A common set of accounting principles, procedures, and standards issued by the Financial Accounting Standards Board (FASB) to deal with the various accounting information are referred to as Generally Accepted Accounting Principles (GAAP). These principles were first introduced in 1936.
Principles of GAAP
To deal with accounting information, there are 10 general GAAP created by the experts. These principles include the followings:
1. Principle of Regularity
According to this principle, the accountant should stick regularly to the rules and regulations created in the GAAP as a standard.
2. Principle of Consistency
In order to make the proper comparison, it is required for the accountants to apply the same standards throughout the reporting process, from one period to another consistently. It is also expected for the accountants to disclose and explain the reasons behind any changed or updated standards in the footnotes of the financial reports.
3. Principle of Sincerity
As per this principle, it is the sincere duty of the accountant to provide an accurate and impartial depiction of the financial status and situation of the company.
4. Principle of Permanence of Methods
An accountant should not change the principles in two accounting periods otherwise it will make it difficult to compare the financial information of the business. Hence, these principles should be consistent.
5. Principle of Non-compensation
This principle states that it is necessary for the accountant of an organization to report both negatives and positives with full transparency and without the expectations of debt compensation.
6. Principle of Prudence
According to this principle, the financial data representation should be based on facts and not be clouded by speculation or forecast.
7. Principle of Continuity
At the time of valuation of assets, it is expected that the business operations will continue over the years.
8. Principle of Periodicity
Various financial entries should be distributed across the appropriate periods of time and on the date when they occur.
9. Principle of Materiality
The disclosure of all financial data and accounting information is required in the financial reports of the business so that the external and internal parties will not lose their interest in the company and the company's Goodwill will not affect.
10. Principle of Utmost Good Faith
This principle derives its meaning from the Latin phrase "uberrimae fidei" which conveys that it is the duty of all parties involved in a transaction, to be honest, and straightforward towards the business dealings.
This principle is highly applicable in the insurance industry because of the huge demand for trust required in them. The insurance company should provide all relevant information related to the pricing and coverage to the insurance purchaser. Also, the insurance purchaser should give complete information regarding his/her health, lifestyle, and any other relevant factor that could have an impact on the pricing or coverage.
Advantages of GAAP
Various advantages of GAAP are as follows:
- Helps in Maintaining Day-to-Day accounts
GAAP is very useful for the accountants who prepare the report of day-to-day accounting information. There is a very least possibility of having discrepancies in the accounting treatment of various transactions because of the proper guidance or principles formulated in GAAP. Practically, it helps in the proper maintenance of the company's accounts.
- Harmonization of Accounting Principles and Practices
If the various firms follow the different accounting principles and techniques during the preparation of accounts then no consistency can be made and thus will be difficult for the companies to make the comparison. The use of GAAP brings such harmonization in accounting principles and practices and consistency in them for the maintaining accounts.
Thus, a comparison can be made among the accounts which are prepared with the GAAP. Also, inter-firm as well as intra-firm comparisons both are possible.
- Effect of Window Dressing
Window dressing in the Balance Sheet of the company done by accountants may give a distorted image to the analysts. With the help of the GAAP application, this problem can be avoided or stopped while maintaining the accounts.
- Acceptance of Qualitative Work in Accounting
The accounting principles formulated in GAAP are prepared by the collective effects of a group of highly knowledgeable and expert professionals in the field of accounting. These principles supply qualitative improvement in the accounting world.
- Reduces Fraud and Manipulation
The company can also reduce the possibility of community fraud and manipulation of accounts by applying the directives of GAAP in the accounting treatment. Thus, GAAP is beneficial for the preparation of accounts in such a way that it satisfies the accounting community as a whole.
- Acceptability of Accounts
The accounts are prepared by the accountants as per the principles and practices of GAAP then they are accepted by all concerned. In other terms, if the company applies the International Accounting Standards during the preparation of their accounts then they are accepted almost everywhere in the world for the purpose of analyzing the financial statements which are further useful in making effective financial decisions.
- Helpful in Stock-exchange Transaction
If the company, honestly follows all the accounting standards and principles while maintaining the accounts then it becomes easy for it to deal with the stock exchange for various purposes such as valuation of stock and others. At the same time, if the company follows the International Accounting Standards for preparing its accounts then its acceptance is widely recognized throughout the world.
Limitations of GAAP
As we know GAAP is applicable in most countries but they are also not free from flaws. Various limitations of GAAP are as follows:
- Difficult to Apply
It is a herculean task to apply GAAP in everyday accounting practices. This is because the principles require a huge cost as well as time for their application. It demands a team of experts in the field which can be difficult for a small firm to afford such expenses.
- Non-comparable in Certain Cases
GAAP can't be applied in all situations and cases irrespective of caste and creed. Two firms may differ as per their size, style, capacity, management, and various other aspects. Even there can be differences in the firms within the same group. So, it is highly confusing to apply the same principles in all types of firms by ignoring the above-mentioned aspects, and also the comparison can't be done effectively.
- Fixed Standard Principles
There are some fixed standard principles in GAAP which are to be strictly followed by the firms while considering GAAP. But it is highly impractical to apply these fixed principles in the same manner in different situations. Also, the business world is consistently changing, so how can a rigid principle be effective to apply to conclude and make comparisons.
- Personal Judgment Can't be Ignored
It is almost impossible for the firm to eliminate the problem of personal judgment in the working of the business while applying these accounting standards set in GAAP. This personal judgment can be seen when the financial manager is preparing the financial statements of the company or when he/she is doing the valuation of the stock. This can manipulate the actual results and also makes the comparison more difficult.
- Proper Interpretation Not Always Possible
It may not be easy for the organization to understand the proper meaning of the principles which can affect the interpretation negatively. The GAAP is set by a group of people/experts for the evaluation of performances. Due to the confusion, such evaluation or interpretation can't be possible in several circumstances.