10 Generally Accepted Accounting Principles (GAAP)
How do potential investors know they're getting an accurate picture of a business's worth? There are various ways a business can make itself appear more valuable than it actually is. Before opening their wallets, investors need a guarantee that they're seeing a company's current value.
Generally Accepted Accounting Principles (GAAP) ensure that businesses keep honest and current income statements, balance sheets, and accounting documents. They must be followed by all public companies in the United States. They were created and issued by the Financial Accounting Standards Board (FASB) in collaboration with the American Institute of Certified Public Accountants (AICPA).
Their purpose is to improve the transparency of business accounting records and make accounting practices in the U.S. uniform so that various records can be easily compared. GAAP make companies maintain sincere accounting information, ensuring it's easier for investors to value them accurately.
What Are GAAP?
GAAP are accounting regulations and practices that businesses in the U.S. must follow when making financial reports. They are different from speculative methods of accounting or pro forma. Pro forma only shows how much money your company has made from its actual business operations and ignores irregularities like lost or destroyed merchandise and sales of large assets.
GAAP reports show the actual amount of income your company has brought in (all factors included). Pro forma reports show the growth potential of your company by eliminating one-time factors that can change from year to year. Both can be beneficial to investors, but pro forma is a non-GAAP reporting method that can't be used in place of GAAP on accounting statements.
Instead of GAAP, many other countries — like the European Union, Japan, Canada, and India — use International Financial Reporting Standards (IFRS). As companies continue to expand their reach around the world, the FASB has been meeting with the International Accounting Standards Board (IASB) to try to merge the two standards.
What Are the 10 Principles of GAAP?
The 10 principles included in GAAP are designed to protect investors, customers, and the government from faulty or misleading financial information. Accurate and thorough accounting records make it easier to evaluate a company's worth.
Without a standardized set of rules for accounting, businesses could rely on alternate accounting processes and pro forma methods to misrepresent their actual value. This was one of the main causes of the Great Depression. Many companies made misleading financial reports that overstated their value, eventually causing the stock market to crash in 1929.
1. Principle of Regularity
This principle indicates that accountants must use standard accounting practices in the U.S. They must adhere to the standards of GAAP and can't pick and choose which accounting methods they use for their financial statements.
2. Principle of Consistency
Accountants pledge to use the same accounting standards in every reporting time period. If they make any changes, they must divulge them, along with a reasonable explanation, in their footnotes.
Uniform accounting practices ensure that financial data from different accounting periods has reasonable comparability.
3. Principle of Sincerity
This full disclosure principle says that accountants must do their best to present a precise picture of a business's financial circumstances. Accountants must not be overly partial to a business so that they can create accurate statements.
4. Principle of Permanence of Methods
The methods an accountant uses shouldn't change. GAAP should be consistently applied in all situations so a company's financial records can be compared to those of other companies without complexity.
However, reporting using GAAP standards can vary across industries. The rules for some types of businesses can be different than the rules for others.
5. Principle of Non-Compensation
Accountants have to show all positive and negative aspects in financial records to present a clear picture of a company's worth. They can't attempt to hide any details and aren't allowed to receive debt compensation (payment in stocks or ownership in a business) from a company.
6. Principle of Prudence
Accounting records must be based in fact and not conjecture. Accountants must show a complete picture of a company's current worth using GAAP methods. They may not rely on pro forma accounting processes to estimate a company's future earnings.
7. Principle of Continuity
Accountants must value assets based on the assumption that the company will stay in business. This means that assets can be valued at their historical value (original price) rather than their disposable value (the amount the asset can be sold for).
8. Principle of Periodicity
When making reports for a business, accountants must use the accrual method of accounting instead of the cash-basis method for revenue recognition. While the cash-basis method recognizes revenue when it's received, the accrual method recognizes revenue when it's earned. This is called the matching principle.
Let's say you have a small business that does landscaping. You trim trees for a hotel in February but don't receive payment until March. The revenue for the job must show up in February on your financial statements because that's when your business earned it.
9. Principle of Materiality/Good Faith
This principle gives accountants leeway to disobey other GAAP accounting rules when the amount of money in question is considered immaterial (doesn't make a difference in the overall accounting picture).
If you own a software startup, for instance, you might decide to buy a used $30 whiteboard for meetings in your office. You estimate that the whiteboard has a useful life of about five years, after which you could sell it for $5 (the salvage value).
The revenue recognition principle of accrual accounting says the whiteboard expense should be recognized as you use the product. For this to happen, you'd have to depreciate the expense (recognize it over time) by $5 each year for five years.
The principle of good faith lets you simply recognize the small purchase in your records once. It also lets accountants round financial records to the nearest dollar.
10. Principle of Utmost Good Faith
This principle comes from the Latin phrase "uberrimae fidei." It means that all parties involved in a transaction must be honest and straightforward in their business dealings.
This principle is commonly used in the insurance industry. The insurance company must reveal all relevant information regarding things like pricing and coverage. The insurance purchaser must clearly represent their health, lifestyle, and any other factors that could affect the price of coverage.
Maintain Accurate Accounting Records Using Skynova
Precise accounting records are more than just a metric you can use to judge your company's performance. They're a U.S. Securities and Exchange Commission (SEC) requirement for any publicly traded company. U.S. GAAP principles provide a standard that helps you make accurate accounting records and stay in compliance.
By compelling businesses to represent their current financial situations rather than their potential, these principles keep accounting reports honest and protect investors from being deceived.
Do you need help keeping accurate accounting records? Skynova has accounting software, software products, and business templates that can make processes like maintaining invoices, tracking expenses, and other bookkeeping simple and fast so you can spend more time doing what you do best.
Notice to the Reader
This article is only meant to introduce the reporting process using GAAP rules. The content within may not be suitable for your particular business situation. You should always seek the expertise of a certified public accountant (CPA) or another financial professional before making any large monetary decisions that can affect your compliance or bottom line.