What Are the 10 Principles of GAAP?

Generally Accepted Accounting Principles (GAAP) is the established framework of accounting rules and standards for financial reporting in the United States. The purpose of GAAP is to ensure that financial reporting is transparent and consistent across all organizations. This standardization provides clear and comparable information about the financial status of for-profit businesses, non-profits, and government bodies. Adherence to these principles allows investors, lenders, and other stakeholders to make informed decisions, reduces the risk of fraud, and improves regulatory compliance.

The 10 Principles of GAAP Explained

Principle of Regularity

The principle of regularity dictates that a business must adhere to established GAAP rules and regulations as a standard practice. Accountants are expected to follow the prescribed methods for recording and reporting financial data consistently. For example, when calculating the depreciation of an asset, a company must use a method accepted under GAAP, such as the straight-line method, and apply it each year.

Principle of Consistency

The principle of consistency requires that once an accounting method is adopted, it should be applied consistently across all reporting periods. This ensures financial statements are comparable from one period to the next, allowing stakeholders to identify trends. If a company changes an accounting method, it must disclose the nature of the change, the reasons for it, and its effect on the financial statements. For example, if a business uses the First-In, First-Out (FIFO) inventory method, it must continue to use it in subsequent years or provide full disclosure if it switches to a different method.

Principle of Sincerity

The principle of sincerity emphasizes that financial reporting should be accurate and provide an impartial depiction of a company’s financial situation. Accountants must not intentionally misrepresent data, and all information should be objective and based on factual evidence. For instance, a company must honestly assess its accounts receivable and establish an allowance for doubtful accounts. Inflating the value of receivables by not accounting for potential bad debts would violate this principle.

Principle of Non-Compensation

The principle of non-compensation dictates that a company cannot offset its assets with liabilities or its revenues with expenses. All aspects of a company’s performance, whether positive or negative, must be reported in full. For example, a company cannot subtract a debt it owes a supplier from an amount that same supplier owes the company and only report the net difference. The full value of the asset and the liability must be reported separately on the balance sheet.

Principle of Prudence

The principle of prudence calls for caution in financial reporting. When there is uncertainty, accountants should choose the solution least likely to overstate assets or income. This means recognizing liabilities and expenses as soon as they are probable, but only recognizing revenues and assets when they are assured. For example, if a company faces a lawsuit with a probable loss, it should record a liability for the estimated amount. However, if the company is the plaintiff, it should not record any potential gain until it is realized.

Principle of Continuity

The principle of continuity, or the going concern principle, assumes a business will continue its operations for the foreseeable future. This assumption allows companies to defer some expenses to later periods when they will help generate revenue. It is the basis for recording assets at historical cost and depreciating them over their useful lives. For example, a company records a purchased building as an asset and spreads its cost over its useful life, rather than expensing the entire cost in the year of purchase.

Principle of Periodicity

The principle of periodicity requires a company’s economic activities to be divided into specific time intervals, such as months, quarters, or years. This allows for regular reporting of financial performance and position, providing timely information to stakeholders. A common application is the preparation of quarterly and annual financial statements. Publicly traded companies in the U.S. must file these reports with the Securities and Exchange Commission.

Principle of Materiality

The principle of materiality allows accountants to disregard trivial matters but requires them to disclose information that could influence the decisions of financial statement users. An item is material if its omission or misstatement could impact a reasonable person’s judgment. For example, a large corporation misstating revenue by $100 is immaterial. However, failing to disclose a lawsuit that could result in a multi-million dollar loss would be highly material.

Principle of Utmost Good Faith

The principle of utmost good faith requires that all parties involved in the accounting process act with honesty and integrity. This principle assumes that accountants, managers, and executives are providing truthful and complete information. For example, company management is expected to provide auditors with all relevant documents during a financial audit. Withholding information or providing misleading data is a direct violation of this principle.

GAAP and International Financial Reporting Standards (IFRS)

While GAAP is the standard in the United States, many other countries use International Financial Reporting Standards (IFRS). The primary philosophical difference between the two frameworks is their approach to regulation.

GAAP is considered a “rules-based” system, providing specific and detailed rules for how to account for transactions. This approach aims to reduce ambiguity and ensure consistency, but it can also lead to complexity.

In contrast, IFRS is a “principles-based” system. It provides a broader framework and leaves more room for professional judgment. For example, IFRS allows for the revaluation of certain assets like property and equipment to fair value, whereas GAAP requires them to be carried at historical cost.

The Financial Accounting Standards Board (FASB)

The Financial Accounting Standards Board (FASB) is responsible for establishing and maintaining GAAP for public and private companies and non-profit organizations in the United States. Established in 1973, the FASB is an independent, private-sector organization. Its independence helps ensure the standard-setting process is objective. The U.S. Securities and Exchange Commission (SEC) officially recognizes the FASB as the designated accounting standard setter for public companies.