Explain the meaning of generally accepted Accounting Principles and define and apply the several key principles.
Explain the meaning of generally accepted Accounting Principles and define and apply the several key principles
Generally accepted accounting principles (GAAP) is a setup in place for a safe, efficient and fair transaction. It includes a common set of accounting principles, standards, and procedures with which the company must comply while creating/maintaining their book of account (Fisher, 2011).
There are several principles under GAAP of which few of key ones along with their application are as listed below:
Monetary Unit Assumption states that anything which is to be recorded in the financial statement/report should also be expressed in monitory value. Only those transactions which are expressed in the same currency as of the economic activity is recorded. The result of this accounting practice is that the purchasing power of the currency is considered to be constant over time disregarding inflation. For example, Nepalese rupee from transactions in 1990 is shown along with the dollars from the transactions from 2018.
Full Disclosure Principle states that the stakeholder should be aware of all the information that is important. Thus the business should disclose those documents to the stakeholders. That ensures that the stakeholders are informed about the company and can make decision-based on it. A business follows through it by providing financial statements, notes to it and further supplementary information (Korn & Schiller, 2003). For example, if the organization is facing a lawsuit of whose result doesn’t go in favor of the company, it will require to pay off a significant amount of money out. While preparing financial statement the final verdict of the lawsuit can’t be known so as part of the full disclosure, this lawsuit should be listed in the notes section of the financial statement.
Time Period Assumption also known as periodicity assumption. It involves of artificially dividing the economic life of the business. These divisions made based on artificial time period is usually of a month, quarter, and year. Through the use of the assumption, a firm’s periodic positioning can be understood to formulate strategies and make changes to the strategies as per the need.
Economic Entity Assumption states that the business owner’s personal transactions need to be kept separately from all other business transactions. It is an accounting principle so is different from legal which consider the business as a whole instead of separating the owner and the rest. This principle enables the business to have on its own name assets and liabilities.
Matching Principle as per its name requires matching between the revenue and the related expense. It allows real-time analysis of the records i.e. revenue and expense. An example of this could be that the inventory of the business would simply be considered as an asset and not expense until it’s sold in the balance sheet. When sold, the cost of goods is recorded along with the revenue from it.
Fisher, S. (2011). Measuring The Evolution Of Generally Accepted Accounting Principles. Journal Of Applied Business Research (JABR) , 14 (3), 105.
Korn, E., & Schiller, U. (2003). Voluntary Disclosure of Nonproprietary Information: A Complete Equilibrium Characterization. Journal Of Business Finance & Accounting , 30 (9-10), 1327-1339.
There are various methods of accounting. Some companies keep accounts on accrual basis while other keep it on cash basis. Getting into more detail companies record inventory in either LIFO or FIFO method. Similarly long term lease, depreciation etc. can be recorded differently as per companies need and requirement. Therefore to analyze the final reports of two similar companies a financial analyst must understand the accounting system differences before comparing them. To overcome these differences, there are set principle to prepare, book and report a company’s financial position. These are called generally accepted accounting principles (GAAP). In the United States, the GAAP is known as Standards Board issues Statements of Financial Accounting Standards (SFAS), which describe accounting rules that companies must follow in preparing their financial statements. (Moyer, McGuigan, Rao, & Kretlow, 2012, p. 94) Similarly IFRS or International Financial Reporting Standard, is another GAAP followed.
Listed below are some of the basic principles of GAAP
Specific currency principle
The financial statement of a company will be shown in a common currency. For example, the financial statement of Nepali organization will be shown in Nepali rupees and not in foreign exchange. Even foreign currency will be converted into Nepali currency and shown in the report.
Specific time period principle
A financial statement is done for a specific period. This helps the reader to understand what period the report represents. For example, in Nepal the fiscal year starts on the first day of Shrawan and ends on the last day of Ashar. This roughly reflects start date of 16 July to 15 July in English calendar.
Full disclosure principle
This principle dictates that all the functioning in the financial statements should be shown and nothing should be hidden. This helps reduce the possibility of fraud. For example, hidden accounts cannot be maintained and all sources of funds and its applications must be clearly shown.
The recognition principle
This principle explain that a company should show income and expenditure at the same time they are done. Revenue of the next fiscal year cannot be shown in this year report and this year’s expenses cannot be shown in the next period.
These are some of the principle mandated and followed by the generally accepted accounting principle.
Moyer, C. R., McGuigan, J. R., Rao, R., & Kretlow, W. J. (2012). Contemporary Financial Management. Natorp Boulevard: South-Western, Cengage Learning.
General Accepted Accounting principal is a framework of accounting, standard, rules, and procedures define by the professional accounting industry, which has been adopted by nearly all publicly traded U.S Companies (Kotharia & Karthik, 2010). Basically, it is a uniform set of principles, rules, procedure, standards, and guidelines of financial accounting and reporting. The major role of GAAP are
It must be used in the preparation of accounting records and financial statements.
It must be complied with in order to obtain an unqualified opinion from independent auditors.
It must be complied with for securities to be listed on a stock exchange and to issue a new security.
The following is a list of the main Accounting Principle and Guidelines.
Economic Entity Assumption : The accountant keeps all of the business transactions of a sole proprietorship separate from the business owner’s personal transactions. For legal purposes, a sole proprietorship and its owner are considered to be one entity, but for accounting purposes, they are considered to be two separate entities.
Monetary unit assumption: An economic entity’s accounting records include only quantifiable transactions. Certain economic events that affect a company, such as hiring a new General Manager or introducing a new product, cannot be easily quantified in monetary units and, therefore, do not appear in the company’s accounting records. Furthermore, accounting records must be recorded using a stable currency.
