GENERALLY ACCEPTED ACCOUNTING PRINCIPALS

GAAP (Generally Accepted Accounting Principals)

Generally accepted accounting principles (GAAP) are the guidelines and standards used in financial accounting and reporting all non-government organizations. They are the universal standard by which all financial accounting and reporting must conform. Having a single accounting standard that all companies are required to adhere to – regardless of industry, ownership structure or the regulatory body they are beholden to – is the very thing that allows the performance and value of one company, including all assets and holdings, to be compared accurately to the value of another company.

Financial accounting and reporting refers to tracking financial information and preparing financial statements that a company presents to the public. In using the generally accepted accounting principles as the common platform for assessment and reporting of value and performance, the investing public is assured of like to like comparisons between companies so as to be protected against inconsistencies that would arise from multiple valuation and reporting systems.

The Financial Accounting Standards Board (FASB) originally established GAAP and continues to oversee the amendments that need to be made from time to time. In The Wall Street MBA, author Reuben Advani compares the FASB to the Supreme Court; just as the Supreme Court is the final decider of legal questions, the FASB is the final decider of generally accepted accounting principles for the private sector. However, the FASB must still follow any legal requirements the Securities and Exchange Commission hands down.
The body that set the accounting standards used by state and local government is the Governmental Accounting Standards Board (GASB), while the Federal Accounting Standards Advisory Board (FASAB) sets standards for federal entities.

The generally accepted accounting principals are based on the basic tenets of accounting:

• Four basic assumptions
• Four principles
• Four constraints

The Four Basic Assumptions of Accounting

• Economic or Separate Entity: The company is treated as a separate economic entity for accounting purposes, even if it isn't a separate legal entity.
• Monetary Unit: The only business transactions recorded are those in financial terms (dollars and cents in the U.S.).
• Time Period: Financial reports cover a specific period of time.
• Going concern: Financial reporting assumes, unless otherwise known, that the business will continue operating indefinitely.

The Four Principles of Accounting

• Historical Cost: Initial recording of financial transactions must be at their original cash equivalent cost.
• Full Disclosure: Financial statements contain enough information that they are not misleading.
• Revenue Recognition: A company records revenue in the accounting period when services are completed or goods are delivered to the customer, not when the customer makes payment.
• Matching: A company records expenses in the accounting period in which it helped create revenue, not when payment was made for the expenses.

The Four Constraints of Accounting

• Materiality: Should purchases of assets be expensed or depreciated? Theoretically, an asset expected to last four years would be depreciated over four years. However, if the asset cost is immaterial, for example $30, expensing the $30 may be acceptable.
• Conservatism: If a company could equally use more than one accounting method, the company should use the one that affects the financial statements in the least favorable immediate way.
• Cost-Benefit: Cost-benefit analysis compares the outflows of resources needed to create additional inflows of resources. The benefits should outweigh the costs.
• Industry Practice: Some industries have unique requirements, and companies in those industries can follow standard industry practices.

GAAP and International Accounting Standards

GAAP are U.S.-based accounting standards. Each country has its own accounting standards, creating challenges for companies that do business across borders. These differences affect everything from how depreciation and amortization are treated to how financial statements are structured.

Although the differences between GAAP and the standards used in some countries, such as the UK, are minor, significant differences exist with the standards used by many other countries, in particular Asian countries that are among the top U.S. trade partners.

The International Accounting Standards Board (IASB) works to develop internationally accepted financial reporting standards. A movement is underway to align the standards of the FASB and IASB to make accounting across borders consistent.