What Are Generally Accepted Accounting Principles?
Generally Accepting Accounting Principles (GAAP) are a crucial aspect of financial business accounting within the US. While these are by no means legal laws or rules, they act as well-established conventions.
Complying with GAAP can ensure that your business’s financial statements are recorded and updated in a calculated, safe, and reliable manner, increasing your accountability and transparency and allowing you to be better prepared for any investors or financiers in the future.
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What Is GAAP?
In the US, GAAP is a combination of various accounting procedures and conventions that accounting policy boards like the Financial Accounting Standards Board (FASB) have defined as highly important when considering a business’s day-to-day practices.
GAAP serves as a “guiding mechanism” through which business owners can ensure that their presentations, measurements, timings of recognition, and disclosure are both of an extremely high standard and of a highly productive nature.
Below, we have outlined the 10 distinct GAAP principles for your business. All of them serve a similar purpose and follow a very coherent and virtually identical ideology. GAAP aims to allow business owners to present their business’s financial data using informed, consistent, and reliable methods, which can then be easily analyzed by any reader — regardless of whether they are specialized accountants or not.
General Accounting Principles to Use for Your Small Business
1. Economic Entity Assumption
The economic entity assumption principle distinguishes an individual’s business from themselves and highlights the importance of considering them as two separate financial entities in a financial accounting context.
In practical terms, this means that the financial information for transactions made by a certain business should be recorded (and consequently reported) completely and separately from any financial transactions made by the owner(s) of that business — or any other third-party or affiliated entity.
2. Historical Cost
The historical cost principle establishes that all business transactions made must be recorded at their initial (or “historical” cost) on a financial statement.
For example, if your business purchased a building 20 years ago for $100,000, you would still record its asset value as $100,000 today, regardless of whether its current value is $400,000 or not.
The reason for this is simple: as previously noted, accountants tend to adopt a rather “conservative” or “glass half full” approach when making estimations. You never really want to be in a position where you negligently overpromise and underperform when presenting your financial data to third parties, and from an accountancy perspective, there is really no accurate way of knowing what your asset is actually worth until after you have sold it.
For example, you may hire five different appraisers to assess the value of your property in 2021, but the truth is that you may end up with five distinct (albeit similar) evaluations. You may end up with the same market value, but after attempting to sell your property, you may not pragmatically find a buyer that is willing to pay that much. Similarly, you may end up selling the property for an even higher amount depending on the state of the US property market.
As you will not want to have reported a loss unnecessarily on your financial statement, and you will also definitely not want to pay taxes on revenue that your business hasn’t actually received, you should follow the historical cost principle, which suggests that the value of a purchased asset should not be changed until after it has been actually sold.
The objectivity concept — also known as the measurement principle — states that any data which is recorded by a business should always be: objective, free of bias, and verifiable.
This ensures that a business’s financial statements remain consistent and reliable, which can then be used to allow potential investors and third parties to accurately predict its future performance consistently.
4. Monetary Unit
The monetary unit principle simply means that all financial transactions which are recorded within a business should be expressed: a) as a monetary currency and b) in the same currency (e.g., the US dollar).
This is to dissuade accountants from recording information in different currencies — as these all generally have different values and would make for a quite complicated and non-delineative read — and ensure that there is always a common “monetary unit” that individuals can use when tracking the financial transactions of a business.
5. Revenue Recognition
The revenue recognition accounting principle suggests that whenever a business sells a product or service, they should record it immediately (rather than when they actually receive payment).
This is because, in an accounting context, cash is not really synonymous with revenue. As soon as a product or service has been provided, the principle of revenue recognition suggests that a business has already “earned” the revenues associated with that product.
The actual payment (which may be processed and received days, weeks, or even months later) is considered to be a mere confirmation of what a business already knows it is entitled to.
For contextual purposes, it may be beneficial to consider the situation of an employee who is paid weekly at work. As Monday to Friday passes, that person will have “earned” a set amount of money, even though that money would not actually be in his bank account immediately.
