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Accounting Principles: What is GAAP?

Posted by Early Growth

September 20, 2021    |     5-minute read (883 words)

If you’ve ever considered going public or raising capital with a VC, you’ve no doubt heard of GAAP. GAAP stands for Generally Accepted Accounting Principles and is a set of accounting rules that all public companies in the United States should abide by. Not only do investors and financial institutions expect it, but it’s also an exceptional financial tool for your company.

But what is GAAP, exactly? And why is it important? To better understand the GAAP definition, it pays to know first about accounting principles and how they relate to U.S. GAAP standards.

What Are Accounting Principles?

Accounting principles are the underlying rules that form the basis of the U.S. GAAP. They ensure all financial statements have a high level of accuracy, consistency, and transparency. The goal of accounting principles is to set a common standard that all businesses, financial institutions, and stakeholders use to analyze financial data. It makes it possible to compare the financial picture of two different companies. Creditors will also have an easier time forming a picture of a business’s financial health to make better lending decisions.

10 Basic Accounting Principles

  1. Matching Principle
All expenses must be recorded on the period when their corresponding revenues occur and not when they’re paid, per the accrual method. Sales commissions, for example, must be accounted for at the time of the sale, even if the actual commission won’t be realized until much later.

  1. Revenue Recognition Principle
Similar to the matching principle, revenue recognition requires that all revenues be accounted for in the same period when the transaction occurred, regardless of whether the company received the cash or not. 

  1. Economic Entity Principle
Accounting for a business’s activities must be separate from those of its owners and stakeholders.

  1. Time Period Principle
Accounting must be done in short, specific time intervals, be it in a week or a fiscal year. The period used must also be specified clearly in the header of the financial statement. 

  1. Cost Principle
The cost recorded for the purchase of an asset, goods, or service must reflect the amount the company paid at the time, called the historical cost. That item’s value must not change regardless of price fluctuations in the market.

  1. Monetary Unit Principle
All financial statements must be in a relatively stable currency, ignoring inflation and other economic influences.

  1. Full Disclosure Principle
All data and information relevant to the complete understanding and accurate representation of a financial statement must be disclosed in said statement.

  1. Conservatism Principle
Accounting methods must always lean more on being conservative. When in doubt, potential losses should be considered more while income should not.

  1. Materiality Principle
This principle states that if a value has an insignificant impact and will not create a misleading result, it can be safely ignored. For example, cents can be rounded to the nearest dollar amount.

  1. Going Concern Principle
A company or business must do accounting with the intent of going with its operations, as usual, meeting its financial obligations, and using its current assets.

What are Generally Accepted Accounting Principles (GAAP)?

GAAP are rules defined by the Financial Accounting Standards Board (FASB) that govern accepted accounting practices of public companies in the United States. It provides a standardized framework so creditors and investors can quickly evaluate financial statements regardless of company or industry.

Besides being a requirement for listing in US stock exchanges, GAAP accounting also allows you to better manage your business’s financials, even if you’re a private company. It can help you make better forecasts and business decisions. GAAP-compliant financials also form the basis of your exit strategy.

Ten principles govern GAAP accounting:

  1. Principle of Utmost Good Faith
All transactions and data must be made with complete honesty and transparency.

  1. Principle of Full Disclosure
All information relevant to the correct interpretation of the financial statement must be included.

  1. Principle of Periodicity
Accounting should be done in distinct periods suitable to the business’s operations.

  1. Principle of Continuity
Accounting must be done with the assumption that the company will continue operations as usual.

  1. Principle of Prudence
Financial data must be presented as accurately as possible without any interpretation or bias.

  1. Principle of Non-Compensation
Whether positive or negative, all financial data must be disclosed without the assumption of compensation through debt.

  1. Principle of Permanence of Methods
The accounting methods used by a business must be consistent for all reports and statements.

  1. Principle of Consistency
Accounting standards adopted must be applied consistently to all reports and statements.

  1. Principle of Regularity
Accounting should comply with GAAP rules.

  1. Principle of Sincerity
Accounting must always strive to show the accurate financial picture of a business.

However, while GAAP deals with most aspects of sound accounting, it doesn’t cover all of them. Some businesses have diverse structures or models that can make GAAP implementation challenging or less effective. It’s also only a U.S.-based standard, limiting its use when dealing with foreign companies.

We Know How Important GAAP Compliance Is

At Early Growth, GAAP forms the basis of all of our accounting services. In fact, it’s non-negotiable with every client we take in. If you’re struggling with GAAP standards in your own company, give us a call. We’ll be happy to help you set things straight.

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