RODRIGUEZ, Marion Patricia L.

4LM3

Generally Accepted Accounting Principles (GAAP)

GAAP is a cluster of accounting standards and common industry usage that have been
developed over many years. It is used by organizations to: (Bragg, 2017)
 Properly organize their financial information into accounting records;
 Summarize the accounting records into financial statements; and
 Disclose certain supporting information
The Generally Accepted Accounting Principles are a common set of accounting principles,
standards and procedures that companies must follow when they compile their financial
statements. GAAP is a combination of authoritative standards (set by policy boards) and the
commonly accepted ways of recording and reporting accounting information. It also improves the
clarity of communication of financial information.

Main Accounting Principles

1. Economic Entity Assumption
The accountant keeps all of the business transactions of a sole proprietorship separate from
the business owner's personal transactions. For legal purposes, a sole proprietorship and its owner
are considered to be one entity, but for accounting purposes they are considered to be two separate
entities.

2. Monetary Unit Assumption

Economic activity is measured in U.S. dollars, and only transactions that can be expressed
in U.S. dollars are recorded.

Because of this basic accounting principle, it is assumed that the dollar's purchasing power
has not changed over time. As a result, accountants ignore the effect of inflation on recorded
amounts. For example, dollars from a 1960 transaction are combined (or shown) with dollars from
a 2017 transaction.
3. Time Period Assumption
This accounting principle assumes that it is possible to report the complex and ongoing
activities of a business in relatively short, distinct time intervals such as the five months ended
May 31, 2017, or the 5 weeks ended May 1, 2017. The shorter the time interval, the more likely
the need for the accountant to estimate amounts relevant to that period. For example, the property
tax bill is received on December 15 of each year. On the income statement for the year ended
December 31, 2016, the amount is known; but for the income statement for the three months ended
March 31, 2017, the amount was not known and an estimate had to be used.

It is imperative that the time interval (or period of time) be shown in the heading of each
income statement, statement of stockholders' equity, and statement of cash flows. Labeling one of
these financial statements with "December 31" is not good enough–the reader needs to know if the
statement covers the one week ended December 31, 2017 the month ended December 31, 2017
the three months ended December 31, 2017 or the year ended December 31, 2017.

4. Cost Principle
From an accountant's point of view, the term "cost" refers to the amount spent (cash or the
cash equivalent) when an item was originally obtained, whether that purchase happened last year
or thirty years ago. For this reason, the amounts shown on financial statements are referred to
as historical cost amounts.

Because of this accounting principle asset amounts are not adjusted upward for inflation.
In fact, as a general rule, asset amounts are not adjusted to reflect any type of increase in value.
Hence, an asset amount does not reflect the amount of money a company would receive if it were
to sell the asset at today's market value. (An exception is certain investments in stocks and bonds
that are actively traded on a stock exchange.) If you want to know the current value of a company's
long-term assets, you will not get this information from a company's financial statements–you need
to look elsewhere, perhaps to a third-party appraiser.
5. Full Disclosure Principle
If certain information is important to an investor or lender using the financial statements,
that information should be disclosed within the statement or in the notes to the statement. It is
because of this basic accounting principle that numerous pages of "footnotes" are often attached
to financial statements.

As an example, let's say a company is named in a lawsuit that demands a significant amount
of money. When the financial statements are prepared it is not clear whether the company will be
able to defend itself or whether it might lose the lawsuit. As a result of these conditions and because
of the full disclosure principle the lawsuit will be described in the notes to the financial statements.

A company usually lists its significant accounting policies as the first note to its financial
statements.

6. Going Concern Principle

This accounting principle assumes that a company will continue to exist long enough to
carry out its objectives and commitments and will not liquidate in the foreseeable future. If the
company's financial situation is such that the accountant believes the company will not be able to
continue on, the accountant is required to disclose this assessment.
The going concern principle allows the company to defer some of its prepaid expenses until future
accounting periods.

7. Matching Principle
This accounting principle requires companies to use the accrual basis of accounting. The
matching principle requires that expenses be matched with revenues. For example, sales
commissions expense should be reported in the period when the sales were made (and not reported
in the period when the commissions were paid). Wages to employees are reported as an expense
in the week when the employees worked and not in the week when the employees are paid. If a
company agrees to give its employees 1% of its 2017 revenues as a bonus on January 15, 2018,
the company should report the bonus as an expense in 2017 and the amount unpaid at December
31, 2017 as a liability. (The expense is occurring as the sales are occurring.)
 Because we cannot measure the future economic benefit of things such as advertisements
(and thereby we cannot match the ad expense with related future revenues), the accountant charges
the ad amount to expense in the period that the ad is run.

8. Revenue Recognition Principle

Under the accrual basis of accounting (as opposed to the cash basis of
accounting), revenues are recognized as soon as a product has been sold or a service has been
performed, regardless of when the money is actually received. Under this basic accounting
principle, a company could earn and report $20,000 of revenue in its first month of operation but
receive $0 in actual cash in that month.

For example, if ABC Consulting completes its service at an agreed price of $1,000, ABC
should recognize $1,000 of revenue as soon as its work is done—it does not matter whether the
client pays the $1,000 immediately or in 30 days. Do not confuse revenue with a cash receipt.

9. Materiality
Because of this basic accounting principle or guideline, an accountant might be allowed to
violate another accounting principle if an amount is insignificant. Professional judgement is
needed to decide whether an amount is insignificant or immaterial.

An example of an obviously immaterial item is the purchase of a $150 printer by a highly

profitable multi-million dollar company. Because the printer will be used for five years,
the matching principle directs the accountant to expense the cost over the five-year period.
The materiality guideline allows this company to violate the matching principle and to expense the
entire cost of $150 in the year it is purchased. The justification is that no one would consider it
misleading if $150 is expensed in the first year instead of $30 being expensed in each of the five
years that it is used.

Because of materiality, financial statements usually show amounts rounded to the nearest
dollar, to the nearest thousand, or to the nearest million dollars depending on the size of the
company.
10. Conservatism
If a situation arises where there are two acceptable alternatives for reporting an item,
conservatism directs the accountant to choose the alternative that will result in less net income
and/or less asset amount. Conservatism helps the accountant to "break a tie." It does not direct
accountants to be conservative. Accountants are expected to be unbiased and objective.

The basic accounting principle of conservatism leads accountants to anticipate or disclose

losses, but it does not allow a similar action for gains. For example, potential losses from lawsuits
will be reported on the financial statements or in the notes, but potential gains will not be reported.
Also, an accountant may write inventory down to an amount that is lower than the original cost,
but will not write inventory up to an amount higher than the original cost. (Harold Avercamp CPA)

GAAP is only standards. Although these principles work to improve the transparency in
financial statements, they do not provide any guarantee that a company’s financial statements are
free from errors or omissions that are intended to mislead investors. There is a plenty of room
within GAAP for unethical accountant to distort figures. So, even when a company uses GAAP,
you still need to scrutinize its financial statements. (Investopedia)

References:
Bragg, S. (2017, December 19). What is GAAP. Retrieved from Accounting Tools :
https://www.accountingtools.com/articles/what-is-gaap.html

Harold Avercamp CPA, M. (n.d.). Accounting Principles. Retrieved from Accounting Coach :
https://www.accountingcoach.com/accounting-principles/explanation

Investopedia. (n.d.). Generally Accepted Accounting Principles- GAAP. Retrieved from

Investopedia: https://www.investopedia.com/terms/g/gaap.asp