An introduction to generally accepted accounting principles (GAAP)

Cups, feet, ounces, inches. Familiar measurements in the US but all-but-unknown in countless countries around the world. Accounting in the US takes a similar stance. The system of guiding principles in the US are known as GAAP accounting principles, compared to most of the rest of the world’s use of IFRS (International Financial Reporting Standards). Find out everything you need to know about GAAP accounting principles and why they’re so important, below.

What is GAAP?

So, what is GAAP? GAAP stands for generally accepted accounting principles. It’s a set of standardized procedures and principles issued by the Financial Accounting Standards Board (FASB) that aims to improve the consistency, clarity, and comparability of financial information. These basic accounting principles are used by many US businesses, state and local governments, non-profit organizations, and non-US companies that are listed on the US stock exchange.

What are the generally accepted accounting principles (GAAP)?

GAAP is an attempt to standardize and regulate the assumptions, methods, and definitions used in accounting across different industries. There are 10 concepts behind the GAAP accounting principles:

1. Principle of Regularity – Accountant adheres to GAAP regulations and rules as standard, on a regular basis.

2. Principle of Consistency – Apply the same standards throughout the financial reporting process to prevent errors and discrepancies.

3. Principle of Sincerity – Accountant aims to provide an accurate and impartial depiction of the company’s financial state.

4. Principle of Permanence of Methods – The procedures used in financial reporting must be consistent.

5. Principle of Non-Compensation – Both positives and negatives must be reported with full transparency.

6. Principle of Prudence – The focus should be on fact-based financial data that isn’t clouded by speculation.

7. Principle of Continuity – When valuing assets, the accountant should assume that the business will continue to operate.

8. Principle of Periodicity – All financial entries should be placed in the relevant time period.

9. Principle of Materiality/Good Faith – Accounts must aim for full disclosure in their financial reports.

10. Principle of Utmost Good Faith – Assumes that all businesses are being honest in their financial reporting, derived from the Latin phrase “uberrimae fidei”.

These ten concepts provide the basis for a broad range of GAAP standards and processes. GAAP covers an enormous number of topics, including assets, liabilities, equity, expenses, leases, non-monetary transactions, derivatives, business combinations, and more. To find out exactly what accounting standards your business needs to follow, you’ll need to access the Accounting Standards Codification, provided by the FASB.

Why are the generally accepted accounting principles important?

GAAP provides several advantages for business organizations. Most importantly, it enhances the comparability of your financial statements. This enables organizations to compare financial statements from different time periods, benchmark performance, and optimize operations. In addition, GAAP accounting principles are consistent, making financial statements more usable and ensuring that stakeholders can evaluate financial data more easily. Furthermore, GAAP improves the reliability of your financial reporting, making it easier for lenders to evaluate your suitability for a loan. This also helps management make better decisions about your business’s operational objectives and provides you with the right information to adjust if your profitability drops or your cash flow runs into difficulty.

Who enforces the GAAP accounting principles?

In the U.S., if your business’s stock is publicly traded, you are legally required to make sure that your financial statements adhere to the rules set out by the U.S. Securities and Exchange Commission (SEC). One of these rules requires publicly traded companies to file regular GAAP-compliant financial statements. So, what are the requirements for non-publicly traded companies? While GAAP isn’t required, it is viewed favorably by lenders, and many financial institutions require GAAP-compliant financial statements as a condition of issuing business loans. Because of this, most companies in the United States follow the basic accounting principles detailed by GAAP.

Why should an entrepreneur know basic accounting principles?

GAAP’s ultimate goal is to make sure that every business’s financial statements are consistent and comparable, making it easier for investors to extract useful information from these statements. For entrepreneurs and small business owners, a solid understanding of the generally accepted accounting principles can help you track and improve your business’s financial performance. If you need to properly organize your financial information into standardized accounting records, disclose supporting information, or summarize your accounting records into financial statements, GAAP accounting principles can be extremely effective.

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