Generally Accepted Accounting Principles (GAAP) are an important part of financial company accounting in the United States. While they are not legally binding laws or norms, they do serve as well-established customs.
Following GAAP may guarantee that your company’s financial statements are recorded and updated in a calculated, safe, and trustworthy way, enhancing accountability and transparency and helping you to be better prepared for prospective investors or financiers.
What Exactly Is GAAP?
In the United States, GAAP is a collection of accounting processes and conventions that accounting policy bodies such as the Financial Accounting Standards Board (FASB) have identified as critical when examining a company’s day-to-day operations.
GAAP acts as a “guiding mechanism” for company owners to guarantee that their presentations, measurements, timing of recognition, and disclosure are both of exceptionally high quality and highly productive.
We have listed the ten key GAAP principles for your organisation below. They all serve a similar function and adhere to a highly cohesive and almost identical worldview. GAAP seeks to enable business owners to communicate their company’s financial data in an educated, consistent, and dependable manner that can be readily assessed by any reader – whether or not they are professional accountants.
Accounting Principles to Apply in Your Small Business
1. Assumption of an Economic Entity
The economic entity assumption concept differentiates a person’s company from themselves and emphasises the significance of treating them as two independent financial entities in a financial accounting environment.
In practise, this implies that the financial information for transactions made by a specific firm should be recorded (and so reported) totally and independently from any financial transactions made by the business’s owner(s) — or any other third-party or related organisation.
2. Historical Price
The historical cost principle states that all company transactions must be reflected on a financial statement at their original (or “historical”) cost.
The explanation for this is simple: as previously said, accountants prefer to estimate in a “conservative” or “glass half full” manner. You never want to be in a situation where you knowingly overpromise and underperform when providing your financial data to other parties, because from an accounting standpoint, there is no precise method of knowing what your asset is truly worth until you sell it.
Because you don’t want to report a loss on your financial statement that isn’t necessary, and you certainly don’t want to pay taxes on revenue that your company hasn’t actually received, you should adhere to the historical cost principle, which states that the value of a purchased asset should not be changed until it is actually sold.
3. Reliability
The measurement principle, often known as the objectivity notion, argues that all data collected by a firm should always be objective, devoid of bias, and verifiable.
This guarantees that a company’s financial statements stay consistent and dependable, which can subsequently be utilised to properly anticipate its future performance by prospective investors and outside parties.
4. monetary unit
The monetary unit principle basically states that all financial transactions recorded inside a firm must be expressed: a) as a monetary currency and b) in the same currency (e.g., the US dollar).
This is to discourage accountants from recording information in different currencies — which all have different values and would make for a very complicated and non-delineative read — and to ensure that there is always a common “monetary unit” that individuals can use when tracking a business’s financial transactions.
5. Recognizing Revenue
According to the revenue recognition accounting concept, if a company sells a product or service, it should record the sale promptly (rather than when they actually receive payment).
This is due to the fact that, in an accounting context, cash is not necessarily synonymous with revenue. The revenue recognition concept indicates that once a product or service is given, a company has already “earned” the revenues connected with that offering.
The actual payment (which may be processed and received days, weeks, or even months later) is seen as just confirmation of what a company already knows it is entitled to.
Consider the situation of an employee who is paid weekly at work for context purposes. From Monday through Friday, the individual will have “earned” a certain amount of money, even if it will not be in his bank account right away.
Businesses follow the same logic; revenue should be reported when sales are completed in compliance with GAAP. This is due to the fact that the availability of revenue in a business can have a significant impact on its future options and should thus be recorded as accurately and quickly as possible.
6. Accounting Period
This GAAP concept is similar to the one above in that it is interested in the time period after the period in which transactions are performed, but it does not concentrate just on revenues.
According to the accounting period principle, each transaction should be documented in the precise time period in which it occurred. This enables prospective shareholders and future investors to precisely examine a company’s previous (or future) performance, which, if done correctly, may have a significant impact on its chances of securing external finance.
7th. The Matching Principle
The GAAP matching concept was developed to guarantee that all costs inside a corporation are recognised (and hence reported) in the same time range as the revenues that they contributed to.
Expense records, of course, are not real payments. On the contrary, they serve as “evidence” of a monetary right gained by a company as a consequence of providing a certain product or service to a person or a corporation.
This implies that enterprises should record costs when they occur, rather than when they are paid for at a later period.
8th. Ongoing Business
The continuing concern concept assumes that firms will not become bankrupt or insolvent in the foreseeable future and will continue to function practically forever (or at least, for a long enough period of time to fulfil their current objectives and financial commitments).
The reason for this is self-explanatory, and it has to do with foreign money. If we anticipate that X firm will not be running within the next year or two, it will be difficult to find a financier (such as a bank) ready to provide them a loan.
Similarly, it would (theoretically) be similarly impossible for X firm to execute prepaid costs, since no one would probably allow a company to delay payments to a future period unless they were satisfied that the company would still be stable and functioning at that moment.
