The Generally Accepted Accounting Principles, GAAP, are the guidelines through which an entity records its financial transactions. They must be applied consistently and any departure that impairs the objectivity of users of the financial statements has to be disclosed and justified.
The Business Entity Concept
An economic unit is being accounted for. The business entity concept provides that the accounting for a business or organization be kept separate from the personal affairs of its owner. The balance sheet of the business must reflect the financial position of the business alone. Also, when transactions of the business are recorded, any personal expenditures of the owner are charged to the owner and are not allowed to affect the operating results of the business.
The Going (Continuing) Concern Concept
The going continuing concern concept assumes that a business will continue to operate in the foreseeable future. If any uncertainties about the going concern or continuing of the entity, it has be disclosed in the financial statements justifying this concern with reasons and basis for such a determination. Until reasonable facts indicate otherwise, it is assumed that the accounting entity will exist long enough to use assets and fulfill its commitments.
The Principle of Conservatism
The principle of conservatism provides that accounting for a business should be fair and reasonable. Probable losses must be recognized as soon as they are discovered and expenses are recorded as incurred. For example, to reflect accuracy in the accounts receivable, the allowance for bad debts reduces de amount that will be recovered. Estimates requiring subjective analysis should not overstate revenue and asset values or understate expenses and liabilities.
The Objectivity Principle
The objectivity principle states that accounting will be recorded on the basis of objective evidence. To be reliable, accounting information must be objective. Objectivity requires unbiased opinions of verifiable events concerning business transactions. Primary sources are the best. The source document for a transaction is almost always the best objective evidence available.
The Time Period Concept
The time period concept provides that accounting take place over specific time periods also known as fiscal periods. Fiscal periods are of equal length and are used when measuring the financial progress of a business. To be useful, accounting information must be current, presented in a timely basis.
The Revenue Recognition Principle
The revenue recognition convention provides that revenue recognized at the time the transaction is completed. With accrual accounting, revenue is recorded when earned, and costs are recorded when incurred. If it is a cash transaction, the revenue is recorded when the sale is completed and the cash received.
The Matching Principle
Simply stated, when determining income, expenses must be matched with the revenue they generate. The matching principle is an extension of the revenue recognition principle. It states that each expense item related to revenue earned must be recorded in the same accounting period as the revenue it helped to generate. Doing otherwise prevents the financial statements for measuring the results of operations fairly.
The Cost Principle
The accounting for purchases must be at their cost price, the figure on the source document for the transaction in almost all cases. Income Statement and Balance Sheet accounts must be recorded at cost, as evidenced by their objective fair market value at time of acquisition. Called historical costs, these figures are generally not adjusted to current market value.
The Consistency Principle
Accounting methods used to determine income and value balance sheet items must be consistently applied from period to period. Users of financial statements assume that consistency has been applied if there is no statement to the contrary. Full disclosure of changes in accounting methods is required.
The Materiality Principle
Accounting principles need not be followed when the effect of a given action is immaterial and its impact would not effect the reader's interpretation of the accounting information. The materiality principle requires accountants to use generally accepted accounting principles except when to do so would be expensive or difficult, and where it makes no real difference if the rules are ignored.
The Full Disclosure Principle
All relevant material facts must be incorporated into financial statements. Some information, such as a contingent liability, is easily communicated with a footnote, while other information, such as the effect of inflation, requires more complex procedures and calculations that need to presented along with the notes to the financial statements. The full disclosure principle states that any and all information that affects the full understanding of a company's financial statements must be included with the financial statements.
Fraudulent financial statements are pervasive. Forensic accountants help investigate violations of accounting principles. Investors, financial institutions, and government have been deceived by fraudulent financial statements that have not followed GAAP or have departed from them without disclosing this fact in the notes to the financial statements.