What is Generally Accepted Accounting Principles(GAAP)?
GAAP refers to a common set of accounting principles, standards, methods, and procedures that is issued by the Financial Accounting Standards Board (FASB). Public companies in the United States must follow GAAP when their accountants compile their financial statements. GAAP is a combination of the set by policy boards and the commonly accepted ways of recording and reporting accounting information. GAAP aims to improve the clarity, consistency, and comparability of the communication of financial information.
It is used by organizations to:
- Properly organize their financial information into accounting records;
- Summarize the accounting records into financial statements
- Disclose certain supporting information.
Methods of Generally Accepted Accounting Principles(GAAP)
- Business Entity Assumption: Every business entity should be treated as an entity that is separate from its owners. All the financial transactions should also be labeled in such a manner. This method is especially important for recording the financial transactions of a sole proprietor. When the entire business with its assets and liabilities belong to the proprietor, the financial transactions need to be distinguished between those related to the business and those related to the proprietor personally.
- Monetary Unit Assumption: All the financial transactions of a business should be capable of being expressed in a monetary unit and if it is not possible to do so, then it should not be recorded in the books of accounts of the business.
- Accounting Period: This principle entails that the accounting process of a business should be completed within a certain time period which is usually a financial year or a calendar year. Thus, every transaction which relates to a particular accounting period will form a part of the financial statements prepared for that period.
- Historical Cost Concept: As a general rule, when certain economic resources or assets are acquired by an enterprise, they are recorded as per the cash or cash equivalent actually spent to acquire that resource or asset on the transaction date – even if the transaction happened the previous day or ten years ago. This would result in the value of the remaining asset constant irrespective of the accounting period. The market value of the asset is not taken into account unless specifically required by law or an accounting standard.
- Going Concern Assumption: The business entity is assumed to be a going concern, i.e., it will continue to operate for an indefinite amount of time. This assumption is important because if the business entity were to liquidate in the near future, it would have to restate its assets and liabilities in the accordance with the actual amount that could be realized or payable as the case may be so as to reflect the true financial position of the entity.
- Full Disclosure Principle: An accounting entry may not independently be able to provide all the relevant information relating to the transaction. Hence the full disclosure principle requires the entity to disclose all the financial information relevant to the investor/user to assist him in decision making. At the transactional level, this is done by recording an adequate narration with every transaction and at the financial statement level, this is implemented by providing notes to the accounts.
- Matching Concept: This concept requires the revenue for a particular period to be matched with its corresponding expenditure so as to show the true profit for the period.
- Accrual Basis of Accounting: This principle requires all revenue and expenditure to be recorded in the period it is actually incurred and not when cash or cash equivalent has been received/spent. The earning of the income and the incurring of the expenditure is important, irrespective of the corresponding cash flow.
- Consistency: An entity may decide to follow a particular accounting procedure in relation to a series of transactions. Such accounting procedures need to be followed consistently over the following accounting periods so as to facilitate comparison of the results between two periods. For example, an entity might choose to adopt the straight-line method of depreciation of its tangible fixed assets. This method needs to be consistently followed even in the coming years.
- Materiality: This accounting principle allows an entity to disregard another accounting principle if the result of the same does not affect the decision-making of the user of the financial statements. Certain errors or omissions may also be ignored if their effect is immaterial to the financial statements. For example, when a fixed asset is purchased, the matching concept requires the entity to recognize the expenditure over the useful life of the asset. If an entity purchases a keyboard for Rs. 300 and the turnover of such an entity is in crores of rupees, it would be immaterial to the user of financial statements whether such an asset is recognized as an asset or expense. Thus, even if the computer keyboard is considered as an expense in the year of purchase, it would not be violating the basic accounting principles since the amount involved and the impact of the same is immaterial.
- Conservatism: In the process of accounting, one might come across various situations where there are two equally acceptable ways of accounting for a particular transaction. One might even have to choose between recording a transaction or not recording the same. In such a situation, a conservative approach should be followed. This means that while accounting for a particular transaction, all anticipated expenses or losses will need to be accounted for but all potential income or gains should not be recorded until actually earned/received. This is why a provision for expenses like bad debts is made but there is no corresponding record provided for an increase in the realizable value of an asset.