What Is GAAP, and Why Is it Important?
The acronym “GAAP” stands for “generally accepted accounting principles.” They are the basic accounting principles established by the American Institute of Certified Public Accountants (AICPA) to guide financial professionals in their work. Certified public accountants (CPAs) must adhere to these principles of accounting when preparing financial statements.
What Are the Basic GAAP Accounting Principles?
- Full Disclosure Principle: Financial statements should include the full disclosure of pending lawsuits, incomplete transactions, and other conditions that can significantly affect the company’s accounts. This information is usually conveyed through footnotes.
- Revenue Recognition Principle: Revenue is earned and then recognized only after the delivery of the product or the completion of the service.
- Matching Principle: The costs of goods sold, commissions earned, insurance premiums, supplies used, salaries earned, and all other costs of doing business are recorded in the same period as the revenues they helped generate.
- Cost Principle: Assets are recorded at cost, which is defined as their value at the time of acquisition.
- Going Concern Principle: It’s assumed that the company will remain in business indefinitely when financial statements are prepared.
- Principle of Conservatism: When accountants have to use their own judgment to estimate transactions or expenses, they will choose the less optimistic estimate when two estimates are determined to be equally likely.
- Materiality Principle: The requirements of any of these principles can be ignored if there is no effect on the users’ financial information.
What Are the Five Basic Accounting Assumptions?
- Economic Entity Assumption: Economic entities like churches, governments, businesses, school districts, and social organizations must keep separate financial records.
- Monetary Unit Assumption: Accounting records only include quantifiable transactions.
- Time Period Assumption: Accounting practices are maintained and reported during a specified period of time. The time period should be consistent for as long as the business is in operation.
- Reliability Assumption: A business has to be able to prove a transaction before they record it via receipts, billing statements, bank statements, or invoices.
- Consistency Assumption: Companies must use the same accounting method across all of their practices and accounting periods. Exceptions may be made if another method is more relevant or efficient. Efficiency is important so different records can be compared easily and accurately.
What Is the Difference Between Cash and Accrual Accounting?
The GAAP accounting method favors accrual accounting, in which future credits (deposits) and debits (payments) are accounted for, over the cash method, in which credits and debits are recorded only when they actually occur. The main difference between these basic accounting principles is that one reflects your actual cash balance, while the other reflects your company’s overall financial condition.
From a GAAP bookkeeping standpoint, the accrual method is more complicated, in that the accountant must recognize both transactions that have already occurred and transactions that are anticipated to occur to give a better idea of a company’s overall worth as opposed to just its actual cash value. In other words, if your small business is currently in the red because you’ve overdrawn your business accounts but you are expecting a significant payment in the near future, the accrual method of bookkeeping would take into account that payment as well, so it might reflect your business’s standing as in the black.
Many municipalities and businesses are steering away from the basic accounting principles of the cash method in favor of the accrual method. Both can work well for any business, but which one is right for you?
Why Some Businesses Use the Cash Method Anyway
While the generally accepted accounting principles favor the accrual method, the cash method might work better for you if you run a small business. You likely conduct your business on a cash basis with your vendors and employees and have no need to present a financial picture to any investors. You can simply check your business’s bank account information daily to keep your records neat and tidy. If this sounds like your business, then the cash method of accounting can save you both time and money. Using this method, a company might be able to report smaller revenues at tax time, saving money on taxes. It can save time as well, simply because it’s less complicated than the accrual method. Financial statements using the cash method of accounting are still valid, but if they are prepared by a CPA, the CPA cannot claim that the statements are consistent with the GAAP bookkeeping standards.
Find GAAP Accounting Help
Ignite Spot provides outsourced financial services designed to help you with all of your financial needs, including accounting that follows the GAAP principles. Hiring your own in-house accountant can be expensive, but outsourcing your accounting and bookkeeping to a firm like Ignite Spot can actually save you time and money, allowing you to focus on what you do best. With outsourced accounting from Ignite Spot, you won’t have to worry about the principles of accounting; you have enough to worry about just running your business. We are here to help your business grow, and as you will see when you download our pricing guide online, our services are reasonably priced. Contact us today!
Learn More About Similar Accounting Topics
- Understanding the Accrual Accounting Method
- What Does Equity Mean?
- The Difference Between Cash-Basis and Accrual-Basis Accounting
- The Purpose and Practice of the General Ledger
- How to Write Off Bad Debt
- What Is a Trial Balance?
- How to Reconcile Accounts
- What Is a Credit Memo?
- Is Inventory an Asset?
- What Is the Cash Method of Accounting?
- What Is Activity-Based Costing?
- Self-Employment and FICA
- Employer FICA Rates
- Affordable Care Act and Small-Business Requirements
- Know Your Options in Small-Business Finances
- The Effects of Small-Business Bankruptcy
- How Do Small-Business Loans Work?
- The Importance of a Business Plan
- Choosing the Best Small-Business Credit Card
- What Are Retained Earnings?
- What Is a Business Investment, and How Should it Be Accounted For?
- How Hard Is it to Get a Small-Business Loan?
- Understanding Different Entity Types
- How Much Capital Is Needed to Start a Small Business?
- Getting Involved in Business and Community Organizations
- What Are Business Liabilities?
- What Is Business and Financial Leverage?
Written by Eddy Hood