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Generally Accepted Accounting Principles (United States)

In the U.S., generally accepted accounting principles, commonly abbreviated as US GAAP or simply GAAP, are accounting rules used to prepare, present, and report financial statements for a wide variety of entities, including publicly-traded and privately-held companies, non-profit organizations, and governments. Generally GAAP includes local applicable Accounting Framework, related accounting law, rules and Accounting Standard.

Similar to many other countries practicing under the common law system, the United States government does not directly set accounting standards, in the belief that the private sector has better knowledge and resources. US GAAP is not written in law, although the U.S. Securities and Exchange Commission (SEC) requires that it be followed in financial reporting by publicly-traded companies. Currently, the Financial Accounting Standards Board (FASB) is the highest authority in establishing generally accepted accounting principles for public and private companies, and men as well as non-profit entities. For local and state governments, GAAP is determined by the Governmental Accounting Standards Board (GASB), which operates under a set of assumptions, principles, and constraints, different from those of standard private-sector GAAP. Financial reporting in federal government entities is regulated by the Federal Accounting Standards Advisory Board (FASAB).

  • The US GAAP provisions differ somewhat from International Financial Reporting Standards (IFRS), though former SEC Chairman Chris Cox set out a timetable for all U.S. companies to drop GAAP by 2016, with the largest companies switching to IFRS as early as 2009.

History

Auditors took the leading role in developing GAAP for business enterprises.[2] Circa 2008, the FASB issued the FASB Accounting Standards Codification, which reorganized the thousands of US GAAP pronouncements into roughly 90 accounting topics[3] In 2008, the Securities and Exchange Commission issued a preliminary "roadmap" that may lead the U.S. to abandon Generally Accepted Accounting Principles in the future (to be determined in 2011), and to join more than 100 countries around the world instead in using the London-based International Financial Reporting Standards.[1]

Basic objectives

Financial reporting should provide information that is:

  • useful to present to potential investors and creditors and other users in making rational investment, credit, and other financial decisions.
  • helpful to present to potential investors and creditors and other users in assessing the amounts, timing, and uncertainty of prospective cash receipts.
  • about economic resources, the claims to those resources, and the changes in them.

Basic concepts

To achieve basic objectives and implement fundamental qualities GAAP has four basic assumptions, four basic principles, and four basic constraints.

Assumptions

  • Business Entity: assumes that the business is separate from its owners or other businesses. Revenue and expense should be kept separate from personal expenses.
  • Going Concern: assumes that the business will be in operation indefinitely. This validates the methods of asset capitalization, depreciation, and amortization. Only when liquidation is certain this assumption is not applicable.
  • Monetary Unit principle: assumes a stable currency is going to be the unit of record. The FASB accepts the nominal value of the US Dollar as the monetary unit of record unadjusted for inflation.
  • The Time-period principle implies that the economic activities of an enterprise can be divided into artificial time periods.

Principles

  • Cost principle requires companies to account and report based on acquisition costs rather than fair market value for most assets and liabilities. This principle provides information that is reliable (removing opportunity to provide subjective and potentially biased market values), but not very relevant. Thus there is a trend to use fair values. Most debts and securities are now reported at market values.
  • Revenue principle requires companies to record when revenue is (1) realized or realizable and (2) earned, not when cash is received. This way of accounting is called accrual basis accounting.
  • Matching principle. Expenses have to be matched with revenues as long as it is reasonable to do so. Expenses are recognized not when the work is performed, or when a product is produced, but when the work or the product actually makes its contribution to revenue. Only if no connection with revenue can be established, cost may be charged as expenses to the current period (e.g. office salaries and other administrative expenses). This principle allows greater evaluation of actual profitability and performance (shows how much was spent to earn revenue). Depreciation and Cost of Goods Sold are good examples of application of this principle.
  • Disclosure principle. Amount and kinds of information disclosed should be decided based on trade-off analysis as a larger amount of information costs more to prepare and use. Information disclosed should be enough to make a judgment while keeping costs reasonable. Information is presented in the main body of financial statements, in the notes or as supplementary information

Constraints

  • Objectivity principle: the company financial statements provided by the accountants should be based on objective evidence.
  • Materiality principle: the significance of an item should be considered when it is reported. An item is considered significant when it would affect the decision of a reasonable individual.
  • Consistency principle: : It means that the company uses the same accounting principles and methods from year to year.
  • Prudence principle: when choosing between two solutions, the one that will be least likely to overstate assets and income should be picked (see convention of conservatism).

Required Departures from GAAP

Under the AICPA's Code of Professional Ethics under Rule 203 - Accounting Principles, a member must depart from GAAP if following it would lead to a material misstatement on the financial statements, or otherwise be misleading. In the departure the member must disclose, if practical, the reasons why compliance with the accounting principle would result in a misleading financial statement. Under Rule 203-1-Departures from Established Accounting Principles, the departures are rare, and usually take place when there is new legislation, the evolution of new forms of business transactions, an unusual degree of materiality, or the existence of conflicting industry practices.[4]