Understand the GAAP Accounting Principles

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financial accounting

What are Accounting Principles?

Generally accepted accounting principles, also known as GAAP, are a universal set of principles, standards, and procedures that define the basis of financial accounting policies and practices.

These standards state how accounting transactions should be recorded and reported. The accounting standards most commonly issued are the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB).

The History of GAAP

Before any accounting standards were in place, each company followed its own standards and practices. Following the stock market crash in October of 1929, the American Institute of Accountants and the NYSE created the Committee on Accounting Procedure. This committee produced the first version of today’s accounting standards with five broad accounting principles. 

Once the Securities and Exchange Commission was established, they were charged with reviewing the fillings of companies to ensure they adhered to GAAP requirements. They were explicitly watching for full disclosure, adherence to proper accounting, and comparability.

Over the years, these accounting principles have been edited, changed, and expanded to today’s version of GAAP. 

Why do we have GAAP?

Before a standard of accounting principles existed, each company followed its own set of rules. No two companies reported their financials the same way. This practice confused many and led to bad transactions.   

The purpose of GAAP is to ensure that financial reporting is transparent and consistent from one organization to another.

GAAP is vitally important because it helps maintain trust in the financial markets. Without it, there would be fewer and more expensive transactions, slowing the economy. Without it, investors’ confidence in the integrity of the information provided would be low. 

Lastly, GAAP makes the “apples to apples” comparison of companies easier to perform. The standards allow investors to make educated decisions based on data they can trust.  

What are the Accounting Principles?

There are 10 general concepts that lay out the main mission of GAAP.

1. Principle of Regularity

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

2. Principle of Consistency

Accountants commit to applying the same standards throughout the reporting process, from one period to the next, to ensure financial comparability between periods. Accountants are expected to fully disclose and explain the reasons behind any changed or updated standards in the footnotes to the financial statements.

3. Principle of Sincerity

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

4. Principle of Permanence of Methods

The procedures used in financial reporting should be consistent, allowing a comparison of the company’s financial information.

5. Principle of Non-Compensation

Both negatives and positives should be reported with full transparency and without the expectation of debt compensation.

6. Principle of Prudence

This refers to 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 reported in its relevant accounting period.

9. Principle of Materiality

Accountants must strive to fully disclose all financial data and accounting information 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 all transactions.

 

Final Thoughts

Due to the stock market crash of 1929 and the ensuing Great Depression, GAAP was born. The US Government, along with others, believed some of the blame for the crash was due to less than honest practices by publicly traded companies. 

Since the creation of GAAP in 1936, investors can confidently compare the financial health of different businesses. Using these generally accepted accounting principles also benefits regulators, lenders, corporate managers, and the entire accounting community.

 

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