Understanding Generally Accepted Accounting Principles (GAAP) — Backoffice (2022)

In 1999, NASA famously lost the $125 million Mars Climate Orbiter in flight—not because of a rogue asteroid or heat shield failure. It’s because Lockheed Martin’s engineering team uses the imperial measurement system to build the craft while NASA’s flight team uses the metric system to operate it.

The lesson? It’s important to use the same language—and the same measurement system—when communicating across organizations.

To avoid a financial disaster of this scale, the United States Securities and Exchange Commission (SEC) requires public companies to adhere to a common set of standards in their accounting and reporting processes. Known as “generally accepted accounting principles” (GAAP), this set of standards is designed to facilitate transparency and consistency when it comes to financial information.

Following GAAP principles can also help small business owners communicate with accountants and bookkeepers, and it can ease the transition process if you experience turnover in your accounting team. Because many accountants are already familiar with GAAP accounting standards, adopting a GAAP-compliant accounting system from the start will help you ensure that the language you use to communicate your financial information is clear and useful to you, your business partners and any vendors you work with in the future.

What are generally accepted accounting principles (GAAP)?

Generally accepted accounting principles are a set of standards that outline the accounting process of a business. GAAP standards are maintained by the Financial Accounting Standards Board (FASB), a private sector nonprofit organization that exists to improve financial reporting standards and to educate stakeholders about their use.

10 Principles of GAAP

GAAP standards are based on 10 principles. Overall, these principles outline the accounting rules, practices and methods required in an accounting system that complies with GAAP. Here’s an overview of each.

1. The principle of consistency

GAAP rules require businesses to use the same accounting standards from year to year. For example, if a business chooses the depreciating balance method to calculate depreciation on an asset, that method should be applied to all depreciating assets each year, with both depreciation and historical cost shown on the company’s balance sheet.

This principle allows stakeholders to compare financial reports over time and prevents companies from disguising information (intentionally or otherwise) by changing the way the information is recorded.

2. The principle of permanent method

The principle of permanent method is related to the principle of consistency, but it applies specifically to accounting practices and methods, which should be consistent from year to year. For example, once a company uses a particular profit and loss template, it should continue to use the same template in each subsequent reporting period rather than alternating between different presentations of the same data.

Like the consistency principle, this principle increases transparency and facilitates long-term comparison of financial performance.

3. The principle of non-compensation

The principle of non-compensation requires organizations to provide a thorough and comprehensive accounting of all debts and assets. This prevents businesses from using assets to offset debt (or vice versa) in their financial statements.

For example, if a business owes $30,000 on a startup loan and has $50,000 of working capital as a reserve, GAAP rules require the business to report both numbers instead of subtracting liabilities from assets and reporting only the net balance.

4. The principle of prudence

The business world loves starry-eyed dreamers, but the accounting world lives in the realm of facts. The principle of prudence requires a factual basis for all financial reporting and caution against understated losses or overstated gains. Requiring assets to be valued using historical cost—the price of the asset at the time of purchase—is one way GAAP rules prevent asset overvaluation.

5. Principle of regularity

The principle of regularity requires that all accountants in the organization follow GAAP principles consistently. Compliant organizations should not use tactics that violate GAAP principles in any of their financial keeping or reporting.

6. The principle of sincerity

The principle of candor requires that accountants must be honest (and avoid bias) in reporting financial information.

7. The principle of good intentions

Borrowed from the insurance industry, the principle of good faith states that accountants should act honestly and assume that other parties are also acting honestly.

8. Material principle

GAAP rules require accounts to fully and accurately disclose all financial data related to a company’s performance—this means not omitting outstanding loan obligations from the report, for example, or withholding a portion of profits from the balance sheet.

9. The principle of continuity

This principle states that all valuations should be based on the assumption that the business will continue to operate in the future as it has in the past.

This principle is particularly clear when considering the valuation of assets such as common stocks. If an accountant assumes that Apple will go out of business tomorrow (or acquire Amazon tomorrow), the value of Apple shares held by the company will change significantly. GAAP principles require that the value of these assets be based on the assumption that Apple will continue to operate in a manner consistent with its current performance.

10. The periodic principle

The periodic principle states that organizations should adhere to regular and generally accepted accounting periods, such as monthly, yearly or quarterly. Organizations should not implement atypical reporting periods (say, every 37 days) or inconsistent reporting periods (such as alternating between weekly, monthly and quarterly reports).

How does GAAP work?

In the United States, GAAP is a generally accepted method for ensuring accuracy and transparency in financial reporting. GAAP rules are maintained by the Financial Accounting Standards Board and updated through Accounting Standards Updates (ASUs). ASU 2014, for example, replaced industry-specific revenue recognition guidelines with a universal revenue recognition framework. ASUs are issued when the FASB has changes to communicate. In 2018, the FASB issued 20 updates, while 2021 saw just 10.

GAAP is related to International Financial Reporting Standards (IFRS), a set of rules maintained by the International Accounting Standards Board (IASB) that determine how transactions should be reported on financial statements. Like GAAP, IFRS standards exist to increase transparency and facilitate the communication of financial information.

Although both GAAP and IFRS exist to achieve the same goal, their precise disclosure requirements differ. Therefore, a company that complies with GAAP does not automatically comply with IFRS and issuing a statement that complies with IFRS requires the company to include additional information.

Who follows GAAP?

The Securities and Exchange Commission requires all publicly traded companies in the US to adhere to GAAP principles and file financial statements that comply with GAAP.

Non-publicly traded companies are not required to follow GAAP rules, but many choose to follow them anyway—GAAP-compliant financial reports are attractive to lenders and investors, and companies that may one day benefit publicly from establishing a GAAP-compliant accounting system. from the beginning

Compliance rules

To achieve compliance, companies must comply with all 10 GAAP rules and verify compliance through an external audit. Some companies also assemble an internal auditing team, which is responsible for reviewing statements and practices prior to third-party certification. If issues are found during the audit process, the external auditor can work with your organization to resolve the issue and allow certification at a future date.

State by state requirements

While the federal government requires all publicly traded companies to comply with GAAP standards, financial reporting requirements for state and local governments differ based on location. US states are classified as either fully compliant with GAAP, mostly compliant with GAAP, somewhat compliant with GAAP, or not compliant with GAAP at all.

In states that fully comply with GAAP, all local and county governments are required to comply with GAAP principles. In most states and relatively compliant, requirements vary by region.

Final thoughts

There are many reasons to adopt a GAAP-compliant accounting system, including complying with SEC regulations, positioning yourself to take your company public and providing clear and reliable financial information to potential investors.

Incorporating GAAP principles into your accounting practices also makes good business sense. By ensuring accuracy and transparency in financial reporting, GAAP principles can help you identify and correct mistakes or errors and provide you with the information you need to meet your business goals.

source: https://www.shopify.co.id/blog/gaap