There are a number of organizations and individuals involved in setting accounting principles; however, the GAAP apply to corporate, government and small business accounting. The Generally Accepted Accounting Principles are a set of twelve rules that are crucial in assuring transparency and accuracy throughout the accounting cycle.
Why Standard Principles of Accounting Are Important
An organization or business entity's financial statements serve a number of functions, both internally and externally. The GAAP help organizations to prepare financial statements that are:
- Relevant- Internal users (managers, boards of directors) and external users (banks, investors) need relevant information to make good business and financial decisions.
- Reliable- Users must be able to trust the accuracy of accounting information to make good decisions.
- Consistent- In order to measure and compare performance, information must be collected and recorded using the same procedures in each accounting period.
- Comparable- To compare information from several entities, they must all use similar accounting procedures.
Quick Reference: GAAP Guide to Assumptions, Principles and Constraints
There are twelve Generally Accepted Accounting Principles, which fall into three categories:
Assumptions:
- Business Entity- A business is a separate entity from its owner(s).
- Going Concern- Financial statements are prepared with the assumption that the business will continue to operate, unless there is sufficient evidence to show it will close or be sold.
- Monetary Unit- Transactions are expressed in monetary units, ie.: dollars, euros, rupees.
- Time Period- The entity's activities are separated into periods of time, ie.: months, quarters or years.
Principles:
- Cost- The information used to prepare financial statements must reflect actual costs incurred during the time period in question.
- Full Disclosure- All information pertaining to the operations and financial position of the entity must be reported within the period of time in question.
- Revenue recognition- Whether or not cash is exchanged, revenue is recorded at the time of the transaction.
- Matching- In the period that revenues are reported, all expenses incurred as a result must be recorded.
Constraints:
- Conservatism- When two or more equally likely solutions are presented, the one with the least optimistic outcome is used.
- Consistency- The entity employs the same accounting methods in each time period.
- Materiality- Also called the cost-to-benefit constraint; an amount may be ignored only if its effect on financial statements is not important to users.
- Objectivity- Independent, objective evidence supports information used to prepare financial statements.
Departures from GAAP
The American Institute of Certified Public Accountants states in Rule 203 under their Code of Ethics that "... upon occasion there may be unusual circumstances where the literal application of pronouncements on accounting principles would have the effect of rendering financial statements misleading. In such cases, the proper accounting treatment is that which will render the financial statements not misleading."
It is also noted that it is rarely necessary to deviate from the GAAP, as the outcome when following these accounting rules is almost always fair and accurate.
For more information on the Generally Accepted Rules of Accounting, please see Larson & Jensen's Fundamental Accounting Principles, 12th Edition (McGraw-Hill Ryerson, 2007).
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