Updated July 28, 2023
Definition of Generally Accepted Accounting Principles
Generally Accepted Accounting Principles, popularly known as GAAP, are a strategically compiled collection of accounting principles, standards, and rules that the management of every company must follow while compiling their financial statements.
GAAP not only obliges a company over specific standard rules but also guides the accountants to systematically record and report the accounting information and maintain consistency while drafting the company’s financial statements.
Need for Generally Accepted Accounting Principles (GAAP)
1. There are various beneficiaries and users of the financial statements presented by a company other than the management itself, like shareholders and investors, governments or taxation departments, customers and suppliers, etc.
2. GAAP is helpful for simplified reporting of a company’s financial information, providing better understandability and improved clarity for all the associated parties.
3. GAAP, introduced by the Financial Accounting Standards Board (FASB), provides standards applicable to every corporate organization to generate comparable, transparent, and fair information.
4. Financial statements, including balance sheets, income statements, and cash flow statements compiled using GAAP, can represent the accurate economic picture of a company.
5. Without GAAP, companies become free to manipulate financial information, and accounting fraud will increase. The best example of committing accounting fraud was Enron, where it hid its liabilities and inflated its earnings.
Generally Accepted Accounting Principles (GAAP)
GAAP system of accounting introduces ten basic principles that clarify the objective of accounting standards while compiling financial statements
1. Principle of Regularity: Every company’s management must comply with the rules and regulations imposed by GAAP under general accounting practices.
2. Principle of Consistency: The accountants of an entity must consistently follow the same accounting methods and procedures from period to period. E.g., a company that depreciates its fixed assets using the written down value (WDV) method at 10% per annum. The company should also consistently follow the WDV method for depreciation in future years.
3. Principle of Sincerity: The management must sincerely compile the financial information that reflects the company’s financial status. The financial statements should represent the company’s economic and financial health.
4. Principle of Permanence of Methods: The accounting standard provides logical and consistent financial information that allows intra-company (period to period) and inter-company comparative analysis.
5. Principle of Non-Compensation: The accountants must disclose full details of the financial accounting information and not indulge in manipulative practices like compensating a debt with an asset, compensating revenues with expenses, etc.
6. Principle of Prudence: The entity’s management should present the fact-based financial picture, i.e., the reality “as it is” without any speculation, and not make things look prettier.
7. Principle of Continuity: It is also known as the going concern assumption because a business operates indefinitely. The importance of the principle lies in the fact that if a company is going to liquidate shortly, then it should revalue its assets and liabilities at the market or actual amount.
8. Principle of Periodicity: Every entry of accounting is of a specific period as per the guidelines mentioned in the following points:
- Matching Concept: The comparison of the revenues of a particular period with their corresponding expenditures is necessary to represent the period’s exact real profits.
- Accrual basis of Accounting: This records all the revenues and expenditures incurred in a particular period irrespective of cash flows. In other words, record income earned and expenses if incurred and not when cash has been received/spent.
9. Principle of Materiality: The principle states that financial statements should include significant or material information and avoid reporting non-material information. In other words, reporting some transactions can be ignored using the rules of an accounting standard if the net impact of such transactions is negligible while compiling financial statements. However, there is a requirement for proper disclosure in footnotes as per the rules.
10. Principle of Utmost Good Faith: The principle requires the transacting parties to act honestly without misleading or withholding critical information from one another. It is the most fundamental principle in the insurance industry, and this should be the minimum standard that applies to everyone while making financial transactions.
GAAP vs IFRS
Companies in the USA mainly practice GAAP or US GAAP, while more than 110 countries across the globe use International Financial Reporting Standards (IFRS). The global acceptance of IFRS is due to its principle-based logical system representing the economics of financial transactions better than GAAP.
FASB has been working with the help of IASB for the convergence of GAAP into IFRS since 2002. As a result, in 2007, the USA’s Securities and Exchange Committee (SEC) withdrew the obligation for non-US companies registered in America to report in GAAP if they were compiling their financial statements under the IFRS system.
Key Differences Between GAAP vs. IFRS
Given below are the key differences between GAAP and IFRS:
|
Basis of Comparison Between GAAP vs IFRS |
GAAP |
IFRS |
|
Issuing Authority |
Issued by the Financial Accounting Standards Board (FASB) of the USA. | Issued by the International Accounting Standards Board (IASB). |
| Cost Method | LIFO is allowed. | LIFO is prohibited. |
| Cost of Development | Charge as and when they are incurred. | The high cost can be capitalized and amortized over multiple periods. |
| Writedowns | You are not allowed to reverse even if an asset’s or inventory’s market value increases. | You can reverse as per the rules. |
Conclusion – Generally Accepted Accounting Principles
GAAP is just a collection of rules and standards that provides guidelines and methods to compile the financial transaction of a company into financial statements for a particular period. It adds clarity and transparency for outside parties and obligates the company’s management. However, GAAP does not guarantee error-free reporting; therefore, investors should act wisely while reading financial statements before investing.
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