Generally Accepted Accounting Principles (GAAP) is a set of rules and standards that govern the field of accounting. If a company distributes its financial statements (Income Statement and Balance Sheet) to the public, it must follow the GAAP while preparing its financial statements to ensure the information contained is consistent and accurate. The Generally Accepted Accounting Principles make it easier for investors to analyze the financial statements and make decisions whether they want to do business with the company. By using GAAP, we can compare one’s company financial statements to others in the same industry because the same accounting methods and principles are being used. Following is the list of ten accounting principles.
1. Business Entity Assumption
Business entity assumption states that owner and business are two separate entities. The business has its own financial status. The personal transactions of a business owner should be kept separated from the business transactions. When recording the business transactions, any personal expenditure of the owner should be charged to the owner (Drawing Account). Similarly, if the owner has two businesses, say a hotel and a real estate, there should be separate accounting records for each division. The expenses of hotel cannot be recorded in th real estate business. This concept is also known as economic entity assumption.
2. Monetary Unit Assumption
This assumption specifies a currency for reporting financial statements. The monetary unit is universally recognized for communicating financial information. Through monetary unit we can easily and effectively record, classify, summarize, analyze and interpret the financial data. Most of companies use dollar currency because it is stable in value and available everywhere. This assumption also gives a consistent method of comparing the results of one firm with other firms.
3. Time Period Assumption
The time period assumption suggests that the accounting process of a business should be completed within a certain time period which is known as financial period. This concept allows us to prepare financial statements on a monthly, quarterly or annual basis. Once the financial period has been decided, the accountant uses GAAP to record and report financial statements accordingly. The time period concept is important because without the application of it, the business will not be able to issue financial reports on time.
4. Matching Principle
The companies use the accrual basis of accounting method for application of matching principle. According to the matching principle, expenses have to be matched with revenues. For example, salaries of employees should be recorded in the period in which the employees worked, not in the period in which they were paid. Similarly, sales commission expense should be recorded in the period when the sales were made, not in the period when the sales commissions were paid.
5. Historical Cost
The historical principle states that companies must record assets in their balance sheet with the value at which they were purchased rather than current market value. It means, the cost of asset can never be adjusted due to change in market value. For example, a land purchased in 1995 at a cost of Rs. 1500000 and still owned by the owner. So, according to historical cost principle, the land should be reported in the balance sheet with the value of original cost of Rs. 1500000 even though the current cost is much higher.
6. Going Concern Principle
The going concern principle states that the business will continue to operate for an indefinite period of time and not to liquidate the business. A company is going concern, if there is no evidence that it will cease its operations in foreseeable future. The example of going concern is prepayment and accrual of expenses. The company prepays and accrues expenses because it believes that it will continue operations in future. The going concern principle is applied to business as a whole. For instance, an enterprise discontinues one of its product and continues with others, it does not mean that the enterprise is no longer a going concern because the going concern assumption is applicable to the business as a whole not to a particular product.
7. Full Disclosure Principle
The financial statements are primarily prepared for shareholders of the entity. The full disclosure principle requires the entity to disclose all the financial information related to the business. The information may be pending lawsuits, tax disputes, incomplete transactions or change in depreciation or inventory method. It is important to disclose all these and other information which may have significant effects on the company's financial status. These information may be disclosed either in footnotes of the financial statements or in the supplemental information to the financial statements. For example, if the account on the balance sheet is unclear, the notes can be used to explain it. This way, the investors and creditors can see the bigger picture of the company’ before taking any decision.
8. Revenue Recognition Principle
This principle states that revenue is earned and recognized when the product is sold or service is completed regardless of when the cash is actually received. For example, a company sells goods of Rs. 1220000 in January, so the sales revenue of January will be the same amount of Rs. 1220000 even the company does not receive cash in January. This sales revenue amount will be recorded as Account Receivable till the amount is fully received. Similarly, a consulting company receives Rs. 10000 for consulting services but according revenue recognition principle the company cannot recognize the money as income until it provides services of Rs. 10000. So, this amount will be recorded as unearned income till the service is completed.
9. Materiality Principle
The material principle suggests that an accounting standard can be ignored. For example, the organization purchases a fixed asset, the matching principle suggests the organization to recognize the expenditure over the useful life of the asset. But on the other hand, if the organization purchases a register for Rs. 400 and the turnover of such an organization in million rupees, it would be immaterial to the reader of financial statements whether such a register is recognized as an asset or expense.
Another example may be an entity paid prepaid rent of Rs. 12000 for six months. Under matching principle, the entity should charge Rs. 2000 for each month. However, if the entity turnover in million rupees, the amount of rent expense would be so small that no user of the financial statements would be mislead if the entity charge the entire amount (Rs. 12000) to expense in the current period.
The materiality concept differs based on the size of the organization. Some financial information may be material to one entity but may be immaterial to other. For example, the big entity may consider Rs. 15000 transaction immaterial but small the entity may consider it material.
Under materiality principle certain items may also be omitted, if their impact is immaterial to the financial statements. But for this, an accountant needs to exercise judgment if the transaction is immaterial (unimportant).
If there is a situation in which an accountant has to choose between two alternatives for reporting an item, the conservatism suggests the accountant to select the alternative that will result in less net income. In the same way, if the choice of outcome will affect the value of an asset, recognize the transaction that will lower the value of the asset. Under conservatism principle, the potential losses should be disclosed. Therefore provision for bad debts is made. But potential gains should not be reported until they actually earned.