U.S. GAAP (Generally Accepted Accounting Principles)
Generally Accepted Accounting Principles (GAAP) are a set of common and widely accepted standards used by accountants and organizations in preparing financial information about a business entity. GAAP is borne out of some clearly defined objectives which include the necessity for business organizations to provide financial information that are useful for evaluation by external parties like creditors and investors. Consistency in the approach, format and presentation derived from the accounting framework and applicable laws makes the provided information very helpful in the decision making process for outside parties.
In order to meet its objectives, financial accounting in the U.S. conforms to a set of basic concepts. They are all outlined briefly below.
- Business Entity Concept: requires that a business entity is separate and distinct from its owners and other businesses.
- Going Concern Concept: assumes that a business entity has indefinite life. Follows the idea of continuity and assumes that a business will outlive its owners and employees.
- Objectivity Concept: information provided by the organization or accountant is objective, verifiable and neutral. Assumes that others will come to the same conclusion given the same information.
- Historical Cost Concept: requires that a business accounts for its assets and discloses information about those assets based on the historical acquisition cost and not on the fair market value of the asset. Some exceptions apply as it relates to marketable investment securities and debt instruments.
- Unit of Measure Concept: assumes that all transactions are analyzed, evaluated and reported based on the same unit of currency. In the U.S. the requirement would be of course, the U.S. dollar.
- Accounting Period Concept: used for reporting purposes and assumes that a business reports its results in uniform periods of time (operating cycle). Although popular, an accounting period need not be a year.
- Revenue Recognition Concept: required organizations to recognize revenue in the period when it was earned regardless of when the payment is received. This concept lends itself to what we know as “accrual based accounting”.
- Matching Concept: incurred business expenses have to be matched with earned revenues as long as there is a direct relationship between the two. Applies to all revenue generating resources including capital assets and inventory. Exceptions to this rule as it relates to expenses are those that are clearly not part of the revenue generation process such as General & Administrative expenses.
- Adequate Disclosure Concept: requires full disclosure of all information meaningful to the decision making process by external parties. No omission of material information allowed regardless of whether it is qualitative or quantitative. Full disclosure is usually made in accompanying documents to the financial statements.
- Materiality Concept: requires an evaluation of particular items when they are reported. An item is material and should be reported if it can have an impact on decisions made based on that information.
- Consistency Concept: requires information presented to follow the same accounting methods period over period. Supports the idea of comparability. Does not mean that a company cannot change its accounting methods but requires a restatement of financial information for prior periods when methods are changed. (Every annual report has 3 full years of information for the income statement and statement of shareholder equity and 2 years of information for the balance sheet).
- Conservatism Concept: when faced with a choice this principle requires that organizations and accountants choose the alternative that’s the least likely to overstate income or assets (i.e., choose the least “rosy”).]