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Generally accepted accounting principles, or GAAP as they are more commonly known, are rules and guidelines that help companies prepare financial statements. What exactly the principles contain varies slightly from jurisdiction to jurisdiction, but in most cases they cover assumptions, basic principles, and basic constraints. They are used predominantly by corporate accountants who are preparing public earnings statements and financial reports, and the goal is usually to provide some level of uniformity across industry sectors.
Most countries require publicly traded companies to release annual financial statements to their shareholders and, in many cases, to the general public. These reports are really important for investors, banks, and creditors since in many ways they speak to the financial health and profitability of the company, but unless all companies prepare their reports according to the same basic principles the results can be tough to sort through and fairly compare. Requiring that statements from all companies comply with a standardized set of general assumptions, rules, and restrictions can be one way to improve transparency as well as to streamline reporting for things like taxes, earnings, and executive salaries.
The key assumptions of generally accepted accounting principles are broken down into four subsets, namely business entity, going concern, monetary unit, and time period. The “business entity” assumption presumes that the business functions as a legal and financial entity separate from its owners or any other business. This means that all the amounts shown as revenue or expense in the financial statements are for the business alone and do not include any personal expenses.
"Going concern" is the assumption that the business will operate for the foreseeable future. This is important when calculating the values for assets, depreciation and amortization. The “monetary unit” assumption is that all the amounts listed use one stable currency, and that any amounts in another currency are clearly listed. "Time period" assumes that all the transactions reported did in fact occur within the time period as listed.
There are also four basic principles. These are cost, revenue, matching and disclosure. The “cost” principle refers to the notion that all values listed and reported are the costs to obtain or acquire the asset and not the fair market value, while the “revenue” principle states that all revenue must be reported when is it realized and earned, not necessarily when the actual cash is received. This is also known as accrual accounting. The “matching” principle holds that the expenses in the financial statement must be matched with the revenue. Accountants must include the value of the expense in the financial statements when the work product is sold, not necessarily when the work or invoice is issued. Finally, the “disclosure” principle holds that information pertinent to make a reasonable judgment on the company's finances must be included, so long as the costs to obtain that information is reasonable.
When it comes to constraints, the GAAP covers objectivity, materiality, consistency, and prudence. The objectivity constraint states that all the information included in the financial statements must be supported by independent, verifiable evidence. What this means is that the significance of the item must be considered under the materiality constraint when deciding whether it should be included on the financial statements. In general, if this information would be significant to a reasonable third party, it must be included.
The company is required to use the same accounting methods and principles each year under the consistency constraint and any variation must be reported in the financial statement notes. Under the constraint of prudence, accountants are required to choose a solution that reduces the likelihood of overstating assets and income.
How They’re Used
The principles are, as their name suggests, simply principles — they aren’t hard and fast rules and there is usually some room for interpretation. Companies can more or less choose how they are going to comply with each area, but by publishing their reports publicly they are, in most cases, asserting that the assumptions and general principles of the rules have been followed and present an accurate and true picture.
Most countries have GAAP rules, but they can vary from place to place in terms of specificity and particular procedural requirements. In most cases, special financial accounting standards boards are responsible for drawing up the rules, and may also be tasked with resolving common problems in a systematic, coherent way. These boards are usually housed in the government, but can be privatized, too. A lot depends on location.
Differing principles and rules from country to country can pose problems, or at least complications, for businesses that operate in several places simultaneously. In these cases accounting professionals usually have to be aware of all relevant principles, and sometimes have to publish different forms of their financial reports that are tailored to rules of particular localities. A number of experts encourage the development of a single, international board to administer to resolve this problem; a singular code would, they say, promote a greater level of uniformity in accounting standards around the world.