in accounting?
- Principle of regularity: The account has recognized to follow the GAAP rules and regulations as the standard.
- Principle of Consistency: This same standard is used throughout the entire reporting process. For each period, the reporting process should be coherent from a period to the next. If one decides to change, they’ll need to justify their decision.
- Principle of Sincerity: The accountant should provide accurate results of their company’s financial statements and situation.
- Principle of Permanence of Methods: The methods applied to determine the company’s financial are consistently done the same way.
- Principle of Non-Compensation: Both negative and positive results should be reported.
- Principle of Prudence: is ensuring that fact-based data, not speculations, are represented and that one has not overstated their assets or income, to overvalue their company nor understated their expenses. It is to be prudent and prepare for any future loss.
- Principle of Continuity: The company shall operate as it has been and when stating financial information.
- Principle of periodicity: Every entry is to be submitted in its designated time period.
- Principle of Materiality: Every relevant material information of financial data and accounting information should be revealed in the financial reports.
- Principle of Utmost Good Faith: Derived from the Latin phrase uberrimae fidei used within the insurance industry. It presupposes that companies shall act faithfully and remain honest in every financial reporting.
To conclude, for the accounting of your company’s financial situation to make sense internationally, you must understand the importance of implementing the GAAP principle.