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What are the Generally Accepted Accounting Principles?

An accountant at his desk.
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  • Written By: Carol Francois
  • Edited By: Lucy Oppenheimer
  • Last Modified Date: 23 March 2014
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Generally accepted accounting principles, or GAAP as they are more commonly known, are rules for the preparation of financial statements. Every publicly traded company must release their financial statements each year. These statements are used by investors, banks and creditors to determine the financial health of the company and its suitability for investment or extension of credit. In order to properly compare and evaluate companies and their results, the financial statement must provide similar information in a similar format. Every country has its own generally accepted accounting principles, and all publicly released financial statements must comply with these rules.

Although there is no comprehensive list of generally accepted accounting principles, the structure is based around four key assumptions, four basic principles and four basic constraints.

Four Key Assumptions

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The key assumptions in generally accepted accounting principles are: business entity, going concern, monetary unit and time period principle. The business entity assumption is the idea that the business functions as a legal and financial entity separate from its owners or any other business. This assumption 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.

Four Basic Principles

The four basic principles in generally accepted accounting principles 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. 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. The value of the expense is included 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.

Four Basic Constraints

The four basic constraints in generally accepted accounting principles are: objectivity, materiality, consistency and prudence. The objective constraint states that all the information included in the financial statements must be supported by independent, verifiable evidence. When deciding what to include or exclude from the financial statements, the significance of the item must be considered under the materiality constraint. 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.

Each country has a financial accounting standards board, which works closely with the boards in other countries to resolve common problems in a systematic, coherent way. There are several international organizations encouraging the development of a single, international board to administer a greater level of uniformity in accounting standards around the world.

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Discuss this Article

anon338742
Post 5

Please tell us those principles in the GAAP that are included also in the IFRS?

babylove
Post 3

I imagine CPA's and other accounting professionals use the GAAP book more often than a CEO would. Financial reports should adhere to GAAP requirements as mandated by the SEC. Who knows how heavy that's enforced. I have heard though that the SEC is proposing to convert from gaap standards to International Financial Reporting Standards (IFRS) around 2014.

whitesand
Post 2

Any company, large or small should should maintain a current copy of the GAAP guide. Besides helping ensure that their financial reports adhere to GAAP requirements -- which is especially important for small businesses -- it can also help eliminate fraudulant activity.

ashybadashy
Post 1

Materiality can vary greatly based on the size of the company. For example, $10,000 seems material to most people. And to a business that makes $60,000 a year, it is very material. However, for a company that brings in $30 million per year, it would generally not be considered material. This would mean that in an audit, issues pertaining to this amount of money could be completely left out. Many people do not realize this. However, gaap accounting also dictates that fraud is always material, regardless of the amount involved.

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