Generally Accepted Accounting Principles

Generally Accepted Accounting Principles or GAAP are Accounting Rules used to prepare present and report financial statements for a variety of entities.

In the U.S., generally accepted accounting principles GAAP, commonly abbreviated as US GAAP or simply GAAP, are accounting rules used to prepare, present, and report financial statements for a wide variety of entities, including publicly traded and privately held companies, non-profit organizations, and governments. Generally, GAAP includes local applicable Accounting Framework, related accounting law, rules, and Accounting Standard. Like many other countries practicing under the common law system, the United States government does not directly set accounting standards, in the belief that the private sector has better knowledge and resources. US GAAP is not written in the law, although the U.S. Securities and Exchange Commission (SEC) requires that it be followed in financial reporting by publicly traded companies. Currently, the Financial Accounting Standards Board (FASB) is the highest authority in establishing generally accepted accounting principles for public and private companies, as well as non-profit entities. For local and state governments, GAAP is determined by the Governmental Accounting Standards Board (GASB), which operates under a set of assumptions, principles, and constraints, different from those of standard private-sector GAAP. Financial reporting in federal government entities is regulated by the Federal Accounting Standards Advisory Board (FASAB). The US GAAP provisions differ somewhat from International Financial Reporting Standards, though former SEC Chairman Chris Cox set out a timetable for all U.S. companies to drop GAAP by 2016, with the largest companies switching to IFRS as early as 2009. History Auditors took the leading role in developing GAAP for business enterprises. Circa 2008, the FASB issued the FASB Accounting Standards Codification, which reorganized the thousands of US GAAP pronouncements into roughly 90 accounting topics In 2008, the Securities and Exchange Commission issued a preliminary “roadmap” that may lead the U.S. to abandon Generally Accepted Accounting Principles in the future (to be determined in 2011) and to join more than 100 countries around the world instead of in using the London-based International Financial Reporting Standards. Basic objectives Financial reporting should provide information that is:

• useful to present to potential investors and creditors and other users in making rational investment, credit, and other financial decisions.
• helpful to present to potential investors and creditors and other users in assessing the amounts, timing, and uncertainty of prospective cash receipts.
• about economic resources, the claims to those resources, and the changes in them.

Basic concepts to achieve basic objectives and implement fundamental qualities GAAP has four basic assumptions, four basic principles, and four basic constraints.

Business Entity: assumes that the business is separate from its owners or other businesses. Revenue and expense should be kept separate from personal expenses.

Going Concerned: assumes that the business will be in operation indefinitely. This validates the methods of asset capitalization, depreciation, and amortization. Only when liquidation is certain this assumption is not applicable.

Monetary Unit principle: assumes a stable currency is going to be the unit of record. The FASB accepts the nominal value of the US Dollar as the monetary unit of record unadjusted for inflation.

The Time-period principle implies that the economic activities of an enterprise can be divided into artificial periods.

Principles

The cost principle requires accountants and companies to account for and report based on acquisition costs rather than fair market value for most assets and liabilities. This principle provides reliable information (removing the opportunity to provide subjective and potentially biased market values), but not very relevant. Thus there is a trend to use fair values. Most debts and securities are now reported at market values.

Revenue principle requires companies to record when revenue is (1) realized or realizable and (2) earned, not when cash is received. This way of accounting is called accrual basis accounting.

Matching principle. Expenses must be matched with revenues as long as it is reasonable to do so. Expenses are recognized not when the work is performed, or when a product is produced, but when the work or the product makes its contribution to revenue. Only if no connection with revenue can be established, may cost be charged as expenses to the current period (e.g. office salaries and other administrative expenses). This principle allows greater evaluation of actual profitability and performance (shows how much was spent to earn revenue). Depreciation and Cost of Goods Sold are good examples of the application of this principle.

Disclosure principle. The amount and kinds of information disclosed should be decided based on trade-off analysis as a larger amount of information costs more to prepare and use. Information disclosed should be enough to make a judgment while keeping costs reasonable. Information is presented in the main body of financial statements, in the notes, or as supplementary information.

Constraints

Objectivity principle: the company’s financial statements provided by the accountants should be based on objective evidence.

Materiality principle: the significance of an item should be considered when it is reported. An item is considered significant when it would affect the decision of a reasonable individual.

Consistency principle: It means that the company uses the same accounting principles and methods from year to year.

Prudence principle: when choosing between two solutions, the one that will be least likely to overstate assets and income should be picked (see a convention of conservatism).