9. Conservative Restriction
As a business owner or accountant, the last thing you want to do is promote a component of your company as being financially better off than it is and, maybe more crucially, than you can really show. This may have serious consequences, which is why (usually speaking) accountants use a pessimistic or “glass half empty” attitude when recognising and documenting a company’s assets.
This holistic accounting “thought” penetrates other GAAP ideas as well, such as the historical cost principle. Once again, its significance stems from the need to ensure that a company’s financial statements and documentation are constantly presented in a dependable, consistent, and transparent manner.
10. substance
In accounting, the idea of materiality evaluates the impact of erroneous and misleading data on the “reasonable” reader, specifically how the exclusion (or inclusion) of such important information would pragmatically alter that reader’s judgement of a company’s past and future predictions.
This implies that, under the materiality principle, accountants or small company owners are urged to use reasonable judgement in determining whether information is relevant, taking both quantitative and qualitative factors into consideration.
Despite the fact that the vast majority of materiality judgments in the United States have traditionally involved quantitative elements, it should be noted that the nature of an omitted transaction may render it material even if the actual amount is objectively immaterial.
For example, if an accountant or small company owner omits a transaction that, although little, is significant in shifting a profit to a loss or compliance to non-compliance (e.g., with ratios in a debt covenant), it is still regarded substantial.
Similarly, the nature of the transaction might have a significant impact on whether it is regarded substantial or immaterial. Transactions that would be deemed very inconsequential if they happened as part of a normal review are almost always considered substantial if they happen as part of a special corporate endeavour.
Why Is GAAP Important for My Company?
According to the Securities and Market Commission, publicly traded firms’ financial statements are required by law to produce GAAP-compliant financial statements on a regular basis in order to stay publicly listed on the US stock exchange (SEC).
Even though this is not the case for private enterprises, company owners who incorporate GAAP rules into their operations may reap significant benefits – particularly if they want to grow utilising external finance in the future.
This is because GAAP-compliant financial statements not only promote a company’s brand image and prestige to prospective investors, but they are also given in a fashion that traditional lenders can understand and analyse. This might guarantee that you get off to a good start straight away.
In the long run, you will also be well-positioned to convert into a publicly listed model if that is something you wish to do, since you will already be meeting all legal requirements (at least in relation to your bookkeeping and accounting).
Other advantages of GAAP for your company include:
More risk: Investors are often wary of financial statements that are not produced in accordance with GAAP since they are seldom directly comparable with those of other firms (even within the same sector).
Increased access to business financing: When giving business loans, many financial institutions demand yearly GAAP-compliant financial statements as part of their debt covenants.
State GAAP Requirements
Discovering how many state and local governments in the United States are obligated to use GAAP when creating audited reports has historically been one of the most often asked inquiries about governmental reporting standards and accounting methods.
At the same time, it has been incredibly difficult to respond correctly since there was no concrete estimate of how many of the 87,575 non-federal government bodies in the United States really implemented GAAP (and to what extent).
In 2008, the Governmental Accounting Standards Board (GASB) performed a research that looked at the proportion of states that required GAAP compliance, taking into consideration each state’s total population, expenditures, revenues, and enrollment (for school districts).
GASB was ultimately able to cast some light on the aforementioned problem based on the ratios discovered — that is, the proportion of a state’s county governments, municipal governments, and independent school districts that were either required or not obliged to comply with GAAP.
For the sake of clarity, we have divided all 50 US states into four GAAP groups, which are as follows:
Completely Compliant
Generally Compliant
Infrequently Compliant
Non-Compliance
Keep in mind that the findings of the study are relatively limited for a variety of reasons. For example, GASB discovered that, although certain states seem to be “completely compliant” with GAAP in legislation, this was not carried out in reality, and no enforcement mechanism measures were in place (or implemented) to correct this.
Similarly, the survey found that even in places where GAAP compliance was not required by law, it was nonetheless observed in practise. For example, more than half of California’s local governments obtained the Government Finance Officers Association’s Certificate of Achievement or Excellence in Financial Reporting in 2005, requiring complete GAAP compliance.
States that are fully compliant
Arizona
Colorado
Connecticut
Georgia
Hawaii
Kentucky
Louisiana
Maine
Maryland
Massachusetts
Minnesota
State of New Mexico
North Carolina (NC)
Virginia
Wisconsin
Utah
States that are mostly compliant
Delaware
Florida
Mississippi
Nevada
Ohio
Tennessee
States That Are Rarely Compliant
Arkansas
California
Iowa
Montana
Nebraska
State of New Hampshire
Newark, New Jersey
Oregon
Pennsylvania
Providence, Rhode Island
South Carolina (SC)
South Dakota (SD)
Texas
Wyoming
States that are not compliant
Alabama
Alaska
Idaho
Illinois
Indiana
Kansas
Michigan
Missouri
New York City
Dakoda, North
Oklahoma
Vermont
In Washington, D.C.,
West Virginia (WV)