What are generally accepted accounting principles?

What are generally accepted accounting principles?
By definition generally accepted accounting principles, or GAAP, are the accounting rules used to prepare financial statements for publicly traded companies. However, many private companies use these as well. The Generally Accepted Accounting Principles, are a set of specific accounting rules used to standardize the reporting of financial statements in the United States. This standardization can be very valuable to you as an investor, and helps put each publicly traded company on equal footing when it comes to financial reporting, thus differences are clear and easy to see and understand. Understanding GAAP can help you make better investing decisions.

It is important to note that the generally accepted accounting principles for the US as a whole are often different than those of local or state governments. Generally accepted accounting principles for local and state governments are usually under a different set of assumptions, principles, and constraints, which are determined by the Governmental Accounting Standards Board (GASB).

So is this a law you have to stick by?
The answer is NO! The GAAP is not written in law, however, the U.S. Securities and Exchange Commission(SEC) requires that it be followed in financial reporting by publicly traded companies. So, it might as well be as you won't be able to operate with the go ahead from the SEC if you don't follow the generally accepted accounting principles laid out.

So are the generally accepted accounting principles for the US the same as international financial reporting standards?
Unfortunately the answer to this question is no! The provisions of the US GAAP do have some differences from those of international standards, however, the FASB and SEC are in the process of trying to reconcile these differences in a way that reports created under international standards will be acceptable to the SEC for companies listed on US markets. However, until this does happen, you will have to use different standards for international financial reports than you do for those in the US. Every country has their own version of GAAP, so be aware that just because your company meets US GAAP requirements, does not mean it will meet them elsewhere.

The idea behind GAAP is that accounting information should be assembled and reported without bias. So, standards were set to make sure this process was done objectively. Thus, the objectives of GAAP were laid out to ensure that financial statements were useful to those looking to learn about the company, helpful in nature, and concise, meaning only about economics, nothing more.

How Specific is GAAP?
GAAP is not just broad guidelines for financial reporting, the truth is that while there are generalities, there are also detailed rules and procedures that must be followed, especially if you are a publicly traded company.

GAAP has four basic assumptions, four basic principles, and four basic constraints that were put in place to help achieve objectivity. Let's take a look at these:

A. Assumptions: 1. Economic Entity Assumption; 2. Going Concern Assumption; 3. Monetary Unit Assumption; 4. Periodic Reporting Assumption
B. Principles: 1. Historical cost principle; 2. Matching Principle; 3. Full Disclosure Principle; 4. Revenue Recognition Principle.
C. Constraints: 2. Cost-benefit Relationship; 2. Materiality; 3. Industry practices; 4. Conservatism

Now what do these mean?

Economic Entity Assumption

This assumption simply means that the business is separate from its owners or other businesses. So, business and personal expenses are assumed to be kept separate.

Going Concern Assumption
This assumption means that the business will be in operation for a long time.

Monetary Unit Assumption
This assumption means that the business is using a stable currency. And that this currency is going to be the unit of record

Periodic Reporting Assumption
This assumption means the business operations can be recorded and separated into different periods, to show differences between past and present.

The Historical Cost Principle
This means that companies have to say what they acquired something for, not the current fair market value.

The Revenue Recognition Principle
This requires that companies record when revenue is realized and earned, not received.

The Matching Principle
This is the principle idea of expenses matching revenues, so basically the product or service should contribute to the revenue.

The Full Disclosure Principle
Basically, it is impossible to report it all, but you can't hide stuff, the information reported needs to be enough to allow people to make accurate judgments.

Cost-benefit relationship
This constraint is basically in place to show that the information provides should be beneficial enough to justify the cost to provide it.

Materiality
This is in place to make sure crap isn't reported. It evaluates the significance of an item when it is reported.

Industry Practices
Pretty much this is there to ensure that the accounting procedures follow industry practices.

Conservatism
When choosing between two possible solutions, the one that will be least likely to overstate assets and income should be chosen.

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