Generally Accepted Accounting Principles

Supporting Material

Generally Accepted Accounting Principles

The information communicated to external users in financial reporting is based on standards that establish generally accepted accounting principles (GAAP). The evolution of GAAP in the United States took place over many years. It involved several accounting policy-making bodies, including the Financial Accounting Standards Board (FASB), Accounting Principles Board (APB), American Institute of Certified Public Accountants (AICPA), and Securities and Exchange Commission (SEC).

Assumptions of GAAP

The Generally Accepted Accounting Principles (GAAP) are built on several foundational assumptions to ensure consistency and reliability in financial reporting. Here are four key assumptions of GAAP.

Business Entity / Economic Entity

This assumption states that the business is treated as a separate entity from its owners or other businesses. All financial activities are recorded for the business alone, without mixing personal or unrelated business transactions. A business entity is an economic unit that owns its assets and owes its obligations.

The owner(s) may have personal bank accounts, real estate, and other assets, but these will not be considered assets of the business. For instance, if the owner of a bakery uses personal funds to buy a new car, the transaction is not recorded in the bakery’s financial records. Only transactions directly related to the bakery’s operations—like buying flour or paying employees—are included in the business’ accounting.

Going Concern

The assumption that the business will continue to operate for the foreseeable future, meaning its assets are valued based on their use in ongoing operations. An entity is said to be a going concern if it has neither the intention nor the necessity of the liquidation. An entity prepares financial statements on a going concern basis when, under the going concern assumption, the entity is viewed as continuing in business for the foreseeable future.

The valuation principle of assets and liabilities depend on this concept. If an entity is not a going concern, its assets and liabilities are to be valued in an altogether different manner. For instance, a manufacturing company buys machinery for $100,000. Under the going concern assumption, the machinery will be depreciated over its useful life (say 10 years) because the company expects to use the machinery in its operations. If the company were planning to close in the next year, the machinery would instead be valued at its liquidation value.

Stable Monetary Unit

This assumption assumes that currency remains constant over time, ignoring inflation or deflation. Financial transactions are recorded at their historical cost without adjusting for changes in purchasing power.

A piece of land bought for $100,000 in 2000 is recorded at that value, even if it’s worth $500,000 today. A U.S. company reports all transactions in U.S. dollars, even in countries with high inflation. This assumption simplifies accounting but can misrepresent the real value of assets in inflationary periods.

Accounting Period

Financial performance is reported for specific and regular periods, like months, quarters, or years, to help stakeholders assess a company’s performance over time. This assumption describes that the activities of a going concern are continuous flows. In order to judge the performance/position of a business entity, the best way to judge a business is to have a periodic performance appraisal.

A company prepares financial statements every quarter (January–March, April–June, etc.). If the company makes a sale in March, it will record the revenue in the first quarter’s financial statements, even if the cash is received in April. This allows consistent performance tracking.

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Operating Conventions of GAAP

Operating conventions of GAAP are the practical guidelines or rules that businesses follow when preparing and presenting financial statements. Here are five key operating conventions of GAAP, explained with examples:

Historical Cost

The historical cost convention dictates that assets should be recorded and reported at their original purchase cost rather than their current market value. This convention ensures objectivity and reliability in financial reporting.

Assets such as land, buildings, plants, machinery, etc., and obligations, such as loans and public deposits, should be recorded at historical cost (i.e., cost as on acquisition). If a company buys a piece of equipment for $50,000, it is recorded at this historical cost in the financial statements. Even if the market value of the equipment increases or decreases, it remains reported at $50,000, unless impaired.

Realization

The realization concept, also known as the revenue realization concept or revenue recognition concept, is a fundamental principle in accounting that dictates when revenue should be recognized and recorded in the financial statements. According to this concept, revenue should be recognized when it is earned and realizable, rather than when cash is received. This does not demand that the revenue has to be received in cash.

Revenue from sales transactions should be recognized when the seller of goods has transferred to the buyer the property in the goods for a price and no uncertainty exists regarding the consideration that will be derived from the sale of goods. A software company sells a one-year subscription to its software in January. Under the revenue recognition convention, the company should recognize the revenue evenly over the 12 months of the subscription period, rather than recognizing the full amount in January when the cash is received.

Matching

The matching convention requires that expenses be matched with the revenues they help generate in the same period. This ensures that financial statements reflect the true profitability of a company by associating costs directly with the revenues they produce. The aim of every business is to earn profit. In order to ascertain the profit, expenses and revenues are matched.

A company purchases a piece of machinery for $24,000 with an expected useful life of 8 years. Instead of recording the entire $24,000 expense in the year of purchase, the cost of the machinery is spread over its useful life through depreciation. If using the straight-line method, the company would recognize $3,000 of depreciation expense each year for 8 years.

Duality

The duality concept, also known as the dual aspect concept, is a fundamental principle in accounting that states every financial transaction has two equal and opposite effects on the accounting equation. This concept is the foundation of double-entry bookkeeping, where every transaction impacts at least two accounts in such a way that the accounting equation remains balanced.

The dual concept stated that “for every debit, there is credit.” The duality concept is implemented through the double-entry bookkeeping system, where each transaction is recorded with equal debits and credits to ensure accuracy and completeness.

 Money Measurement

Money Measurement Concept discusses that each transaction and event must be expressible in monetary terms. If an event cannot be expressed in monetary terms, it cannot be considered for accounting purposes.

For example, if you successfully pass a distance learning program at a university, it will give you a great deal of satisfaction. But that satisfaction cannot be expressed in monetary terms. Hence, such an event is not fit for accounting. This concept implies that the legal currency of a country should be used for such measurement.

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Quality Consideration of GAAP

In the context of Generally Accepted Accounting Principles (GAAP), quality considerations refer to the attributes that financial information should possess to be useful and reliable for decision-making. These attributes are essential for ensuring that financial statements provide a true and fair view of an entity’s financial position and performance. The primary quality considerations in GAAP are below.

Objectivity

The objectivity concept in accounting ensures that financial information is based on unbiased, verifiable evidence and is free from personal opinions or subjective judgments. This concept aims to provide reliable and accurate financial reporting.

This requires that each recorded business transaction in the books of accounts should have enough evidence to support it. As accounting records are based on documentary evidence that is capable of verification, they are universally acceptable.

Prudence

This concept guides how accountants should deal with uncertainty in financial reporting. The core idea is to recognize expenses and liabilities as soon as possible but to recognize revenues and assets only when they are assured of being realized. This concept aims to avoid overestimating income or assets and underestimating liabilities and expenses.

Consistency

The consistency concept in accounting dictates that once an entity adopts a particular accounting method or policy, it should consistently use that method for similar transactions and events over time. This consistency allows for comparability of financial statements from period to period, providing users with a reliable basis for making comparisons and evaluating financial performance.

Materiality

Materiality Concept requires all relatively relevant information should be disclosed in the financial statements. Unimportant and immaterial information is either left out or merged with other items.

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