Required Departures from GAAP Under the AICPA’s Code of Professional Ethics under Rule 203 – Accounting Principles, a member must depart from GAAP if following it would lead to a material misstatement on the financial statements, or otherwise be misleading. In the departure, the member must disclose, if practical, the reasons why compliance with the accounting principle would result in a misleading financial statement. Under Rule 203-1-Departures from Established Accounting Principles, the departures are rare and usually take place when there is new legislation, the evolution of new forms of business transactions, an unusual degree of materiality, or the existence of conflicting industry practices. Setting GAAP The SEC was created as a result of the Great Depression. At that time there was no structure setting accounting standards. The SEC encouraged the establishment of private standard-setting bodies through the AICPA and later the FASB, believing that the private sector had the proper knowledge, resources, and talents. The SEC works closely with various private organizations setting GAAP but does not set GAAP itself. In 1939, urged by the SEC, the AICPA appointed the Committee on Accounting Procedure (CAP). During the years 1939 to 1959 CAP issued 51 Accounting Research Bulletins that dealt with a variety of timely accounting problems. However, this problem-by-problem approach failed to develop the much-needed structured body of accounting principles. Thus, in 1959, the AICPA created the Accounting Principles Board (APB), whose mission it was to develop an overall conceptual framework. It issued 31 opinions and was dissolved in 1973 for lack of productivity and failure to act promptly. After the creation of the FASB, the AICPA established the Accounting Standards Executive Committee (AcSEC). It publishes:

Audit and Accounting Guidelines, which summarizes the accounting practices of specific industries (e.g. casinos, colleges, airlines, etc.) and provides specific guidance on matters not addressed by FASB or GASB.

Statements of Position, which provides guidance on financial reporting topics until the FASB or GASB sets standards on the issue.

Practice Bulletins, which indicate the AcSEC’s views on narrow financial reporting issues not considered by the FASB or the GASB.

Realizing the need to reform the APB, leaders in the accounting profession appointed a Study Group on the Establishment of Accounting Principles (commonly known as the Wheat Committee for its chair Francis Wheat). This group determined that the APB must be dissolved, and a new standard-setting structure is created. This structure is composed of three organizations: The Financial Accounting Foundation (FAF, it selects members of the FASB, funds and oversees their activities), the Financial Accounting Standards Advisory Council (FASAC), and the major operating organization in this structure the Financial Accounting Standards Board (FASB). FASB has 4 major types of publications:

Statements of Financial Accounting Standards – the most authoritative GAAP setting publications. More than 150 have been issued to date.

Statements of Financial Accounting Concepts – first issued in 1978. They are part of the FASB’s conceptual framework project and set forth fundamental objectives and concepts that the FASB uses in developing future standards. However, they are not a part of GAAP. There have been 7 concepts published to date.

Interpretations – modify or extend existing standards. There have been around 50 interpretations published to date.

Technical Bulletins – guidelines for applying standards, interpretations, and opinions. Usually solves some very specific accounting issues that will not have a significant, lasting effect.

In 1984 the FASB created the Emerging Issues Task Force (EITF) which deals with new and unusual financial transactions that have the potential to become common (e.g. accounting for Internet-based companies). It acts more like a problem filter for the FASB – the EITF deals with short-term, quickly resolvable issues, leaving long-term, more pervasive problems for the FASB. Governmental Accounting Standards Board (GASB) Created in 1984, the GASB addresses state and local government reporting issues. Its structure is like that of the FASB’s. Other influential organizations (e.g. American Accounting Association, Institute of Management Accountants, Financial Executives Institute) Other influential organizations The Government Finance Officers Association (GFOA) also influences financial policies for governments. Disagreements between the GFOA and GASB are rare but can continue for many years. Precedence of GAAP-setting authorities In the United States, GAAP derives, in order of importance, from:

issuances from an authoritative body designated by the American Institute of Certified Public Accountants(AICPA) Council (for example, the Financial Accounting Standards Board Statements, AICPA Accounting Principles Board Opinions, and AICPA Accounting Research Bulletins);

• other AICPA issuances such as AICPA Industry Guides;
• industry practice; and
• into para-accounting literature in the form of books and articles.

Codification in Accounting – FASB Accounting Standards Codifications The Codification is effective for interim and annual periods ending after September 15, 2009. All existing accounting standards documents are superseded as described in FASB Statement No. 168, The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles. All other accounting literature not included in the Codification is nonauthoritative. The Codification reorganizes the thousands of U.S. GAAP pronouncements into roughly 90 accounting topics and displays all topics using a consistent structure. It also includes relevant Securities and Exchange Commission (SEC), guidance that follows the same topical structure in separate sections in the Codification. To prepare constituents for the change, the FASB has provided a number of tools and training resources. While the Codification does not change GAAP, it introduces a new structure—one that is organized in an easily accessible, user-friendly online research system. The FASB expects that the new system will reduce the amount of time and effort required to research an accounting issue, mitigate the risk of non-compliance with standards through improved usability of the literature, provide accurate information with real-time updates as new standards are released, and assist the FASB with the research efforts required during the standard-setting process.