Generally accepted accounting principles (GAAP) are the national accounting standards for companies in the United States and those international companies doing business in the United States. GAAP policies exist so companies have a minimum standard they must follow for certain accounting activities. The most common GAAP policies, which apply to all companies, include historical cost, revenue recognition, matching, and full disclosure principles. These building blocks define how a company starts its accounting process. Failure to follow these basic accounting principles can result in fines and other negative actions from outside agencies.
The historical cost principle means that all assets get recorded into a company’s accounting book at the original cost paid. This reflects the cost it takes to run a business and allows the company to depreciate fixed assets as used by the business. For some assets, companies must make periodic revaluations in order to reflect the current market value for assets. This allows a company to update its accounting books for major changes in asset values. Changes in asset values due to revaluation ultimately affect a company’s net income.
Revenue recognition GAAP policies indicate when a company should record transactions that relate to the sale of goods as services. GAAP policies typically require a company to use the accrual method of accounting. The accrual method requires a company to record transactions as they occur rather than when cash changes hands. Most major companies must use GAAP in order to prepare financial statements. Other methods may be approved if a company requests a deviation from this policy.
A company must attempt to match its revenues with the expenses related to generating the revenue. The matching principle is part of GAAP policies to ensure a business can accurately reflect the transactions it takes to run a company. Failure to accurately match revenues and expenses can result in untimely transaction recording and the inability to recognize trends in the company’s business activities. Stakeholders can also find it difficult to accurately determine a company’s financial strength.
Full disclosure represents GAAP policies that require a company to disclose certain accounting actions to stakeholders. The most common disclosures relate to major accounting actions, inventory accounting, subsequent events, and other one-time accounting changes or adjustments. The information is usually a small footnote placed on the bottom of financial statements for review by outside individuals. In some cases, a certified public accountant may need to sign off on these statements to ensure they fully disclose certain accounting actions.