If you have ever found yourself reading a report that uses some accounting language, you most likely saw the acronym “GAAP” in a few places. This is not surprising at all given that this tiny acronym is what a large chunk of the entire profession of accounting in the United States relies on.
GAAP stands for Generally Accepted Accounting Principles. The basic definition of it is any accounting principles accepted by the general public during a specific time period. The reason why the time period is mentioned is the fact that these principles continuously evolve as the industry progresses. For example, a lot of principles crucial to the financial world today were not in existence many years ago. Hence problems like the Great Depression and other economic disasters occurred. So, what exactly are generally accepted accounting principles that exist in the United States today?
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The Big Four
Just like there are four big international accounting firms, there are currently four most important principles that have to be included in every GAAP-related conversation. These four include the following:
- Historical Cost
- Revenue Recognition
- Full Disclosure
There many other important assumptions and constraints that trained accountants have to understand in order to fully utilize and interpret rules set by the code. Nevertheless, the aforementioned four are the most common topics that arise between passionate accountants who are trying to save their clients from breaking these crucial guidelines.
The principle of historical cost states that businesses have to report assets and liabilities that they acquire at their historical cost instead of the current market value. The reason why this is important is due to the fact that it minimizes the need for subjective evaluations of new purchases where companies could inflate the values of their acquisitions based on biased valuation procedures. Instead, everyone has to report their purchases under the exact same set of rules.
The next generally accepted principle is arguably the most important one out of the four. It states that companies have to record their revenues when they earn them, not when they get paid for performing a service or selling a product. This means that a roofing company, per se, should record revenue for the latest project as soon as they finish fixing someone’s roof and not when that client actually hands the cash over or swipes their card.
The matching principle simply forces enterprises to record their expenses in the same time period in which the revenues corresponding to those expenses occurred. So, for instance, if a firm spends $1,000 on supplies that are necessary to do a landscaping project, they will write that $1,000 expense when they complete the landscaping service. That way, they will be able to match the right revenue and expense and avoid under or overstating their financials for any given timeframe.
Ultimately, the full-disclosure principal ensures that all material information about an entity and their operations is disclosed to parties who rely on such data.
These and the additional principles, as listed by Investopedia.com, make it easy for investors to understand, analyze and extract information presented by companies. They also enable easier comparison of the performance and value of organizations. GAAP can be labeled as the authoritative set of guidelines whose purpose is to help people achieve a higher level of assurance that businesses are reporting their financials consistently.