What is GAAP in Accounting?
Generally accepted accounting principles (GAAP) are the minimum standard and uniform guidelines for the accounting and reporting which establishes proper classification and measurement criteria of financial reporting and provides a better picture when the financial reports of different companies are compared by the investors.
In simple words, it is defined as the collection of commonly used and followed accounting rules and procedures for the Financial reporting of a company. GAAP describes us about the accounting concepts and the principles to be followed while preparing a financial statement of a company or a Firm.
- GAAP standards change from place to place. For example, in the United States, they follow the Securities and Exchange Commission ( SEC), which mandates the financial reports stick to the requirements.
- Many countries in the world follow International Financial Reporting Standards (IFRS). IFRS is followed in more than 110 countries. IFRS specifies to prepare and disclose the financial statement of the companies globally.
- Indian Accounting Standard (Referred to as Ind-AS) is the accounting standard adopted by the Indian companies under the supervision of the Accounting Standards Board (ASB ).
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Why GAAP?
- To make transparent and fair of the Accounting and the financial reporting of the company and
easily understandable to ordinary people. - The Generally Accepted Accounting Principles is necessary for the accounting rules and the standardizing the reporting of financial
statements like balance sheetsBalance SheetsA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more, income statementIncome StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements.read more and the cash flow statementThe Cash Flow StatementStatement of Cash flow is a statement in financial accounting which reports the details about the cash generated and the cash outflow of the company during a particular accounting period under consideration from the different activities i.e., operating activities, investing activities and financing activities.read more for all the
companies. - The financial statements preparedFinancial Statements PreparedFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more under GAAP are intended to show the economic reality.
What Happens if GAAP is Not Available?
- Without these principles, there are chances of fraudulent cases in Accounting and financial reporting. Thus affecting the interest of the Investors and the creditors in the market.
- Without Generally Accepted Accounting Principles, companies would be free to decide themselves what financial information to report and how to report it, which will be very difficult for the investors and creditors who have stake or shares in that company.
- For example, if we see the Punjab National Bank scam happened due to fraudulent financial reporting by the employees, auditors, and the customer without practicing any of the accounting rulesAccounting RulesAccounting rules are guidelines to follow for registering daily transactions in the entity book through the double-entry system. Here, every transaction must have at least 2 accounts (same amount), with one being debited & the other being credited. read more and standards, because of which the ultimate losers are the Investors who invested in that company.
Advantages of Generally Accepted Accounting Principles
- It promotes the interest of the Investors, Shareholders, and Creditors in the market.
- By following Generally Accepted Accounting Principles, procedures, consistency can be maintained and the overall performance can
be determined. - Identifying the areas that need improvement and required modifications for the better
performance of the company. - The financial reports which are made using the GAAP help to maintain investor’s trust and interest in investments of that company;
- Complying with GAAP gives the guarantee to anyone who wants to invest in that company.
- With the help of the GAAP report, one can easily understand the financial statements and can also compare easily with another.
- Generally Accepted Accounting Principle, reports it is easy to find out the profit, loss, expenses, investment, income, and revenues of the company.
- Generally Accepted Accounting Principles reduce risks and avoids fraud cases by monitoring them properly.
The Basic Principles of Generally Accepted Accounting Principles
The following are the top 10 basic principles of GAAP (Generally Accepted Accounting PrinciplesAccounting PrinciplesAccounting principles are the set guidelines and rules issued by accounting standards like GAAP and IFRS for the companies to follow while recording and presenting the financial information in the books of accounts.read more).
#1 – The Business as a single Entity Principle
A business is a separate entity in terms of the law. All its activities are treated separately from that of its owners. In terms of accounting, the business is independent, and the owners are different.
#2 – The Specific Currency Principle
A currency is specified for the reporting of financial statements. In India, we deal with Indian Rupee. Hence it should be treated as INR for the money specific. In the United States, they economically deal with the US dollar, and their financial reporting will be mentioned in USD.
#3 – Time period Specific Principle
Financial statements pertain to a specific period i.e., end time and start time. Balance sheets are also reported on a particular date, like monthly, quarterly, half-yearly, and annually.
#4 – The Cost Principle
In accounting, “Cost” refers to the amount spent on obtaining the goods or services. Hence for this, the amounts shown in the financial statements also referred to as the Historical cost amounts.
#5 – The full disclosure Principle
The Full disclosure principleFull Disclosure PrincipleFull Disclosure Principle is an accounting policy backed by GAAP and IFRS, asking the management of an organization to disclose every relevant and material financial information to creditors, investors and any other stakeholder who depend on the financial reports and decision-making process.read more states that a company should disclose all the financial statements fully. It is vital for an investor or the lender to know about the significant account policies. A company generally lists its accounting policiesAccounting PoliciesAccounting policies refer to the framework or procedure followed by the management for bookkeeping and preparation of the financial statements. It involves accounting methods and practices determined at the corporate level.read more as the first note to its financial statements.
#6 – The Recognition Principle
This revenue recognition principleRevenue Recognition PrincipleThe revenue recognition principle falls under GAAP, which outlines the specific conditions under which the revenue is recognized and recorded. A business may receive payment early or later after delivering the goods and services to the customer, and still, revenue gets recognized.read more states that the companies should reveal the income and expenses of the company in that period where they have occurred.
#7 – The Non-death Principle of Business
It is also called as Principe of continuity as for accounting. There should not be an end as its continuing to operate until and unless any winding up of the company.
#8 – Matching Principle
This Matching Principle requires companies to use the accrual basis of accounting. The matching principle requires that expenses should be matched with the revenues.
#9 – The Principle of materiality
This Principle generally states about the adjustment of the very minute errors, that is, while maintaining accounting reportsMaintaining Accounting ReportsAccounting reports are created using a company's accounting data to check ledger-by-ledger transactions over a given time period. Accounting reports also include financial statements such as cash flow statements, profit and loss statements, and balance sheets.read more, there could be some small errors like $5 error which is not matching, here this can be used and adjusted accordingly.
#10 – The Principle of Conservative Accounting
Conservative Accounting Principle should be adopted by all companies wherein when expenses occur that are to be recorded immediately, but the income to be recorded when actual cash flow is there. In addition to all these, the Principle of Honesty to be maintained.
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