GAAP: Understanding It and the 10 Key Principles

The accountant should be objective, but when doubt exists, conservatism should be used to break the tie. Materiality also allows for a mid-size company to report the amounts on its financial statements to the nearest thousand dollars. If neither of the above is logical, expenses are reported in the accounting period that the expenses occur. Examples are advertising expense, research expense, salary expense, and many others.

In baseball, and other sports around the world, players’ contracts are consistently categorized as assets that lose value over time (they are amortized). This approach has often been referred to as the revenue recognition principle. The money measurement assumption underlines that in accounting, every worth-recording event, happening, or transaction is recorded in terms of money.

The majority of businesses are required to use the accrual basis of accounting. These rules or standards allow lenders, investors, and others to make comparisons between companies’ financial statements. The conceptual framework sets the basis for accounting standards
set by rule-making bodies leveraged buyout analysis that govern how the financial statements
are prepared. Here are a few of the principles, assumptions, and
concepts that provide guidance in developing GAAP. The procedural part of accounting—recording transactions right
through to creating financial statements—is a universal process.

Even though the
customer has not yet paid cash, there is a reasonable expectation
that the customer will pay in the future. Since the company has
provided the service, it would recognize the revenue as earned,
even though cash has yet to be collected. As you may also recall, GAAP are the concepts, standards, and
rules that guide the preparation and presentation of financial
statements. International accounting rules are called
International Financial Reporting Standards (IFRS). Publicly traded
companies (those that offer their shares for sale on exchanges in
the United States) have the reporting of their financial operations
regulated by the Securities and Exchange Commission (SEC).

Accounting Principles

To meet these needs and satisfy management’s fiduciary reporting responsibility, companies prepare a single set of general-purpose financial statements. However, about one third of private companies choose to comply with these standards to provide transparency. While non-GAAP reports may show more accurate figures for companies that experienced unusual one-time transactions, other businesses often list repeated earnings as one-time figures. Even though they appear transparent, non-GAAP figures can create confusion for investors and regulators.

  • These statements are discussed in detail in Introduction to Financial Statements.
  • This assumption increases the understanding of the state of affairs of the business.
  • When should Lynn recognize the revenue, on August 10 or at the later payment date?
  • According to accounting historian Stephen Zeff in The CPA Journal, GAAP terminology was first used in 1936 by the American Institute of Accountants (AIA).

Some of the accounting principles in the Accounting Research Bulletins remain in effect today and are included in the Accounting Standards Codification. However, due to the complexities and sophistication of today’s global business activities and financing, GAAP has become more extensive and more detailed. To make the topic of Accounting Principles even easier to understand, we created a collection of premium materials called AccountingCoach PRO. Our PRO users get lifetime access to our accounting principles cheat sheet, flashcards, quick test, and more. As we can see from this expanded accounting equation, Assets
accounts increase on the debit side and decrease on the credit

Principle of Utmost Good Faith

International Financial Reporting Standards (IFRS) are common rules that have been set, in order to ensure consistency, transparency, and comparability in financial statements across the globe. The primary role of IFRS is to specify how companies must maintain and report their accounts, defining types of transactions, and other events with financial impact. Since the U.S. does not fully comply with IFRS, global companies face challenges when creating financial statements. Even though the FASB and IASB created the Norwalk Agreement in 2002, which promised to merge their unique set of accounting standards, they have made minimal progress. In an effort to move towards unification, the FASB aids in the development of IFRS. GAAP compliance makes the financial reporting process transparent and standardizes assumptions, terminology, definitions, and methods.

Going Concern Concept

For U.S. companies, the monetary unit assumption allows accountants to express a company’s wide-ranging assets as dollar amounts. Further, it is assumed that the U.S. dollar does not lose its purchasing power over time. Because of this, the accountant combines the $10,000 spent on land in 1960 with the $300,000 spent on a similar adjacent parcel of land in 2022.

What is GAAP?

GAAP are the concepts, standards, and rules that guide the preparation and presentation of financial statements. International accounting rules are called International Financial Reporting Standards (IFRS). Publicly traded companies (those that offer their shares for sale on exchanges in the United States) have the reporting of their financial operations regulated by the Securities and Exchange Commission (SEC). The financial statements only include transactions that can be measured reliably in accurately using a monetary unit of measurement.

However, one should presume the
business is doing well enough to continue operations unless there
is evidence to the contrary. For example, a business might have
certain expenses that are paid off (or reduced) over several time
periods. If the business will stay operational in the foreseeable
future, the company can continue to recognize these long-term
expenses over several time periods. Some red flags that a business
may no longer be a going concern are defaults on loans or a
sequence of losses. As illustrated in this chapter,
the starting point for either FASB or IASB in creating accounting
standards, or principles, is the conceptual framework. Both FASB
and IASB cover the same topics in their frameworks, and the two
frameworks are similar.

You will
often see the terms debit and
credit represented in shorthand,
written as DR or dr and CR or
cr, respectively. We can
illustrate each account type and its corresponding debit and credit
effects in the form of an expanded
accounting equation. You will learn more about the expanded
accounting equation and use it to analyze transactions in

Define and Describe the Expanded Accounting Equation and Its
Relationship to Analyzing Transactions. The basic components of even the simplest accounting system are
accounts and a general ledger. An account is a
record showing increases and decreases to assets, liabilities, and
equity—the basic components found in the accounting equation. As
you know from
Introduction to Financial Statements, each of these
categories, in turn, includes many individual accounts, all of
which a company maintains in its general ledger.

For each business (such as a
horse stable or a fitness center), the business, not the business owner, is the accounting entity. Therefore, financial statements are identified as belonging to a particular business entity. The content
of these financial statements reports only on the activities, resources, and obligations of that entity. The revenue recognition principle directs a
company to recognize revenue in the period in which it is earned;
revenue is not considered earned until a product or service has
been provided.

Rather, particular businesses follow industry-specific best practices designed to reflect the nuances and complexities of different business areas. For example, banks operate using different accounting and financial reporting methods than those used by retail businesses. These components create consistent accounting and reporting standards, which provide prospective and existing investors with reliable methods of evaluating an organization’s financial standing. Without GAAP, accountants could use misleading methods to paint a deceptive picture of a company or organization’s financial standing. The following principles of accounting are used by accountants to help guide their recording of business transactions. Approximation and judgment because of periodicity To provide periodic financial
information, accountants must often estimate expected uncollectible accounts (see Chapter 9) and the
useful lives of depreciable assets.

The historical cost principle states that virtually everything the company owns or controls (assets) must be recorded at its value at the date of acquisition. There are some exceptions to this rule, but always apply the cost principle unless the IFRS has specifically stated that a different valuation method should be used in a given circumstance. There also does not have to be a correlation between when cash is collected and when revenue is recognised.