Generally Accepted Accounting Principles

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Generally Accepted Accounting Principles (GAAP) is the term used to refer to the standard framework of guidelines for financial accounting used in any given jurisdiction. GAAP includes the standards, conventions, and rules accountants follow in recording and summarizing transactions, and in the preparation of financial statements.

Introduction to Generally Accepted Accounting Principles

Over the years there have been numerous accounting frauds that have been revealed. Everyday investors depend on the accuracy of the financial statements. The financial statements rest heavily in the management’s compliance with the generally accepted accounting principles, more commonly known as the acronym GAAP. However, GAAP is simply used as guidelines, rules, and procedures. There have been many issues with the compliance of GAAP because there is a lack of consistency from management. Prior to the Sarbanes Oxley Act of 2002, GAAP was used loosely and auditors found many problems in the financial statements.

There have been many changes to the accounting standards over the past 50 years. These changes were necessary due to the failure of management and the unfairly stated financial statements. The development of the Sarbanes Oxley Act narrowed in on companies falsifying their financial statements and recording higher profits and lower debt. This resulted in extremely high costs for companies to maintain fairly stated financial statements. There have been many updates to the principles and will continue on to ensure that financial users are given reasonable assurance before making decisions in the market.

Financial Accounting Standards Board

The Financial Accounting Standards Board (FASB) is an independent board that participated in the development of GAAP and plays a major part today in the restructuring of these principles. The FASB was developed in 1973 and as an independent private board took part in standardizing accounting practices. The FASB are also responsible for researching recent accounting issues to find resolutions. Both the FASB and AICPA are private sector companies and the Securities and Exchange Commission (SEC) is a federal government agency. The SEC has a primary interest in protecting the investors and ensuring that the financial statements are established in accordance with GAAP.

GAAP Principles

GAAP is extremely general and vary significantly however; they are all simply based on four principles. These principles are consistency, relevance, reliability, and comparability. There is a strong need in the accounting profession to develop a foundation throughout the principles to encourage a more fluent use of them.

The first principle is consistency. This principle lays the ground work for general accounting throughout the entire industry. For example, a company cannot change their method for accounting for inventory. If the company begins their inventory method as first in first out (FIFO) then they are not able to change their method. The second principle that GAAP is based on is relevance. This principle states that the material in all of the financial statements must be highly relevant. This is due to the use of financial statements by the public. The information must be relevant and contain decision making facts to assist financial users make educated decisions.

The third principle is reliability. This principle is used to ensure the accuracy and reliability of the financial statements. For example, if an independent auditor were to review the financial statements, the reliability will verify that the results are reported with reasonable assurance that there is no material misstatement. The last and most important principle is comparability. The reason why this principle is so crucial is because this is the basis for all of GAAP. If the financial statements were not consistent throughout the same industry, than the financial users would not know which information is dependable. The financial users must be able to compare the financial statements in order to determine a lack of consistency between the two.