Understanding GAAP Accounting Principles

by | Jul 14, 2022

Accounting Principles

Accounting Principles, commonly known as GAAP, are an essential aspect of financial accounting policies and practices. These principles provide guidance on how accounting transactions should be recorded and reported, ensuring transparency and consistency in financial reporting. The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) are the most commonly used accounting standards.

Before the GAAP

Prior to the creation of GAAP, companies followed their own unique set of standards and practices, leading to confusion and bad transactions. The stock market crash of 1929 and ensuing Great Depression highlighted the need for a standardized set of accounting principles. In response, the American Institute of Accountants and the New York Stock Exchange created the Committee on Accounting Procedure, which produced the first version of today’s accounting standards with five broad principles.

Over the years, these accounting principles have been expanded and updated to reflect changes in the accounting industry, resulting in the current version of GAAP. These standards help ensure that financial reporting is transparent and consistent across different organizations, making it easier for investors to compare the financial health of different businesses.

Primary Mission of GAAP

The ten general concepts that make up the primary mission of GAAP include the Principle of Regularity, Consistency, Sincerity, Permanence of Methods, Non-Compensation, Prudence, Continuity, Periodicity, Materiality, and Utmost Good Faith. Each principle is vital to ensuring that financial reporting is accurate and impartial.

Principle of Regularity

The Principle of Regularity requires accountants to adhere to GAAP rules and regulations as a standard. The Principle of Consistency mandates that accountants apply the same standards throughout the reporting process to ensure financial comparability between periods. Accountants are expected to fully disclose and explain the reasons behind any changes or updated standards in the footnotes to the financial statements.

Principle of Sincerity

The Principle of Sincerity requires accountants to provide an accurate and impartial depiction of a company’s financial situation. The Principle of Permanence of Methods requires the procedures used in financial reporting to be consistent, allowing for a comparison of a company’s financial information. The Principle of Non-Compensation mandates that both negatives and positives should be reported with full transparency and without the expectation of debt compensation.

Principle of Prudence

The Principle of Prudential representation emphasizes fact-based financial data representation that is not clouded by speculation. The Principle of Continuity requires that while valuing assets, the business should be assumed to continue to operate. The Principle of Periodicity mandates that entries be distributed across the appropriate periods of time, such as reporting revenue in its relevant accounting period.

 

Principle of Materiality

The Principle of Materiality requires accountants to strive to fully disclose all financial data and accounting information in financial reports. The Principle of Utmost Good Faith is derived from the Latin phrase uberrimae fidei, used within the insurance industry. It presupposes that parties remain honest in all transactions.

The GAAP Benefits

Using GAAP benefits the entire accounting community, including investors, regulators, lenders, and corporate managers. GAAP helps maintain trust in the financial markets by ensuring that financial reporting is transparent and consistent. Without GAAP, there would be fewer and more expensive transactions, slowing down the economy. Investors’ confidence in the integrity of the information provided would be low, and making “apples to apples” comparisons of companies would be challenging.

GAAP the Essential Guide

In conclusion, GAAP is an essential set of standards, procedures, and principles that guide financial accounting policies and practices. These principles ensure that financial reporting is transparent and consistent, making it easier for investors to compare the financial health of different businesses. The ten general concepts that make up the primary mission of GAAP are vital to ensuring that financial reporting is accurate and impartial. Using GAAP benefits the entire accounting community and maintains trust in the financial markets.

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