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Generally accepted accounting principles — or GAAP (pronounced “gap”) for short — are a group of accounting standards that are used to prepare financial statements for companies, not-for-profit organizations and state and local governments. The information in these financial statements help lenders, investors and others evaluate a company or organization.
While you may have hired an experienced professional to deal with the nitty-gritty of your business’s accounting, you owe it to yourself — and your employees, customers, and investors — to understand the basics of GAAP accounting.
First, why is GAAP important?
GAAP rules are maintained by the Financial Accounting Standards Board (FASB) and in place to help protect business owners, consumers, and investors from fraud. They guarantee a measure of consistency in the accounting reports among all businesses. GAAP rules absolutely must be followed by publicly traded companies, but most small-business accountants adhere to them as well.
How does this apply to you, the small-business owner? Well, understanding where your accountant is coming from will help you better communicate with them and allow you to verify your accounting is being done correctly. Even though your accountant is a trusted business advisor, you are ultimately responsible for your business’s financial information.
What are the generally accepted accounting principles?
Generally accepted accounting principles can be organized into three broad categories. Those categories are assumptions, principles, and constraints. Within each of these broader categories, there are a number of rules which dictate how GAAP-compliant accounting is supposed to be done.
We’re going to keep this as a high-level overview and spare you some of the drier details. You’re not training to be a CPA, after all. Think of this as a crash course in GAAP accounting. If you want more details, your accountant will be a valuable resource for you.
Part 1: GAAP assumptions
Principle 1: Business entity assumption
One of the very first things your accountant probably told you when you started your business was to open a separate business bank account and keep your business and personal transactions separate. This wasn’t just because your accountant wanted to make their job easier.
The generally accepted accounting principle behind this advice is the business entity assumption. Basically, this principle means that a business is an entity unto itself, and should be treated as such (which is also why this is sometimes called the “separate entity assumption”).
Even in a sole proprietorship, where your business activity appears on your personal tax return, the business entity assumption still applies. This is because, legally, your business can exist independently of you.
Principle 2: Monetary unit assumption
The monetary unit assumption states all business activity must be recorded in the same currency. This is why you have to go through the extra effort to complete your bookkeeping for foreign transactions.
Another assumption under this generally accepted accounting principle is that the purchasing power of currency remains static over time. In other words, inflation is not considered in the financial reports of a business, even if that business has existed for decades.
Principle 3: Specific time period assumption
Dates are important, and this is especially true when dealing with GAAP accounting.
A balance sheet always reports information as of a certain date. Profit and loss statements, also called income statements, encompass a date range. All financial statements have to indicate the time period for the activity reported in order for them to be meaningful to those reviewing them. This is the specific time period assumption.
Always check your financial statements for dates, and make sure the information reported on your financial statements makes sense for the dates encompassed by the report. A balance sheet will indicate the report is “as of” or “at” a certain date. Profit and loss statements will indicate they are for a specific date range.
Principle 4: Going concern assumption
The going concern assumption is also referred to as the “non-death principle.” This principle assumes the business will continue to exist and function indefinitely.
The going concern assumption is what allows a business to defer the recognition of expenses to a later accounting period. If an accountant is concerned the business might be forced to close and liquidate, they are required to disclose this concern under GAAP.
Part 2: GAAP principles
Principle 5: Historical cost principle
The historical cost principle in GAAP accounting says that the cost of an item doesn’t change in the financial reporting. So, even if you’ve bought something that has skyrocketed in value since you purchased it — like a building in a part of town undergoing regentrification — your accountant will still report the asset at the amount for which it was obtained, regardless of fair market value.
The historical cost principle also highlights an important concept: It’s critical not to confuse cost with value. The value of things will change over time, and this is reflected in the gain or loss on sale of assets as well as in depreciation entries. Cost, however, will always remain the same on your financials.
If you need a true valuation of your business without selling off your assets, you’ll need to bring in an expert in business valuations rather than relying on your financial statements.
