The United States Securities and Exchange Commission (SEC) has adopted a series of Generally Accepted Accounting Principles (GAAP) to standardize the preparation of financial statements. These principles, rules, guidelines, and standards come from the Financial Accounting Standards Board (FASB) and from common practices within the accounting industry. Though these rules are not official law, publicly traded companies must adhere to these guidelines, as outlined by the SEC. Note that additional guidelines exist, as detailed by the Governmental Accounting Standards Board, or GASB. By using GAAP, industry statistics can be created and companies can be financially compared with one another.
GAAP operates under a series of assumptions, principles, and restraints in order to aid companies in making solid financial decisions, enhancing performance, and maintaining records.
The first assumption which forms the basis of GAAP is the concept of the business entity. This idea posits that businesses are separate entities from the business owners and that business transactions must be kept separate from personal transactions. The second assumption is that a business will operate for the foreseeable future. When financial information is presented, asset capitalization and depreciation are considered instead of liquidation values. However, when a business goes under, liquidation values are considered. The third assumption is that financial information will be recorded using a steady currency. Under the FASB, the US Dollar is the standard currency. The fourth assumption is that business activities can be divided into different time periods. By dividing business activity into months, quarters, and years, financial information can be recorded in proper fashion and company performance can be analyzed by time period.
The first principle of GAAP is that companies must report their assets and liabilities at actual cost and not at market value. Using actual costs and values removes subjectivity and biases from the market. However, many debts and securities are reported at market values. The second principle is that revenues must be recorded when earned, but not yet received. This forms the basis of accrual based accounting, which has been detailed in a prior blog. The third principle states that expenses should be recorded when incurred. Following the revenue realization principle, expenses should be recognized when the result contributes to revenues. Costs can be recorded as expenses if there is no connection with revenue. Using the matching principle provides a good picture of profitability in an accounting period. The fourth principle states that all relevant financial information should be presented in financial statements so that owners can make educated business decisions.
The first constraint of GAAP is that objective evidence must be provided for a business’s financial statements. The second constraint is that an item’s importance must be considered when reported. An item’s importance is noted when it affects an owner’s decision making. The third constraint is that accounting methods must be consistent across periods. For example, a company cannot switch back and forth between the accrual and cash based accounting methods between periods. The fourth constraint is that, when deciding between two different solutions, the more conservative and cautious option is preferred. This constraint is put in place to understate assets and income, provisioning for potential losses.