GAAP (Generally Accepted Accounting Principles) may be defined as those rules of action or conduct which are derived from experience and practice and when they prove useful, they become accepted principles of accounting.
According to the American Institute of Certified Public Accountants (AICPA), the principles which have substantial authoritative support become a part of the GAAP (Generally Accepted Accounting Principles).
The main dispute in setting accounting standards is, “Whose rules should we play by, and what should they be?” The answer is not nearly clear.
Users of financial accounting statements have both coinciding and conflicting needs for information of various types.
To meet these needs, and to satisfy the fiduciary reporting responsibility of management, companies prepare a single set of general-purpose financial statements.
Users expect these statements to present the company’s financial operations fairly, completely and clearly. The accounting profession has attempted to develop a set of standards that are generally accepted and universally practiced.
Otherwise, each economic entity would have to develop its standards.
Further, readers of financial statements would have to familiarize themselves with every company’s peculiar accounting and reporting practices.
It would be impossible to prepare statements that could be compared and thus creating chaos in the business and financial world.
This common set of standards and procedures is called generally accepted accounting principles (GAAP).
The term “generally accepted” indicates either that an authoritative accounting rule-making body has established a principle of reporting in a given area or that over time a given practice has been accepted as appropriate because of its universal application.
Although principles and practices continue to provoke both debate and criticism, most members of the financial community recognize them as the standards that over time have proven to be most useful.
The major sources of GAAP come from the organizations; the American Institute of Certified Public Accountants (AICPA), Financial Accounting Standards Board (FASB), Securities and Exchange Commission (SEC).
Accounting is universally necessary and anybody influenced by it; has influenced the formation process of GAAP in various ways.
GAAP is composed of a fusion of over 2,000 documents that have developed over the last 60 years or so. It includes such items as FASB Standards, Interpretations, and Staff Positions; APB Opinions; and AICPA Research Bulletins.
One of the major groups involved in the standard-setting process is the American Institute of Certified Public Accountants.
Initially, it was the primary organization that established accounting principles in the United States. Subsequently, it relinquished its power to the FASB.
Since the enactment of GAAP; may affect many interests, much discussion occurs about who should develop GAAP and to whom it should apply. User groups are possibly the most powerful force influencing the development of GAAP.
User groups consist of those most interested in or affected by accounting rules. Some accountants have said that politicization in the development and acceptance of generally accepted accounting principles (i.e., rule-making) is taking place.
Some use the term “politicization” in a narrow sense to mean the influence by governmental agencies, predominantly the Securities and Exchange Commission, on the development of generally accepted accounting principles.
Others use it more broadly to mean the compromise that results when the groups responsible for developing generally accepted accounting principles are pressured by interest groups such as; SEC, American Accounting Association, businesses through their various organizations, Institute of Management Accountants, financial analysts, bankers, lawyers, and so on.
The general acceptance of the accounting principles or practices depends on how well they meet the following three criteria:
3 Main Criteria of GAAP
3 main criteria of GAAP are (1) relevance, (2) objectivity, and (3) feasibility.
Let’s See what is what;
A principle is relevant to the extent that results in information that is meaningful and useful to the users of the accounting information.
Objectivity connotes impartiality and trustworthiness. A principle is objective to the extent that the accounting information is not influenced by personal bias or judgment of those who provide it.
It also implies verifiability which means that there is some way of ascertaining the correctness of the information reported.
A principle is feasible to the extent that it can be implemented without much complexity or cost.
These criteria often conflict with each other, e.g. information about the value of a new product to the inventor is indeed relevant but the best estimate of the value of a new product made by the management is highly subjective.
Accounting, therefore, does not attempt to record such values. It sacrifices relevance in the interest of objectivity. In developing new principles, the essential problem is to achieve a trade-off between relevance on one hand and objectivity and feasibility on the other hand.
Some argue that having various organizations establish accounting principles is wasteful and inefficient.
Rather than mandating accounting rules, each company could voluntarily disclose the type of information that that is considered important.
Also, if an investor wants additional information, the investor could contact the company and pay to receive the additional information desired.
The GAAP consists of several assumptions, principles, and constraints that explain how companies should recognize, measure, and report financial elements and events.
These are globally accepted concepts or rules for recognition, measurement, treatment, and presentation of the financial status of business enterprises.
4 Basic Accounting Concepts or Accounting Assumptions
The basic concepts/assumptions are like the pillars on which the structure of accounting is based. The four basic concepts/assumptions of Accounting are as under;
Business Entity Assumption
According to this assumption, the business is treated as a unit or entity apart from its owners, creditors, managers, and others. For recording the transactions, it is the business that is the entity and with which we are concerned.
Money Measurement Assumption
The money measurement assumption underlines the fact that in accounting every worth-recording event, happening or transaction is recorded in terms of money.
Going Concern Assumption
Also known as ‘continuity assumption’, the enterprise is normally viewed as a going concern, i.e. continuing in operation for the foreseeable future.
Accounting Period Assumption
The economic activities of a company can be divided into artificial periods.
According to this assumption, the economic life of an enterprise is artificially split into periodic intervals, which are known as accounting periods, at the end of which an income statement and financial position statement are prepared to show the performance and financial position, the use of this assumption further requires the allocation of expenses between capital and revenue.
Read our article where we explained the 4 basic accounting concepts or accounting assumptions in full detail with examples.
5 Basic Accounting Principles or Accounting Conventions
Basic principles of Accounting are essential and these are the general decision-making rules which govern the development of accounting techniques.
These principles guide how transactions should, be recorded and reported. Based on the four basic assumptions of accounting, the following basic principles of accounting have been developed:
Revenue Recognition Principle
A crucial question for many companies is when to recognize revenue. Revenue recognition generally occurs (1) when realized or realizable and (2) when earned.
This approach has often been referred to as the revenue recognition principle.
Historical Cost Principle
According to this principle, an asset is ordinarily recorded in the accounting records at the price paid to acquire it at the time of its acquisition and the cost becomes the basis for the accounts during the period of acquisition and subsequent accounting periods.
According to this principle, the expenses incurred in an accounting period should be matched with the revenues recognized during that period.
Full Disclosure Principle
According to this principle, the financial statements should act as a means of conveying and not concealing.
According to this principle, the accounting data should be definite, verifiable and free from the personal bias of the accountant.
6 Accounting Constraints
Constraints are the limitations or boundaries that are necessary for providing information with qualitative characteristics. To make the information useful, the basic assumptions and principles discussed earlier have to be modified.
These modifying principles are as under:
The cost of applying an accounting principle should not be more than its benefits. If the cost is more, this principle should be modified.
This constraint is an exception to the full disclosure principle. It requires that the items or events having an insignificant economic effect or not being relevant to the user’s need not be disclosed.
It states that, whatever accounting practices (whether logical or not) are selected for a given category of transactions, they should be followed on a horizontal, basis from one accounting period to another to achieve compatibility,
Conservatism means when in doubt choose the solution that will be least likely to overstate assets and income.
According to these constraints, timely information (though less reliable) should be made available to the decision-makers.
The peculiar characteristics of an industry may require a departure from the accounting assumptions, principles and constraints discussed above.