It is important that you understand the concepts of Generally Accepted Accounting Principles (GAAP), which form the basis of accounting and are part of the language of accounting and business. Third parties who invest in or provide loans to any company must know that they can rely on the financial information provided.
This chapter will introduce the agencies responsible for standardizing the accounting principles that are used in the United States and it will describe those principles in full detail. Once you understand these guiding principles, you will have a solid foundation on which to build a complete set of accounting skills. It is useful and necessary that whether an international company is reporting to its stockholders or a proprietor is presenting information to a bank for a loan, these reports follow a consistent set of rules that everyone understands and agrees to.
Generally Accepted Accounting Principles begin with the three basic assumptions made about each business. First, it is assumed that the business is separate from its owners or other businesses. Revenue and expenses should be kept separate from personal expenses. Second, it is assumed that the business will be in operation indefinitely. This validates the methods of putting Assets on the Balance Sheet, depreciation and amortization. Only when liquidation of a business is certain does this assumption no longer apply. Third, it is assumed a business’s accounting records include only quantifiable transactions. Certain economic events that affect a company, such as hiring a new employee or introducing a new product, cannot be quantified in monetary units and, therefore, do not appear in a company’s accounting records.
Financial statements must present relevant, reliable, understandable, sufficient, and practicably obtainable information in order to be useful.
- Principle of Regularity: GAAP-compliant accountants strictly adhere to established rules and regulations.
- Principle of Consistency: Consistent standards are applied throughout the financial reporting process.
- Principle of Sincerity: GAAP-compliant accountants are committed to accuracy and impartiality.
- Principle of Permanence of Methods: Consistent procedures are used in the preparation of all financial reports.
- Principle of Non-Compensation: All aspects of an organization’s performance, whether positive or negative, are fully reported with no prospect of debt compensation.
- Principle of Prudence: Speculation does not influence the reporting of financial data.
- Principle of Continuity: Asset valuations assume the organization’s operations will continue.
- Principle of Periodicity: Reporting of revenues is divided by standard accounting periods, such as fiscal quarters or fiscal years.
- Principle of Materiality: Financial reports fully disclose the organization’s monetary situation.
- Principle of Utmost Good Faith: All involved parties are assumed to be acting honestly.
GAAP (Generally Accepted Accounting Principles) is a set of guidelines and rules that govern how companies prepare and present their financial statements. Here are some examples of GAAP:
- Accrual accounting: Under GAAP, companies must use the accrual method of accounting, which means that revenue and expenses are recognized when they are earned or incurred, rather than when cash is received or paid.
- Consistency: GAAP requires that companies use consistent accounting methods from one period to another to ensure that financial statements are comparable over time.
- Materiality: Companies must disclose all material information in their financial statements. Materiality refers to the significance of an item or event to a company’s financial performance.
- Historical cost: GAAP requires that assets and liabilities be recorded at their historical cost, which is the amount paid for them when they were acquired.
- Full disclosure: Companies must provide complete and transparent financial statements that include all relevant information, including notes to the financial statements.
- Matching principle: GAAP requires that expenses be matched with the revenue they help generate. For example, if a company sells a product in one year but incurs the cost of producing it in the following year, the expense must be recorded in the same period as the revenue.
- Conservatism: GAAP allows companies to be conservative in their financial reporting by recording potential losses and expenses before they occur. For example, companies can create an allowance for bad debts to account for the possibility that some customers may not pay their bills.
- Going concern: GAAP assumes that companies will continue to operate indefinitely, unless there is evidence to the contrary. This means that financial statements must be prepared with the assumption that the company will continue to exist and operate normally in the foreseeable future.
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