Generally accepted accounting principles
Generally Accepted Accounting Principles (GAAP) is the standard framework of guidelines for financial accounting. It includes the standards, conventions, and rules accountants follow in recording and summarizing transactions, and in the preparation of financial statements.
One key aspect of GAAP is an emphasis of "general" as a conceptual realization of variables in method. GAAP therefore accommodates variation in applied accounting methods as long as the methods generally adhere to this set of principles, which are more broad than specific.
GAAP creates an environment in which financial reporting can vary depending on purpose. One company in one fiscal year can produce different reports, all completed within GAAP, for different audiences or different purposes, and all these reports can be considered correct.
Also, a company may report financial performance considered acceptable by the accounting firm that produced the review; yet upon closer investigation oddities may be revealed that require a restatement of all or part of the report. Recently (2006 - 2007) well known corporations such as Apple and Research In Motion have had to restate certain aspects of their financial reports that had previously been presented as accurate yet met with disagreement as to their adherence to certain "best practices".
Overview
Financial accounting information must be assembled and reported objectively. Third-parties who must rely on such information have a right to be assured that the data are free from bias and inconsistency, whether deliberate or not. For this reason, financial accounting relies on certain standards or guides that are called "General Accepted Accounting Principles" (GAAP).
Principles also derive from tradition, such as the concept of matching. In any report of financial statements (audit, compilation, review, etc.), the preparer/auditor/CPA must indicate to the reader whether or not the information contained within the statements complies with GAAP.
- Principle of regularity: Regularity can be defined as conformity to enforced rules and laws. This principle is also known as the Principle of Consistency.
- Principle of sincerity: According to this principle, the accounting unit should reflect in good faith the reality of the company's financial status.
- Principle of the permanence of methods: This principle aims at allowing the coherence and comparison of the financial information published by the company.
- Principle of non-compensation: One should show the full details of the financial information and not seek to compensate a debt with an asset, a revenue with an expense, etc.
- Principle of prudence: This principle aims at showing the reality "as is" : one should not try to make things look prettier than they are. Typically, a revenue should be recorded only when it is certain and a provision should be entered for an expense which is probable.
- Principle of continuity: When stating financial information, one should assume that the business will not be interrupted. This principle is mitigating the previous one about prudence: assets do not have to be accounted at their disposable value, but it is accepted that they are at their historical value (see depreciation).
- Principle of periodicity: Each accounting entry should be allocated to a given period, and split accordingly if it covers several periods. If a client pre-pays a subscription (or lease, etc.), the given revenue should be split to the entire time-span and not counted for entirely on the date of the transaction.
Practical Example: FIFO and LIFO accounting and Inventory Management
As an example of variation in managing a corporation's assets, consider inventory in the form of finished products that are stocked for sale. If ABC Corporation has acquired 1,000 units of widget Z for sale, and demand slows before half the supply has been sold, ABC Corporation might have to buy another 1,000 units. The last portion of the first purchase is older than the quantity of the 2nd purchase. If a customer walks into ABC Corporation's retail store and requests a unit of widget Z, should the corporation go back into the warehouse and come out with widget Z from the first purchase batch ("first in, first out" or "FIFO"), or from the 2nd ("last in, first out" or "LIFO")? The answer is, it depends.
Units remaining from the first batch have probably been depreciated for a longer period of time than the units in the second batch. As such, the residual value of the units from the 1st batch would be lower than that of the 2nd. Selling from the first batch might therefore make more profit. This is, in part, why older merchandise can be sold at discount, since there's less intrinsic value to recoup. The problem with this, though, is that an older unit might not be as reliable if it has aged significantly to affect performance. This can result in lowered customer satisfaction and brand erosion in the marketplace.
There are, of course, many further implications to be considered, the above example being very simplistic. The key concept to appreciate is that both FIFO and LIFO are within GAAP, and any company may base its inventory management strategy in whole or in part on a mix of these two seemingly opposite approaches - yet again, all are within GAAP.
National GAAP
Every country has its own standard accounting practice version of GAAP with standards set by a national governing body.
International GAAP
Many countries use or are converging on the International Financial Reporting Standards, established and maintained by the International Accounting Standards Committee.
See also
- International Financial Reporting Standards
- Generally Accepted Accounting Principles (USA)
- Generally Accepted Accounting Principles (UK)
- Generally Accepted Accounting Principles (Canada)
- Chinese accounting standards