Generally accepted accounting principles

Generally accepted accounting principles, more commonly known as GAAP, are the mandated accounting standards used to ensure a basic level of financial reporting consistency among public companies.

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Expanded Definition

GAAP is the set of rules under which companies report their financial position to shareholders and the SEC. They are designed so that investors or analysts or regulators can look at the financial statements and understand how well the company performed over a certain period of time and be able to judge, at least approximately, what the company is worth.

The principles are broken down into two types: general and specific. The former are the broad outlines while the latter are the detailed rules.

General principles

These are the basic assumptions, concepts, and guidelines that dictate how financial statements are to be prepared.

Objectivity principle

The information presented is supported by independent, unbiased evidence. More than one preparer is needed to avoid bias. Intended to ensure verifiable information

Cost principle

Accounting is based on actual cost, either in cash spent or as an equal-to-cash.

Going-concern principle

This assumes that the company is viable and will continue to be so into the foreseeable future. One aspect is that assets are reported at cost instead of at liquidation value, as they would be if the firm was going out of business.

Monetary unit principle

Transactions can be expressed in units of money, such as the U.S. dollar, the euro, the yen, etc.

Revenue recognition principle

Provides guidance on when a company can record revenue as having been earned. Until it is earned, that is until the sale's terms are satisfied and there is an expectation of payment, any cash paid in advance is not revenue.

Business entity principle

The business is a stand-alone unit, separate from other businesses, including its owner. This covers the type of business, e.g. corporation, sole-proprietorship, or partnership.

Specific principles

These are too numerous to cover here, but they provide the actual rules companies must follow while adhering to GAAP. When exactly is revenue recognized? What if it's a long-term contract? What if you're building something for the customer? When are expenses recognized and matched to the revenue? What if the value of something becomes less than what was paid for it?

These principles answer those and many other questions.

Who sets the rules

In the U.S., the Financial Accounting Standards Board defines what GAAP is for companies trading on U.S. exchanges, while other bodies govern GAAP for other countries. There is a movement toward one global set of accounting standards.

Foreign firms follow the standards set by the International Accounting Standards Board.

Changes

As circumstances change, so does GAAP. For instance, several years ago, stock options were not counted as expense, even though Warren Buffett, among others, argued that they were indeed a compensation expense. Now, they must be deducted from revenue just like any other salary expense on the way to determining net income.