For example, if they were earning $1,000 a week, they would be correct in stating that they earned $200 after finishing their Monday shift, regardless of whether the $200 had been actively paid to them or not.
The same line of reasoning is followed with businesses; revenue should be recorded as sales are completed in accordance with GAAP. This is because the availability of revenue in a business can have a very significant impact on its future options and so should be recorded as accurately and quickly as possible.
6. Accounting Period
This GAAP principle is similar to the one above, as it is interested in the time period in which transactions are recorded following the period in which they are made, but it does not focus exclusively on revenues.
The accounting period concept states that each transaction should be recorded in the exact time period in which it was made. This can allow potential shareholders and future investors to accurately analyze the past (or future) performance of a business, which, if done correctly, will greatly influence its prospects of obtaining external financing.
7. Matching Principle
The GAAP matching concept was established to ensure that all expenses within a business are recognized (and consequently recorded) in the same time frame as the revenues that they helped bring in.
Of course, records of expenses are not actual payments. On the contrary, they act as “proof” of a monetary entitlement that a business has obtained as a result of having provided a certain product or service to an individual or a business.
This means that businesses should record expenses as soon as they arise — rather than when they actually pay for them at a future date.
8. Going Concern
The going concern principle is the assumption that businesses will not become insolvent or bankrupt in the near future and will continue to operate almost indefinitely (or at least, for a long enough period of time to fulfill their current objectives and financial commitments).
The reason for this is relatively self-explanatory and relates to external financing. If we were to assume that X business would not be operating in the next year or so, it would be difficult to find a financier (such as a bank) who would be willing to grant them any loans.
Similarly, it would (theoretically) be equally difficult for X business to perform prepaid expenses, as no one would presumably allow a company to defer payments to a future date if they weren’t certain that that company would in fact still be solvent and operating at that date.
9. Conservative Constraint
As a business owner or as an accountant, the last thing you want to do is present a part of your business as financially better off than it actually is and — perhaps even more importantly — than you can actually prove it to be. This can backfire significantly, which is why (generally speaking) accountants tend to adopt a very pessimistic or “glass half empty” approach when they are identifying and recording a company’s assets.
This holistic “philosophy” of accounting pervades other GAAP concepts as well, including the historical cost principle. Once again, its importance comes down to ensuring that a business’s financial statements and documents are always presented in a reliable, consistent, and transparent manner.
In accounting, the concept of materiality considers the significance of inaccurate and misleading data on the “reasonable” reader and particularly how that material information’s omission (or inclusion) will pragmatically affect the evaluation of a company’s past and future projections by that reader.
This means that — under the principle of materiality — accountants or small business owners are encouraged to exercise reasonable judgment in evaluating what information is material, taking into account both quantitative and qualitative aspects.
Even though the vast majority of materiality judgments in the US have conventionally involved quantitative elements, it should be noted that the nature of an omitted transaction may make it material even if the actual amount is objectively immaterial.
For example, if an accountant or small business owner erroneously omits a transaction that — albeit small — would be defining in changing a profit to a loss or compliance to non-compliance (e.g., with ratios in a debt covenant), then it would still be considered material.
Similarly, the nature of the transaction can also be highly influential in whether it will be considered material or immaterial. Commonly, transactions that would be considered highly immaterial if they occurred as part of a routine check would undoubtedly be considered to be material if they occurred as part of a specific company initiative.
Why Is GAAP Important for My Business?
Publicly traded companies’ financial statements are required by law to regularly file GAAP-compliant financial statements in order to remain publicly listed on the US stock exchange, according to the Securities and Exchange Commission (SEC).
Even though this is not the case for private companies, business owners adopting GAAP protocols into their operations can benefit from it greatly — especially if they are interested in expanding using external financing options in the future.
This is because GAAP complying-financial statements not only propel a business’s brand image and prestige to potential investors, but they are also delivered in a way that is widely understood and easily interpreted by conventional lenders. This can ensure that you start off on the right track from the outset.
In the long term, you will also be adequately suited to transition into a publicly-traded model if that is something that you want to do, as you will already be complying with all legal prerequisites (at least in relation to your bookkeeping and accounting).
