Generally Accepted Accounting Principles (GAAP) are a common set of accounting rules and standards that dictate how financial statements are prepared. Public enterprises, non-profit organizations and government entities are required to prepare financial statements in accordance with GAAP. These guidelines were developed over time by the Financial Accounting Standards Board (FASB) and the American Institute of Certified Public Accountants (AICPA).
Principles covered by GAAP
GAAP encompasses a wide range of accounting practices and philosophies. Some key areas covered by GAAP include:
- Recognition: How assets, liabilities, income and expenses are recognized in the financial statements
- Valuation: How Profits and Losses Are Measured and Reported in Financial Statements
- Presentation: How information should be presented in the financial statements
- Disclosure: what information should be shared in the financial statements
Objectives of GAAP
The objective of GAAP is to create a uniform standard for financial reporting. When financial information is made available to the public, it should be used to help investors make informed decisions about where to invest their money. Likewise, it should allow lenders to properly assess the financial condition of companies looking to borrow money.
When applied to not-for-profit and government organizations, the purpose of GAAP is to ensure full transparency from reporting entities. Information provided under GAAP must be not only clear, complete and easy to understand, but also verifiable by auditors and other external parties.
Importance of GAAP
Without GAAP, companies wouldn’t be subject to a stringent set of standards, meaning they would have much more leeway in deciding what information they choose to share or keep hidden. GAAP therefore performs the very important function of ensuring that companies and organizations cannot “cheat” on their financial reports.
GAAP makes it easy for investors to assess companies by simply looking at their financial statements. If an investor is torn between two companies in the same industry, that investor can compare their respective returns to determine which one is most successful in generating income and managing cash flow.
However, this would not be possible if companies were allowed to choose which financial information to present. When applied to government entities, GAAP helps taxpayers understand how their taxes are spent.
GAAP also helps companies obtain key information about their own practices and performance. In addition, GAAP minimizes the risk of false financial information by putting in place numerous controls and safeguards. Information provided in GAAP financial statements can therefore generally be considered reliable and accurate.
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