GAAP: What Are ‘Generally Accepted Accounting Principles’?
Knowing GAAP will help you understand your accountant's decision-making process better.
Many, or all, of the products featured on this page are from our advertising partners who compensate us when you take certain actions on our website or click to take an action on their website. However, this does not influence our evaluations. Our opinions are our own. Here is a list of our partners and here's how we make money.
Updated · 5 min read
Written by
Edited by
Senior Editor & Content Strategist GAAP stands for generally accepted accounting principles. Publicly traded companies, nonprofits and governments use them to prepare financial statements. This helps ensure they're all using the same standards to measure financial success.
Typically, your accountant will help you deal with these principles. But it's still important to understand what they mean and how they impact your financial reports.
» MORE: Best accounting software
Why is GAAP important?
The Financial Accounting Standards Board (FASB) maintains GAAP rules. The goal is to guarantee consistency in accounting reports. Most small businesses aren't required to adhere to GAAP rules. But most small-business accountants still follow them.
How does this apply to you, the small-business owner? Understanding your accountant's reasoning will help you better communicate with them. And it'll allow you to verify your accounting is being done correctly. Your accountant is a trusted advisor. But you are ultimately responsible for your business’s finances.
Part 1: GAAP assumptions
Generally accepted accounting principles can be organized into three broad categories. These include assumptions, principles, and constraints.
Principle 1: Business entity assumption
It's important to keep your business and personal transactions separate. The generally accepted accounting principle behind this advice is the business entity assumption. Basically, it means that a business is an entity unto itself, and should be treated as such. That's why this is also sometimes called the “separate entity assumption." This applies to sole proprietorships, too.
Principle 2: Monetary unit assumption
This principle states all business activity must be recorded in the same currency. It's also assumed that the purchasing power of currency remains static over time. In other words, inflation isn't considered in financial reports.
Principle 3: Specific time period assumption
All financial statements have to indicate the time period. Otherwise, they aren't as meaningful. This is the specific time period assumption.
Always check your financial statements for dates. And make sure the information reported makes sense for the dates covered. 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.” It assumes the business will continue to exist and function indefinitely.
That means businesses can typically spread out certain expenses or wait to recognize their full cost until 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 says the cost of an item doesn’t change in financial reporting. For example, your accountant will always report an asset at its purchase price. That's true even if the asset has skyrocketed in value since you bought it.
This principle also highlights an important concept: Don't confuse cost with value. The value of items will change over time. 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 can't just rely on your financial statements. Instead, you'll need to bring in a business valuations expert.
Principle 6: Full disclosure principle
Businesses must share all information needed to fully understand financial statements. The extra info goes in notes accompanying the statements. This helps ensure stockholders and investors aren't misled.
In other words, it’s always important to read the fine print.
Principle 7: Matching principle
Most small businesses are on a cash basis for tax purposes. That means they report revenue when they receive cash. And they report expenses when they spend cash. But certain businesses must report all financial information on an accrual basis. This is largely due to the matching principle.
Under the matching principle, businesses must report sales and associated expenses 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 your business's performance better than cash basis reports.
Principle 8: Revenue recognition principle
This principle requires businesses to report revenue when it's earned. They don't need to wait until they actually receive the payment. This helps businesses align their reported income with when the sale was made.
» MORE: 6 accounting formulas to know
Part 3: GAAP constraints
Principle 9: Materiality principle
Under this principle, accountants can use their best judgement to record transactions. The same goes for addressing errors.
You often see the materiality principle at play when an accountant is reconciling books or completing tax returns. If the account is off by a small amount relative to the size of the business, the accountant might deem the discrepancy immaterial. If a discrepancy is immaterial, you can disregard it. Material discrepancies, on the other hand, must be addressed.
Similarly, businesses can recognize immaterial expenses at the time of purchase. But they must depreciate material expenses over time.
It’s important here for the accountant to use their professional opinion. An amount that's material for one business might be immaterial for another.
Principle 10: Conservatism principle
Conservatism is another GAAP principle that encourages accountants to use their best judgment. Sometimes there's more than one acceptable way to record a transaction. Accountants must choose the option with the most conservative results.
But accountants only follow this principle when either option is acceptable. It doesn't let accountants completely disregard other accounting principles.
Principle 11: Objectivity principle
Under this principle, GAAP-compliant financial reports from your accountant must be rooted in objective evidence. This is, in part, why many companies have their reports independently audited.
Principle 12: Consistency principle
Under the consistency principle, businesses should use the same accounting method for each accounting period. This ensures businesses are comparing apples to apples over multiple 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 this principle, the cost of reporting financial information should be less than the benefit derived from it. In other words, following GAAP shouldn't cause undue financial burden.
However, this doesn’t mean a business is exempt from complying with GAAP simply because of the cost. This principle typically applies to only a small number of companies. Additionally, the financial information must be inconsequential compared to the cost.
A version of this article was first published on Fundera, a subsidiary of NerdWallet
Article sources
NerdWallet writers are subject matter authorities who use primary,
trustworthy sources to inform their work, including peer-reviewed
studies, government websites, academic research and interviews with
industry experts. All content is fact-checked for accuracy, timeliness
and relevance. You can learn more about NerdWallet's high
standards for journalism by reading our
editorial guidelines.
Bonus offer
More like this
