Generally Accepted Accounting Principles or GAAP is the industry shorthand for a set of accounting standards and procedures followed by most businesses in the United States. A business that needs to be evaluated by third parties should strongly consider using GAAP to streamline those evaluations.
GAAP standards are utilized by both public and private companies to stay abreast of their financial performance and for tax purposes. These ideals improve clarity and consistency in communicating a business’s financial situation.
If you believe your small business may eventually be subject to GAAP, you may want to adopt these values as early as possible. If you have intentions of selling someday, you should strongly consider conforming with GAAP. Understanding the individual principles will assist you in vetting the right people to advance you on this path.
This article walks you through each of these concepts so you can determine how best to apply these within your organization.
Principle of Regularity
The principle of regularity states that GAAP compliance happens throughout the entire accounting period. Individuals cannot pick and choose which accounting methods they use period by period for their financial statements.
Accountants must adhere to these generally accepted accounting principles provided by the Financial Accounting Standards Board or FASB. Then they must ensure these procedures remain consistent thereafter.
Principle of Consistency
The accounting team should adhere to the same practices across all internal income statements during all accounting periods. This process ensures consistency when comparing multiple periods.
Accountants must explain any variability in this process within the footnotes of the income statement.
Principle of Sincerity
Accountants should remain unbiased with the utmost goal of providing an accurate and objective depiction of the company’s financial health.
An objective perspective provides great significance to an organization. Many businesses choose to employ independently audited financial statements.
Principle of Permanence of Methods
The principle of permanence requires identical financial reporting methods applied throughout each accounting period.
This principle aims to increase clarity around a business’s financial statements and prevent switching methods to get more favorable-looking results.
Principle of Non-Compensation
Per this principle, accountants must report all positive and negative values within the financial statements with complete transparency without attempting to hide debts behind assets or costs behind revenue.
Principle of Prudence
Financial data should be gathered and reported “as is” without speculation or adjustments. A prudent or conservative approach ensures the company’s financial performance is not inflated.
Principle of Continuity
Accountants who are producing financial statements that conform with GAAP work under the assumption that the business will continue its operations indefinitely.
This assumption means that assets are priced at their historical value or original cost rather than their current value.
Principle of Periodicity
All financial entries are distributed across the appropriate accounting periods. This principle prevents stretching periods or numbers to adjust the final numbers within a financial report.
For example, if your business provides a service like auto repairs. You may complete the work on the car in November, but the insurance doesn’t pay until December. If you are an accrual-based company, the revenue for the job must show up in November on your financial statements because that’s when your business earned this money.
Principle of Materiality
A material event is anything that affects a company’s financial standing. Therefore accountants must provide full financial disclosure and report all financial data to the best of their ability.
The materiality principle also allows the accountant to use leeway to GAAP principles and use their best judgment when recording a transaction or addressing an error.
Principle of Utmost Good Faith
This principle comes from the Latin phrase “uberrimae fidei.” It means accountants and business managers should act in good faith by honestly recording transactions and collecting financial data.
Although optional for non-publicly traded companies, GAAP is viewed favorably by banks and creditors. Most financial institutions will require annual GAAP compliant financial statements as a part of their debt covenants when issuing business loans.
These principles are important because they provide an accounting team with the framework for reporting and analyzing data. It keeps all organizations on a level playing field for benchmarking. On the other hand, if each business reported its financials differently, it would be challenging to compare metrics.
On a final note, as a small business owner, it is essential to understand the basic concepts involved in these common accounting principles to understand e your accountant’s viewpoint. This information will help interpret the bigger picture and detect potential hurdles when considering any changes further down the road.
At FINSYNC we know the decision to hire good accountants is crucial. This is why we have personally vetted a network of thousands of accountants and bookkeepers.