Accrual basis accounting: In most cases, GAAP requires the use of accrual basis accounting rather than cash basis accounting. The accrual basis of accounting is generally accepted as providing a more appropriate record of all of an entities transactions over a given period of time than the cash basis or another comprehensive basis of accounting. The cash basis does not result in a presentation of financial information in conformity with GAAP (Mackintosh, 1993). Accordingly, financial statements of public broadcasting entities represented, as being in conformity with GAAP must be prepared using the accrual basis of accounting.
Cost Principle : The cost principle requires one to initially record an asset, liability, or equity investment at its original acquisition cost. The principle is widely used to record transactions, partially because it is easiest to use the original purchase price as objective and verifiable evidence of value. A variation on the concept is to allow the recorded cost of an asset to be lower than its original cost if the market value of the asset is lower than the original cost. However, this variation does not allow the reverse - to revalue an asset upward. Thus, this lower of cost or market concept is a crushingly conservative view of the cost principle.
Full Disclosure Principle : The full disclosure principle states that you should include in an entity’s financial statements all information that would affect a reader’s understanding of those statements. The interpretation of this principle is highly judgmental since the amount of information that can be provided is potentially massive. To reduce the amount of disclosure, it is customary to only disclose information about events that are likely to have a material impact on the entity’s financial position or financial results. Details of contingent liabilities, contingent assets, legal proceedings, etc. are also relevant to the decision making of users and hence need to be disclosed.
Matching Principle: The matching principle is associated with the accrual method of accounting and adjusting entries.
Materiality principle: Accountants follow the materiality principle, which states that the requirements of any accounting principle may be ignored when there is no effect on the users of financial information. Certainly, tracking individual paper clips or pieces of paper is immaterial and excessively burdensome to any company’s accounting department (Ball, 2009).
Accountants use generally accepted accounting principles (GAAP) to guide us in recording and reporting financial information. GAAP comprises a broad set of principles that have been developed by the accounting profession and the Securities and Exchange Commission (SEC) (Wayne, 2007).
Ball, R. 2. (2009). Market and political/regulatory perspectives on the recent accounting scandals. Journal of Accounting Research 47 , 247-251.
Kotharia, S., & Karthik, R. (2010). Implications for GAAP from an analysis of positive research in accounting. Journal of Accounting and Economics , 247-250.
Mackintosh, I. (1993). Accrual Accounting for Departments and the Whole of Government: Costs, Benefits, and Opportunities. Australian Society of Certified Practising Accountants .
Wayne, R. L. (2007). International Accounting Standards and Accounting Quality. SSRN Electronic Journal 46 .
Generally Accepted Accounting Principles (GAAP) refers to the widely accepted set of rules, conventions, standards, principles, policies and practices that provide broad guidelines and detailed procedures for recording the financial and accounting information of an organization. It combines authoritative rules and standards set by Financial Accounting Standard Boards (FASB) with basic accounting principles and generally accepted industry practices to make the financial information standard, uniform, consistent and transparent (Investopedia).
Some of the key principles of GAAP are:
Economic Entity Assumption: According to this principle, the business and its owner are two different entities and their transactions are to be recorded separately. Business is a separate legal and economic entity and exist distinctly from the owner. For example: If Mr. A is the owner of a sole proprietorship company and he has started the company by taking a loan of certain amount. The loan is to be recorded as the liability of business not as liability of Mr. A though he is responsible to pay back the loan amount.
Going Concern Concept: This principle assumes that the business will continue to exist and carry its operations for indefinite time in future. Thus the financial and accounting policies are followed to maintain the continuity of business unit (Diploma in Insurance Services). The calculation of depreciation based on the expected economic life of fixed assets is an example that the company believes it will not liquidate or forced to close down in the future.
Time Period Assumption: Though the business is assumed to continue till indefinite time period, the financial reports are prepared taking into accounts the transactions of certain time period to reduce complexity. It also allows to measure the performance and take corrective actions on time. Generally the financial statements are prepared on annual basis at the end of every fiscal year (in Ashadh) in Nepal. However, the companies prepare may also prepare weekly, monthly, quarterly or semi-annually reports as per their requirement.
Monetary Unit Assumption: This principle deals with the ability to measure transactions in monetary terms without drastic fluctuations in currency values in short term. All the transactions are expressed in dependable and stable monetary units to make the recording consistent as well as comparable. If we look at the financial statements of the government organizations in Nepal, all the values are expresses in NPR that is the adaptation of this concept.
Cost Principle: All the transactions are recorded on the basis of cost or purchase price. Thus the amounts expressed on financial statements are referred to as historical costs (Accounting Coach). For example: Besides shares and bonds, other assets are recorded on the basis of cost price and are not adjusted to represent the value. For example, the calculation of depreciation on a five year old machine is calculated on the basis of its purchase price not on the value of the machine in current time.
In addition to these, the matching principle, revenue realization principle, full disclosure principle, materiality and conservatism are also applied in recording the financial transactions based on GAAP. It tries to facilitate financial decision making process by providing comparable, credible and neutral financial information.
Accounting Coach. (n.d.). Introduction to Accounting Principles. Retrieved from Accounting Principles: https://www.accountingcoach.com/accounting-principles/explanation
Diploma in Insurance Services. (n.d.). Basic Accounting Principles. Retrieved from http://www.nios.ac.in/media/documents/VocInsServices/m1-5f.pdf
Investopedia. (n.d.). What are ‘Generally Accepted Accounting Principles - GAAP’. Retrieved from Generally Accepted Accounting Principles - GAAP: https://www.investopedia.com/terms/g/gaap.asp