Principle 6: Full disclosure principle
Whenever a generally accepted accounting principle makes it into the news, it is almost without fail the full disclosure principle. Or, more specifically, it’s because of failure to follow the full disclosure principle.
Under the full disclosure principle, a business is required to disclose all information that relates to the function of its financial statements in notes accompanying the statements. This principle helps ensure stockholders and investors are not misled by any aspect of the financial reports.
In other words, it’s always important to read the fine print, even — or maybe especially — in your financial statements.
Principle 7: Matching principle
Most small businesses are on a cash basis for tax purposes, meaning revenue is reported when cash is received and expenses are reported when cash is spent (or your business’s credit card is charged). But certain businesses are required to report all financial information on an accrual basis, largely due to the matching principle.
Under the matching principle, sales and the expenses used to produce those sales are reported in the same accounting period. These expenses can include wages, sales commissions, certain overhead costs, etc.
Even if your tax return is on a cash basis, your accountant may prepare your financial reports on an accrual basis. Accrual basis reports reflect the matching principle and provide a better analysis of your business’ performance and profitability than cash basis statements.
Principle 8: Revenue recognition principle
The revenue recognition principle — like the matching principle — is an accrual basis accounting principle. In a nutshell, under the accrual basis of accounting, revenue is reported when it’s earned, regardless of when payment for the product or service is actually received. This is the revenue recognition principle. Similar to the matching principle, the revenue recognition principle accurately reports income, or revenue, when the sale was made, even if you bill your customer or receive payment at a later time.
Part 3: GAAP constraints
Principle 9: Materiality principle
The materiality principle is one of two generally accepted accounting principles that allows the accountant to use their best judgment when recording a transaction or addressing an error.
You most often see the materiality principle at play when an accountant is reconciling a set of books or completing a tax return. If the account is off by a relatively small amount in relation to the overall size of the business, the accountant might deem the discrepancy as immaterial. If a discrepancy is immaterial, it can be disregarded. Material discrepancies, on the other hand, must be addressed.
Similarly, immaterial expenses can be recognized at the time of purchase, but material expenses must be depreciated over time.
It’s important here for the accountant to be empowered to use their professional opinion. Since businesses come in all sizes, an amount that might be significant, or material for one business may be insignificant, or immaterial for another.
Principle 10: Conservatism principle
The principle of conservatism is the other GAAP principle that allows the accountant to use their best judgment in a situation. When there’s more than one acceptable way to record a transaction, the principle of conservatism instructs the accountant to choose the option that yields the most conservative results for the business they’re working with.
There is an important rule to remember here: This principle is only invoked when either way the accountant can record the transaction is acceptable. It does not allow the accountant to completely disregard other accounting principles.
Principle 11: Objectivity principle
The objectivity principle is one of the most important constraints under generally accepted accounting principles. According to the objectivity principle, GAAP-compliant financial statements provided by your accountant must be based on objective evidence.
You can think of this as the “just the facts, ma’am” principle. The objectivity principle is, in part, the reason many companies will have an independently audited set of financial statements produced on a routine basis.
Principle 12: Consistency principle
Accounting can be an art as much as a science. Depending on the accounting methods used, the same data presented in different ways can have a dramatic impact on your business’s financial statements.
The consistency principle seeks to increase clarity around a business’s financial statements and to prevent switching the methods used in order to get more favorable-looking results. According to this constraint, the accountant must use the same accounting methods and follow the same accounting principles for each accounting period. This will ensure you are comparing apples to apples when you review your financial statements for multiple accounting periods.
Principle 13: Cost constraint principle
The final constraint under generally accepted accounting principles is the cost constraint principle. This is also one of the trickier principles, because it can be hard to quantify.
According to the cost constraint principle, the cost of reporting financial information should be less than the benefit derived from that financial information. In other words, providing financial information in accordance with GAAP should not cause an undue financial burden.
However, this doesn’t mean a business is exempt from complying with GAAP simply because of the cost involved. This principle typically applies to a small number of companies and only if the financial information being provided is truly inconsequential in relation to the cost.
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A version of this article was first published on Fundera, a subsidiary of NerdWallet