Generally Accepted Accounting Principles (GAAP) is a set of accounting standards that are used when preparing financial statements for companies, nonprofits, and other entities. Public companies are mandated to follow GAAP standards, but even small private companies can benefit from GAAP as it may help them work with audits or requesting loans from banks. The Financial Accounting Standards Board (FASB) maintains and codifies GAAP, which is primarily used in USA.
Even if you’re not an accountant, it is worth getting a general idea of the underlying concepts that drive the accounting field. GAAP has 4 basic assumptions, 4 basic principles, and 5 constraints:
Assumptions
- Business Entity
- Assumes the business is separate from its owners or other businesses
- Going Concern
- Assumes the business will operate indefinitely
- Monetary Unit Principle
- Assumes a stable currency is used as the unit on the records, such as the US dollar.
- Time Period Principle
- Assumes economic activity can be divided into artificial time periods, such as quarters or months in a year.
Principles
- Historical Cost Principle
- Requires companies to account and report assets at cost, rather than fair market value.
- Revenue Recognition Principle
- Companies should record revenue when earned, but not when received. This is essential to accrual basis accounting.
- Matching Principle
- Expenses must be matched with revenues, as reasonably allowed.
- Full Disclosure Principle
- A company should disclose all relevant information that relates to the function of its financial statements. This helps keep investors or other interested parties aware of relevant financial facts of the company.
Constraints
- Objectivity Principle
- Company financial statements should be based on objective evidence
- Materiality Principle
- The significance of reporting an item should be considered if it may affect the decisions of a reasonable individual.
- Consistency Principle
- The company must use the same accounting principles throughout each time period (quarters, months, years, etc.), such as FIFO or LIFO inventory methods.
- Conservatism Principle
- The accountants preparing reports must choose the option that yields the most conservative result, e.g. reporting on certain depreciation expenses properly.
- Cost Constraint
- The cost of reporting financial info should be less than the benefit derived from that financial info. Essentially, the cost of preparing reports should not cost more than the benefits from having the info.
GAAP is the bedrock of accounting practices that all business owners should be mindful of as they grow their business. A good team of accountants can help savvy business owner keep their businesses GAAP-compliant. Owners have trusted us at MiklosCPA for many years to help keep their accounting and tax concerns straight. Learn how we can help your business and schedule a call! Also, make sure to subscribe to our social media pages for future articles and other good-to-know accounting tidbits.