Generally accepted accounting principles (GAAP) also called “gold standard” in financial reporting refer to a common set of accounting principles, standards, and procedures issued by the Financial Accounting Standards Board (FASB). Public complaints in the United States must follow GAAP when their accountants compile their financial statements. GAAP is a combination of authoritative standards and the commonly accepted ways of recording and reporting accounting information. GAAP aims to improve the clarity, consistency, transparency and comparability of financial information for better communication among the stakeholders.
GAAP may be contrasted with proforma accounting, which is a non-GAAP financial reporting method. Internationally financial reporting standards (IFRS) are equivalent to GAAP in the United States. IFRS is followed in over 120 countries including Nepal (NASB issued NFRS in 2013), however US still follows the GAAP.
GAAP helps govern the world of accounting according to general rules and guidelines. It attempts to standardize and regulate the definition, assumptions, and methods used in accounting across all industries. GAAP covers such topics such as revenue recognition, balance sheet classification, and materiality.
The ultimate goal is GAAP is to ensure a company’s financial statements are complete, consistent, and comparable. This makes it easier for investors to analyze and extract used information from the company’s financial statements, including trend data over a period of time. It also facilitates the comparison of financial information across different companies.
The general concepts of GAAP:
- Principle of Regularity
- Principle of Consistency
- Principle of Sincerity
- Principle of Performance of Methods
- Principles of Non-Compensation
- Principle of Prudence
- Principle of Continuity
- Principle of Periodicity
- Principle of Materiality/ Good Faith
- Principle of Utmost Good Faith
There are four fundamental features to GAAP:
- Relevance: All information required for decision making must be present on financial statements. Nothing should be omitted or misstated of it would cause the interpretation of the statements to change. The information must also be prepared in a timely manner.
- Reliability: All information must be free of error and bias. Information must be objective and be verifiable.
- Understand ability: Readers of the financial statements must be able to understand the reports. Companies will usually provide an extensive set of notes to accompany financial statements.
- Comparability: A company’s financial statements should be comparable from year to year. Financial statements will usually have last year’s financial printed alongside this year’s financials.
Basis Accounting Concepts
Accounting is based on certain assumptions. These assumptions are known as basic accounting concepts. Those basic accounting concepts are as follows:
Business Entity Concept
This concept states that the business and its owners are two separate and distinct entities. According to this concept, all transactions of the business have to be accounted for from the viewpoint of the business and not from the view point of owners. The distinction between the business and its owners is essential in order to ascertain the true picture of a business. If the two are not separated for accounting purposes, the transactions of the business will be mixed up with the personal transactions of its owners and true picture of the business cannot be obtained.
This concept assumes that only those business transactions that are measured and expressed in monetary terms have to be taken into account. It is so assumed because money provides a common measure for different good, services, assets and liabilities. This concept also assumes that monetary units such as ‘rupee’ are stable units in value, but this assumption may not be true in reality. Therefore, in spite of a decrease in the purchasing power of money, accounting is performed assuming that the value of money is stable over time.
Going Concern Concept
This concept implies that a business has an indefinite life and it exits for a long period of time. All business transactions are performed and recorded from the point of view. The long-term expenditures such as the purchase of land, building and machinery that the business makes are recorded in books of account assuming that it will exist and run for a over their estimated working lives. Therefore, the balance sheet always shows fixed assets at cost after subtracting the depreciation.
Cost is simply the monetary value of resource sacrificed or foregone to achieve a specific objective. This concept implies that the cost of anything such as service or an assets is recognized when it is incurred when the services or the assets is used to generate revenue. Besides, the concept assumes that the asset is taken into account at the cost of its purchase and not at its market value. This concept, however, does not mean that the cost of purchase appears in the books every year. Since as asset has a limited life, its cost is written off every year over its life. Thus, the books show the asset at the purchasing cost less its depreciation up-to-date.
The duality concept states very business transaction affects two different accounts and must be recorded accordingly. This concept is the basis of double entry accounting, which is required by all accounting frameworks in order to produce reliable finance statements. The concepts is derived from the accounting equation,
Accounting Period Concept
The accounting period concept implies that for the purpose of reporting financial information, the whole life of the business is divided into imaginary time-travels. Each time travel is called an accounting period which is normally of one year. In Nepal, it begins on the 1st of Shrawn every year and ends on the last day of Asadh, the next year. At the end of each accounting year, financial statements are drawn to ascertain the profit or loss and disclose the financial position of the business, and re reported to their users such as owners, managers and creditors.
This concept is also called revenue concept. The concept states that revenue is assumed to be earned when it is realized. According to the concept, revenue is realized when goods are transferred to the buyers and services are provided to the client for cash, or for assets or in anticipation of realizing the value of sales on a future date. It is not necessary that the revenue must be realized in cash. Besides, revenue is earned in the period when it realized. However, revenue is always net of goods returned from the customer and bad debts.
Accrual concept is the most fundamental principle of accounting which requires records revenues when they are earned and not when they are received in cash, and recording expenses when they are incurred and not when they are paid. GAAP allows preparation of financial statements on accrual basis only (and not cash basis). This is because under accrual concept revenues and expenses are recorded in the period to which they relate and not when they are received or paid. Application of accrual concept results in accurate reporting of net income, assets, liabilities and retained earnings which improves analysis of the company’s financial performance and financial position over different periods.
This concept provides guidelines as to how the profit or loss of a business should be determined. The concept, therefore, states that the revenue earned in a period has to be matched with the expenses incurred in the same period so as to find out the true profit or loss of the business. While matching the expenses with the revenue, the later should be realized first and then only the expenses relating to the revenue should be recognized. Any expense or revenue of the previous or the next year should not be matched with those of current year. If they are matched, the true profit or loss cannot be ascertained.
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