Stepping into the world of accounting can be a daunting task for anyone, especially people new to the field. How do you make sense of all the information, complex rules, and reports thrown at you? Generally Accepted Accounting Principles (“GAAP”) give accountants a guide so everyone is working from the same rulebook.
GAAP specifically details how accountants should report financial statements. It helps to create consistency and transparency across industries. Just think if every company showed their financials with different measures, in a different format, and based on a different set of rules. It would be mayhem!
In order to work effectively, GAAP assumes a couple of core principles. This most important principle that the business is going to be around for a while and that the owners personal expenses are separate from the business. Pretty straight forward, but it can get you in a lot of trouble if you don’t get the basics right.
The second principle is to break down the year into distinct time periods and align revenue with the expenses. For example, if you make a bunch of money selling lollipops, you want to make sure that the cost of the sugar and other ingredients used to make the lollipops are reported in the same time period. The matching principle, as this is called, helps you judge whether or not a company is profitable in a given time period. Reporting this way is called accrual accounting and most companies that use GAAP report this way. There are other methods, like cash accounting, which we will cover in a future article.
GAAP is set by American Institute of Certified Public Accountants (AICPA) and is subject to Securities and Exchange Commission regulations. Both AICPA and the SEC provide detailed guides on GAAP for your reference.
For more information on accounting basics, head on over to our Accounting 101 section for some great pop quizzes and introductory guides!