Definition of GAAP

GAAP is the acronym for generally accepted accounting principles. GAAP consists of the following:

 Basic underlying accounting principles, assumptions, and concepts such as the cost

principle, matching principle, full disclosure principle, and more.
 Detailed reporting standards and other rules established and organized by the Financial
Accounting Standards Board (FASB) in its Accounting Standards Codification (FASB ASC)

 Generally accepted industry practices

GAAP is short for Generally Accepted Accounting Principles. GAAP is a cluster of accounting
standards and common industry usage that have been developed over many years. It is used by
organizations to:

 Properly organize their financial information into accounting records ;

 Summarize the accounting records into financial statements ; and

 Disclose certain supporting information.

One of the reasons for using GAAP is so that anyone reading the financial statements of
multiple companies has a reasonable basis for comparison, since all companies using GAAP
have created their financial statements using the same set of rules.

Examples of the Basic Underlying Accounting Principles

The basic underlying accounting principles are:

 Economic Entity Assumption

 Going Concern Assumption
 Time Period Assumption
 Monetary Unit Assumption
 Cost Principle (or Measurement Principle)
 Matching Principle (or Expense Recognition Principle)
 Revenue Recognition Principle
 Full Disclosure Principle
 Industry Practices
In addition to the basic underlying accounting principles, there are various characteristics that also
guide accountants. Some of the characteristics include objectivity, conservatism, materiality,
cost/benefit, comparability, relevance, and timeliness.

Why GAAP is Important

In order for investors, bankers, financial analysts, portfolio managers, etc. to make informed
decisions, it is necessary to have financial statements that are consistent and which can be
compared to the financial statements of other corporations. This is more likely to occur when there
are common rules for financial reporting. When financial statements are distributed by a business or
other organization, the common rules that must be followed are known as generally accepted
accounting principles or GAAP.

What are Accounting Principles?

Accounting principles are the rules and guidelines that companies must follow
when reporting financial data. The Financial Accounting Standards Board (FASB)
issues a standardized set of accounting principles in the U.S. referred to
as generally accepted accounting principles (GAAP).1 Some of the most
fundamental accounting principles include the following:

 Accrual principle
 Conservatism principle
 Consistency principle
 Cost principle
 Economic entity principle
 Full disclosure principle
 Going concern principle
 Matching principle
 Materiality principle
 Monetary unit principle
 Reliability principle
 Revenue recognition principle
 Time period principle

CONCEPTS

 Principle of Regularity: GAAP-compliant accountants strictly adhere to

established rules and regulations.

 Principle of Consistency: Consistent standards are applied throughout the

financial reporting process.

 Principle of Sincerity: GAAP-compliant accountants are committed to

accuracy and impartiality.
  Principle of Permanence of Methods: Consistent procedures are used in the
preparation of all financial reports.

 Principle of Non-Compensation: All aspects of an organization’s

performance, whether positive or negative, are fully reported with no prospect
of debt compensation.

 Principle of Prudence: Speculation does not influence the reporting of

financial data.

 Principle of Continuity: Asset valuations assume the organization’s

operations will continue.

 Principle of Periodicity: Reporting of revenues is divided by standard

accounting time periods, such as fiscal quarters or fiscal years.

 Principle of Materiality: Financial reports fully disclose the organization’s

monetary situation.

 Principle of Utmost Good Faith: All involved parties are assumed to be

acting honestly.

Qualitative Characteristics of Useful Financial

Information
Fundamental qualitative characteristics
Fundamental qualitative characteristics are those whose absence makes financial
information no longer useful. Relevance and faithful representation are the fundamental
qualitative characteristics.
Relevance gives financial information the capability of making a difference in decisions
made by users. Such capability arises when the information has either predictive value,
confirmatory value, or both. Relevance is applicable in the context of materiality.
Materiality is the quality of financial information which makes its omission or
misstatement significant enough to impact the decisions that users make through
reliance on the information. Materiality acts as a filter on relevant information such that
relevant information is useful only when it is material.

Faithful representation is achieved when financial information truthfully represents the

underlying economics of a phenomena. This is achieved when information is complete,
neutral (without any understatement or overstatement bias) and free from error (at least
in the process used to produce the information).

Enhancing qualitative characteristics

Enhancing qualitative characteristics improve usefulness of financial information.
However, neither do they compensate for lack of relevance or faithful presentation nor
their absence make the information useless. They help decide between two equally
relevant and true and faithful accounting choices for a single transaction. Preparers of
financial information must achieve to maximum enhancing qualitative characteristics.

Enhancing qualitative characteristics include comparability, verifiability, timeliness and

understandability.

Comparability requires financial information to be comparable across periods and

companies. Comparability is achieved through consistency.

Verifiability is the property which enables different knowledgeable users to agree that
particular financial information exhibits truthful representation. It improves usefulness of
financial statements because it assures users that they are indeed true and fair.

Timeliness is achieved when financial information is made available early enough for it
to impact decisions made by the users.

Understandability requires financial information to be classified, characterized and

presented such that it can be understood by users with reasonable knowledge of
business and economic activities.