Meaning and relevance of GAAP
Generally accepted accounting principles (GAAP) refer to a common set of accepted accounting principles, standards, and procedures that companies and their accountants must follow when they compile their financial statements. GAAP is a combination of authoritative standards (set by policy boards) and the commonly accepted ways of recording and reporting accounting information. GAAP improves the clarity of the communication of financial information.
GAAP is meant to ensure a minimum level of consistency in a company’s financial statements, which makes it easier for investors to analyze and extract useful information. GAAP also facilitates the cross-comparison of financial information across different companies.
These 10 general principles can help you remember the main mission and direction of the GAAP system.
(i) Principle of Regularity
The accountant has adhered to GAAP rules and regulations as a standard.
(ii) Principle of Consistency
Professionals commit to applying the same standards throughout the reporting process to prevent errors or discrepancies. Accountants are expected to fully disclose and explain the reasons behind any changed or updated standards.
(iii) Principle of Sincerity
The accountant strives to provide an accurate depiction of a company’s financial situation.
(iv) Principle of Permanence of Methods
The procedures used in financial reporting should be consistent.
(v) Principle of Non-Compensation
Both negatives and positives should be fully reported with transparency and without the expectation of debt compensation.
(vi) Principle of Prudence
Emphasizing fact-based financial data representation that is not clouded by speculation.
(vii) Principle of Continuity
While valuing assets, it should be assumed the business will continue to operate.
(viii) Principle of Periodicity
Entries should be distributed across the appropriate periods of time. For example, revenue should be divided by its relevant periods.
(ix) Principle of Materiality / Good Faith
Accountants must strive for full disclosure in financial reports.
(x) Principle of Utmost Good Faith
Derived from the Latin phrase “uberrimae fidei” used within the insurance industry. It presupposes that parties remain honest in transactions.
GAAP must be followed when a company distributes its financial statements outside of the company. If a corporation’s stock is publicly traded, the financial statements must also adhere to rules established by the U.S. Securities and Exchange Commission (SEC).
GAAP covers such things as revenue recognition, balance sheet item classification and outstanding share measurements. If a financial statement is not prepared using GAAP, investors should be cautious. Also, some companies may use both GAAP and non-GAAP compliant measures when reporting financial results. GAAP regulations require that non-GAAP measures are identified in financial statements and other public disclosures, such as press releases.