GAAP stands for Generally Accepted Accounting Principles. This collection of accounting standards and rules is followed by accountants and used for financial reporting. The goal behind designing a common set of standards was to improve the transparency of financial statements. However, they certainly do not guarantee a company’s statements are free from omissions or errors. The US Securities and Exchange Commission (SEC) adopted the guidelines, including clear definitions of principles and concepts and industry-specific rules. As a result, GAAP helps ensure consistent financial reporting between organizations. Here’s a look at the ten principles of accounting.
1. Principle of Prudence
The principle of prudence refers to the use and representation of factual financial data. The accountant does not let the data be clouded by speculation or assumptions. Instead, everything should be based purely on facts. For example, if a company is making a trade agreement with a client, even if it is finally completed, the revenue cannot be recognized until it materializes.
2. Principle of Utmost Good Faith
The insurance industry uses the Latin phrase uberrimae fidei. The principle of Utmost Good Faith means that all parties should carry on all transactions with the utmost honesty. This principle is applied to the sharing of information. It implies that all parties must be forthcoming about details. For example, someone applying for car insurance must disclose any traffic tickets or insurance claims, so the company can offer a fair quote for services.
3. Principle of Non-Compensation
Non-compensation means presenting financial data that includes positives and negatives. Accounting professionals need to report all information with full transparency without trying to compensate for debts. An accountant cannot conceal information to “compensate’ for what they perceive to be negative.
4. Principle of Sincerity
The principle of sincerity means reporting financial information accurately and honestly. Accountants must provide accurate depictions of a company’s finances without impartiality. This just means they should not overinflate financial records so they look better than they should. So, financial information should be shared as it is based on actual information, not on presumption or bias.
5. Principle of Consistency
An accountant must commit to using the same standards throughout all reporting processes. They must show consistency from one period to the next. It’s the only way to ensure financial consistency and comparability between the various periods. An accountant must explain and fully disclose any change or update in standards. These explanations are included in the financial statements in the footnotes. For example, if a company is using the accrual method for its expenses and revenue, it cannot be suddenly switched to the cash method.
6. Principle of Continuity
When valuing the assets of a company or organization, an accountant must assume that normal operations will continue. For instance, resources must be valued based on their original cost rather than their current values if they were to be sold currently. The accountant must assume the business plans are continuing.
7. Principle of Materiality
Accountants should work to include all accounting information and financial data in their financial reports. Accountants cannot skip accounts or debts, or omit information in an attempt to mislead them.
8. Principle of Regularity
Accountants must adhere to GAAP regulations and observe them as the primary standard. In other words, accountants must use a reputable system for reporting financial information. The information must be actual, and not made up just to create a report.
9. Principle of Permanence Methods
There are many procedures useful for financial reporting. This principle states that accountants should be consistent with the procedures they use. This allows companies to compare their financial information.
10. Principle of Periodicity
Revenue reporting is divided into standard accounting periods. Fiscal years are usually divided into periods, including fiscal years and fiscal quarters. Accountants should enter financial information appropriately across various periods. For example, accountants should report revenue in the period it was received.
Why is GAAP Important?
GAAP was designed to create a consistent, comparable, and clear method of accounting. Business leaders need clarity to get a complete, honest picture of their company’s health. Since consistency is ensured via GAAP, business leaders can compare their performance month after month.
GAAP provides benefits for external purposes. It influences raising capital, preparing for transactions, competitive comparisons, and public trading. Accountant professionals produce complete, comparable financial reports. All businesses benefit from consistency when companies release financial statements.
Where are Generally Accepted Accounting Principles (GAAP) Used?
Businesses in the United States use GAAP to report financial results. Most other countries use the International Financial Reporting Standards (IFRS) for their accounting framework. All publicly-traded companies in the US require the use of GAAP principles. However, most private companies follow the comprehensive accounting framework, too. In addition, GAAP standards apply to accounting practices for all nonprofit, government, and corporate practices.
What is the difference between GAAP and IFRS?
The main difference between IFRS and GAAP is how they are structured. GAAP is more rules-based, whereas IFRS focuses more on general principles. The IRFS is smaller and easier to understand, but GAAP is a more comprehensive accounting framework.
What are the Basic Principles of Accounting?
Businesses that have a grasp of the basic principles of accounting will be assured of more accurate financial positions. Clients and stakeholders need to trust that companies will provide reliable and accurate key information reporting. Therefore, the basic principles of accounting are essential for any organization.
- Revenue Recognition Principle: This principle deals with the period’s revenue is recognized. Those using the accrual basis recognize revenue on the income statement, which recognizes the period the services were provided for the client. Companies using the cash basis recognize revenue in the period cash was received.
- The Matching Principle: Expenses and revenue should match with the accounting periods and be recorded in the period where they occurred. In a period when revenue is recognized on products or services that were sold, the cost of those items should be recognized as well.
- The Cost Principle: This principle involves keeping business expenses orderly by recording assets when a product or service is purchased. Record acquisition prices on items purchased, and remember to depreciate assets appropriately.
- The Objectivity Principle: Accounting professionals must keep personal opinions out of data. Data should be accurate and supported by evidence, including invoices, receipts, and vouchers.
- The Full Disclosure Principle: Financial statements should include complete information to ensure they are not misleading. Partners and clients are made aware of relevant information pertinent to the company.
