What is GAAP?
In order to learn accounting, understand certain transactions, and analyze financial statements, it is important to take a step back and study the accounting principles that are underneath all of the debits and credits. Learning the accounting principles will not only help you understand basic accounting, it will help you analyze transactions in the future. Let’s take a basic look at how US accounting standard are made and who makes them.
In the world of financial accounting, there are many different rules, concepts, and guidelines that govern how companies should account for financial transactions and present their financial statements. These rules and concepts are called generally accepted accounting principles or GAAP. Every private company that issues financial statements to the public, must follow the rules of GAAP. This is useful because it maintains accounting consistancy through years and across companies. This way an investor can compare a 2011 balance sheet of one company to the 2011 balance sheet of another company. The numbers and ratios will be meaningful because both companies used the same methods and techniques to prepare and present their balance sheets. GAAP is created by a private, independent seven-member board called the Financial Accounting Standards Board.
Soon after the stock crash in 1929, Congress designed to take action to help prevent investors from being deceived by fraudulent financial statements. Congress passed the Securities Exchange Acts of 1933 and 1934. These acts established the Security Exchange Commission or the SEC and give it the power to create accounting standards in the United States. The SEC realized that it was in its and the accounting industry’s best interest to keep accounting standard setting private. Thus, the SEC has declined, with a few minor exceptions, to create accounting standards. Instead, the SEC has allowed private organizations the opportunity to regular the accounting industry with principles and standards. There have been a few different organizations since 1933 that have established US accounting standards including the American Principles Board. In 1973 however, FASB was designated to be the only organization to establish private sectors accounting principles and standards in the United States. FASB’s mission is to “establish and improve standards of financial accounting and reporting that foster financial reporting by nongovernmental entities that provides decision-useful information to investors and other users of financial reports.”
While establishing GAAP, FASB was mainly concerned about the end users of financial statements. Who are the end users? End users include people like investors, banks, lenders who use third party financial statements to evaluate business decisions. For instance, an investor will look at a company’s financial statements in order to decide whether to invest. FASB wants to make consistent standards that help end users understand and use the company’s financial data. GAAP’s primary intent is not to help businesses. It is intended to help the end users. All of the objectives that FASB and the prior accounting standard setting bodies wanted to accomplish can be simplified to one main objective: to make financial statements universally understandable and usable for all of their users. Remember, GAAP only has to be used by private companies that issue financial statements. GAAP does not have to be used by a private company that makes internal financial statements.
Since FASB is concerned about financial statement usability, it had to define what makes a financial statement usable. FASB came up with the qualitative characteristics of accounting information to evaluate the usefulness of financial information.
Think of accounting principles as the rules for financial accounting. FASB established these principles based the three objectives that I mentioned earlier. These principles tell accountants and companies how to account for transactions and present financial statements. Here’s a small list of the main principles of accounting.
- Business Entity Concept
- Going Concern Concept
- Monetary Unit Assumption
- Periodicity Assumption
- Historical Cost Principle
- Revenue Recognition Principle
- Matching Principle
- Full Disclosure Principle
- Cost Benefit Principle
- Materiality Concept
- Industry Practices Constraint
- Conservatism Principle
- Objectivity Principle
- Consistency Principle