Other benefits of GAAP for your business include:
- More exposure: Investors are generally very cautious of financial statements that are not prepared using GAAP as they are seldom tangibly comparable with other companies (even within the same sector).
- Increased business loan access: A plethora of financial institutions regularly require annual GAAP-compliant financial statements as a part of their debt covenants when issuing business loans.
GAAP Requirements by State
Discovering how many state and local governments within the US are required to conform with GAAP when preparing their audited reports has in the past been one of the most commonly asked questions in relation to governmental reporting standards and accounting protocols.
At the same time, it has been extremely difficult to answer accurately, as there was really no tangible estimate as to how many of the 87,575 non-federal government entities within the US actually applied GAAP (and to what extent).
In 2008, a study conducted by the Governmental Accounting Standards Board (GASB) examined the percentage of states that mandated GAAP compliance, taking into account each state’s: total population, expenditures, revenues, and enrollment (for school districts).
Depending on the ratios found — meaning the percentage of a state’s county governments, local governments, and independent school districts that were either required or not required to conform with GAAP — GASB was finally able to shed some light on the above issue.
For simplicity purposes, we have categorized all 50 US states into four different GAAP categories, these are:
- Fully Compliant
- Mainly Compliant
- Rarely Compliant
- Not Compliant
Keep in mind that the study’s findings are relatively limited for a number of reasons. For one, GASB found that even though some states appear to be “fully compliant” with GAAP in law, this was not carried out in practice, and no enforcement mechanism measures were in place (or introduced) to remedy this.
Similarly, the study found that in several states where GAAP compliance was not required by law, GAAP compliance was still found in practice. For example, more than 50% of the localities in California received the Government Finance Officers Association’s Certificate of Achievement or Excellence in Financial Reporting back in 2005, which requires full GAAP compliance.
Fully Compliant States
- New Mexico
- North Carolina
Mainly Compliant States
Rarely Compliant States
- New Hampshire
- New Jersey
- Rhode Island
- South Carolina
- South Dakota
Not Compliant States
- New York
- North Dakoda
- Washington D.C.
- West Virginia
Frequently Asked Questions
What are the limitations of GAAP?
GAAP’s approach has been criticized as being too strict in the sense that it fails to account for the prolific number of diverse company types and industries in the US economy — meaning it is rather exclusive in its effectiveness.
A very small business owner, for example, may lack the necessary knowledge and expertise required to incorporate GAAP successfully into his or her business. If you are not publicly traded and required by law to incorporate GAAP, you will need to decide if GAAP is worth implementing in your own business.
What is the difference between GAAP and IFRS?
The main difference between GAAP and International Financial Reporting Standards (IFRS) is that GAAP is only really used within the US, whereas IFRS is an international protocol of standards that have been created by the International Accounting Standards Board (IASB).
The second most significant difference between GAAP and IFRS is that GAAP is rule-based, whereas IFRS is largely principle-based. This means that IFRS commonly has a lot more room for interpretation than GAAP.
What is the hierarchy of GAAP?
The hierarchy of GAAP refers to the four-tier ranking system of authority that individuals should follow when researching an accounting-related issue. By starting at the top of the hierarchy, readers are able to prioritize the highest-authority bodies first and then move downwards if need be.
Who enforces GAAP?
GAAP is primarily enforced by two federal bodies:
- The Financial Accounting Standards Board (FASB)
- The Securities and Exchange Commission (SEC).
Since the FASB is a non-governmental body, it can only set standards through the Accounting Standards Codification (rather than enforce them), whereas the SEC has the authority to do both.
When was GAAP established?
GAAP was initially established as a federal government response to the Stock Market Crash of 1929. Since then, several initiatives have been introduced, all of which have expanded GAAP’s influence and applicability.
A couple of the most notable evolvements include:
- The introduction of the term “GAAP” by the American Institute of Accountants in 1936.
- The issuing of the first ever Accounting Series Releases by the SEC in 1938, which eventually became known as the Financial Reporting Releases after 1982.