Routinely, accountants come across the task of recording financial transactions of the company. They are required to make judgments regarding how to record business transactions. The financial goals of the said company often direct their decisions for which they work. For their help, there is a certain framework of standard rules known as generally accepted accounting principles (GAAP) to guide their judgments.
What is US GAAP
GAAP are a set of accounting patterns that are required to prepare and report the financial statements of public and private companies and non-profit organizations in the US. It chalks down the standards and rules for the aid of accountants so they can record and prepare a summary of their transactions. Governmental Accounting Standards Board (GASB) in the US is responsible for these rules, employed by local and state government. As the term is restricted only to the US, it is known as US GAAP.
Essentials of GAAP
In the United States, the American Institute of Certified Public Accountants (AICPA), The Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC) offer guidance and assistance about standard acceptable practices of accounting.
The financial reporting done with the aid of GAAP guidelines should help investors and creditors in the following ways:
– Make intelligent investment and credit decisions.
– Evaluate the amount and dubiety surrounding cash receipts.
– Know changes in economic resources.
– Take long-term financial decisions.
– Improve business operations.
– Preserve documents.
However, if the above objectives have to be achieved, you need to know that GAAP is based on certain fundamentals, assumptions, principles, and constraints.
The evolvement of GAAP is based on four fundamental qualities that the financial statements must possess. The financial statements must be relevant, reliable, consistent, and comparable.
Economic entity assumption (a business is singled out from its owner or another business, personal expenses are kept apart from revenue)
Going Concern Assumption (a business continues to exist till an indefinite time period)
Monetary Unit Assumption (presumes US dollars as the monetary unit)
Periodic Reporting Assumption (economic activities to be split up according to a time period)
GAAP exercises four basic principles to implement and achieve the objectives. They include:
– Historical Cost Principle: Companies should consider the acquisition costs and not fair market value for their liabilities and assets.
– Revenue Recognition Principle: Accrual basis accounting is preferred.
– Matching Principle: This principle allows greater evaluation of actual profitability and performance as the expenses are matched with the revenues.
– Principle of Full Disclosure: Information disclosed in the financial statement should be enough to make a judgment while keeping the costs reasonable.
The constraints on which GAAP is based on are as outlined below:
Company statements provided should have documented evidence.
The item’s significance should be looked at.
Consistency in accounting principles and methods should be followed every year.
Pick a solution that is less likely to exaggerate assets and income.
Organizations behind GAAP
United States Securities and Exchange Commission (SEC): During the Great Depression, the SEC was created as there was a need for structure setting accounting standards. The SEC works closely with various private organizations, believing that the private sector had the proper knowledge, resources, and talents.
American Institute of Certified Public Accountants (AICPA): SEC urged the AICPA and in 1939, Committee on Accounting Procedure (CAP) came into existence. However, it could not address the growing need for structured body of accounting principles. So, in 1959, the AICPA created the Accounting Principles Board (APB), which also got dissolved in 1973 for lack of productivity and failure to act promptly. So, the AICPA created FASB once again.
Financial Accounting Standards Board (FASB): Realizing the need to reform the APB, a new structure was composed of three organizations: the Financial Accounting Foundation (FAF), the Financial Accounting Standards Advisory Council (FASAC), and the major operating organization in this structure – the Financial Accounting Standards Board (FASB).
Governmental Accounting Standards Board (GASB): With structure similar to that of the FASB, GASB was created in 1984 to address state and local government reporting issues.
Why to Follow GAAP
GAAP is used to prepare all the financial documents of the company and increase its understandability for the investors. Without GAAP, companies won’t be able to follow a standard format and cannot provide accurate as well as consistent financial information and report the same to the investors, stakeowners, and creditors. It also makes sure that the financial documents are not manipulated, and investors and creditors can take decisions as per that.
If a public company does not follow the guidelines, the company will be fined by the Securities and Exchange Commission (SEC). In some cases, criminal actions can also been taken against the company. Private companies are also supposed to follow GAAP, and if not, then the reasons and differences should be mentioned in the notes of the financial statements.
The FASB publishes following 4 major types of publications.
Statements of Financial Accounting Standards: It is one of the most authoritative GAAP setting publications. More than 150 have been issued till date.
Statements of Financial Accounting Concepts: It was first issued in 1978. They are part of the FASB’s framework project and identified and established fundamental concepts and goals guiding the FASB in the development of future standards. However, they are not a part of GAAP. There have been 7 concepts published till date.
Interpretations: This publication is focused towards the modification or extension of existing standards. There have been around 50 interpretations published till date.
Technical Bulletins: These are basically guidelines on applying standards, its interpretations, and opinions. They usually solve some very specific accounting issues that will not have an important and long-lasting effect.
The Accounting Standards Executive Committee (AcSEC) established by AICPA publishes the following publications.
Audit and Accounting Guidelines: It concludes the accounting practices for specific industries like colleges, airlines, and casinos. It offers specific guidance on issues that are not addressed by FASB or GASB.
Statements of Position: This offers guidelines on topics related to financial reporting until they are addressed by FASB or GASB.
Practice Bulletins: It reflects the views of AcSEC on narrow financial reporting issues not addressed by the FASB or the GASB.
Adhering to the constraints and standard rules depicted by GAAP always remains a good policy. However, be mindful that GAAP being only a set of standards, there are many opportunities for unprincipled accountants to falsify figures in their reports. So, a company still needs to inspect its financial statements closely, even though it uses GAAP.