Financial accounting information is historical in nature, reporting on what has happened in the past. To facilitate comparisons between companies, this information must conform to certain accounting standards or principles called generally accepted accounting principles (GAAP). These generally accepted accounting principles for businesses or governmental organizations have developed through accounting practice or been established by an authoritative organization.
The Financial Accounting Standards Board (FASB) develops the Generally Accepted Accounting Principles (GAAP). The process of developing GAAP include:
- FASB members issue a discussion memorandum,
- FASB collects all responses and suggestions from Securities and Exchange Commission (SEC), the American Institute of Certified Public Accountants (AICPA), the American Accounting Association (AAA), public accounting firms, and other involved parties.
- FASB presents the exposure draft,
- FASB obtains responses to the exposure draft from Securities and Exchange Commission (SEC), the American Institute of Certified Public Accountants (AICPA), the American Accounting Association (AAA), public accounting firms, and other involved parties.
- FASB issues the final statement of principle, all principles are modified and refined as accountants respond to constantly changing business environment.
To achieve basic objectives and implement fundamental qualities GAAP has four basic principles, and four basic constraints.
- Historical 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 recognition principle holds that companies may not record revenue until (1) it is realized or realizable and (2) when it is earned. It does not matter if cash has been received or paid. This is the essence of accrual basis accounting. If a company or business believes that they may not receive payment for services or goods rendered, they may not record related revenue.
- 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 has been done or the product has been delivered. 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).
- Full 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
- Objectivity constraint: the company financial statements provided by the accountants should be based on objective evidence.
- Materiality constraint: 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 constraint: It means that the company uses the same accounting principles and methods from period to period.
- Conservatism constraint: when choosing between two solutions, the one which has the less favorable outcome is the solution which should be chosen (see convention of conservatism).
Important Points to Remember!
- The Securities and Exchange Commission has the final voice on all issues and matters related to financial reporting by publicly traded corporations. The SEC also requires all publicly owned companies to comply with Generally Accepted Accounting Principles (GAAP).
- In contrast FASB assists to private sector organizations, and its responsible for establishing accounting and reporting standards.