The Four Main Principles of GAAP (Generally Accepted Accounting Principles)

AAP is an abbreviation for Generally Accepted Accounting Principles and is commonly pronounced “gap.” GAAP specifications include definitions of concepts and principles and industry-specific rules. The goal of GAAP is to ensure that financial reporting is transparent and consistent across public organizations and accounting periods.

History of The Four Main Principles of GAAP

In the early 1970s, the Financial Accounting Standards Board (FASB) and the Governmental Accounting Standards Board (GASB) in the United States developed and implemented GAAP. It debated and implemented four major rules and standards. GAAP varies by country, and there is no universally recognized financial reporting, logging, and posting system in place at the moment.

What is GAAP?

GAAP, also known as US GAAP, is a set of commonly followed accounting rules and standards for financial reporting. The GAAP specifications, which are the standard adopted by the Securities and Exchange Commission (SEC), include definitions of concepts and principles and industry-specific rules. The goal of GAAP is to ensure that financial reporting is consistent and transparent from one organization to the next.

GAAP standardizes the way businesses prepare financial statements and perform accounting tasks. GAAP assists small business owners and accounting professionals in tracking a company’s finances. With GAAP, presenting a company’s finances to outside entities (such as banks) becomes easier and more manageable. While GAAP is not required for all organizations, you may want to consider using these principles when preparing your financial statements.

The Four Main Principles of GAAP

GAAP is a set of rules and guidelines that assist businesses in preparing financial statements. The specifics of the principles vary slightly by jurisdiction, in the majority of scenarios, they encompass assumptions, basic principles, and basic constraints. The four major principles are primarily used by accounting professionals who prepare public earnings statements and financial reports, to provide some level of consistency throughout major industries. They are as follows:

1. The Cost principle,
2. The Revenue Principle,
3. The Disclosure Principle &
4. The Matching Principle.

The Cost principle

The cost principle asserts that all listed values are correct and reflect only actual costs, not the market value of the cost items. According to the cost principle of GAAP, the cost must be reported at its purchase value and not the currently updated time value. All values listed and reported, in the “cost” principle, are the costs of obtaining or acquiring the asset, not the fair market value.

For example, Alexia LTD plans to buy a plot of land for $750,000 in 2023 to use as a manufacturing factory site. The plot of land is expected to be worth $1,000,000 by 2025. Despite the asset’s increasing value, the company would report the original cost of $750,000 on its financial statements.

The Revenue Principle

The revenue recognition principle dictates that all revenue must be reported when it is realized and earned, not when cash is received, according to the “revenue” principle. This is also referred to as accrual accounting. Revenue recognition times can vary depending on whether the organization uses the cash or accrual accounting method, but the GAAP principle is that it will be recognized on time. 

For example, The Matrix Inc. provided window cleaning services to all of Hemingway Holdings’ estate buildings by the terms of their contract. The contract was completed with a service charge of $100,000 as agreed upon. As a result, Matrix Inc. will report $100,000 in revenue regardless of payment receipt status.

The Matching Principle

Revenues and expenses are matched using the matching GAAP principle which is the second of the four main principles of GAAP. This means that the costs of a revenue-generating activity are reported when the item is sold rather than when the organization receives payment or issues an invoice for it. The expenses in the financial statement must be matched with the revenue, based on the “matching” principle. Accountants must include the cost of the expense in the financial statements when the work product is sold, not when the work or payment is approved or received.

Example: Lyza Real Estate LTD. is contractually obligated to pay its agents a 10% commission monthly. If the company makes $500,000 in sales in August, the company will pay a $50,000 commission the following September. Another example would be, Bacon Cycle Shop purchased a tire pumper for $20,000 in 2022, with a 10-year expected lifespan. The cost of the tire pumper must be balanced against the revenue generated by the shop. In this case, it is used for repair and servicing, saving a significant amount of money. In this case, you should charge the bike’s purchase price to a depreciation expense of $2000 per year for a total of ten years.

The Disclosure Principle

The GAAP disclosure principle implies that information needed by anyone assessing the organization’s financial standing be included in the reporting of the organization’s financial status. According to the “disclosure” approach, information relevant to making a reasonable judgment on the company’s finances should be reasonably expected, as long as the costs of obtaining that metadata and documentation are reasonable.

For example, Piano Emporium, for example, is a national guitar retailer. Last year, it reported $2.5 million in piano inventory. GE should disclose its significant accounting policies in the notes to its financial statements. This would include the methods used to evaluate inventory. GE should disclose whether its financial statements use FIFO or LIFO inventory cost methods. If the company sues or is sued by any other entity, the current state of that front must be disclosed in the reports as well. 

Users and Necessity

Accountants and auditors are direct users. They use the four GAAP principles to prepare financial statements and documentation. Investors, lenders, and other users of financial information use GAAP-based financial reporting to make decisions about how and where to provide financing and to help financial markets operate as efficiently as possible.

The overarching goal of GAAP is to ensure that financial statements are complete, consistent, and comparable. This simplifies the analysis and extraction of useful information from the company’s financial statements, such as historical trend data, for investors. The objectivity of the basic four principles is one of the most important constraints under generally accepted accounting principles. GAAP-compliant financial statements provided by the accountant must be based on objective evidence. Because of the objectivity of the four principles, the results turn out to be errorless.

Bottom Line

The goal of the four main principles of GAAP is to create a method of accounting that is consistent, clear, and comparable. It ensures that a business’s financial records are complete and consistent. Cost, revenue, matching, and disclosure are the four basic principles of generally accepted accounting principles. This is critical for business leaders because it provides a comprehensive picture of the company’s health. Because GAAP ensures consistency, business leaders can compare company performance month after month with greater accuracy. Even when GAAP is not mandated by the government, it can be extremely beneficial to businesses. This is because GAAP helps to improve the consistency of financial information and accounting records, summarizes accounting records into complete and consistent financial statements, and provides a basis for comparison among multiple companies.

The goal of GAAP is to create a method of accounting that is consistent, clear, and comparable. It ensures that a business’s financial records are complete and consistent. Cost, revenue, matching, and disclosure are the four basic principles of generally accepted accounting principles. This is critical for business leaders because it provides a comprehensive picture of the company’s health. Because GAAP ensures consistency, business leaders can compare company performance month after month with greater accuracy. Even when GAAP is not mandated by the government, it can be extremely beneficial to businesses. This is because GAAP helps to improve the consistency of financial information and accounting records, summarizes accounting records into complete and consistent financial statements, and provides a basis for comparison among multiple companies.

References

• Epstein, B. J., Nach, R., & Bragg, S. M. (2009). Wiley GAAP 2010: Interpretation and application of generally accepted accounting principles. John Wiley & Sons.
• Zeff, S. A. (2005). Evolution of US generally accepted accounting principles (GAAP). Deloitte IASPlus.
• Bragg, S. M. (2010). Wiley GAAP: Interpretation and application of generally accepted accounting principles 2011. John Wiley & Sons.
• Carpenter, V. L., & Feroz, E. H. (2001). Institutional theory and accounting rule choice: an analysis of four US state governments’ decisions to adopt generally accepted accounting principles. Accounting, organizations and society, 26(7-8), 565-596.
• Wüstemann, J. (2021). Generally Accepted Accounting Principles (pp. 1-225). Duncker und Humblot.
• Strother, J. F. (1975). The establishment of generally accepted accounting principles and generally accepted auditing standards. Vand. L. Rev., 28, 201.
• Grossfeld, B. (2002). Comparative Corporate Governance: Generally Accepted Accounting Principles v. International Accounting Standards. NCJ Int’l L. & Com. Reg., 28, 847.