August 5th, 2011 : Accounting In America - The 4 Principles Of GAAP Explained


Accounting In America - The 4 Principles Of GAAP Explained

Posted in Los Angeles Financial News by Admin

Accounting In America - The 4 Principles Of GAAP Explained

Accounting In America - The 4 Principles Of GAAP Explained

In the United States, there are some accounting principles that are generally accepted. You may have heard about the term GAAP, or Generally Accepted Accounting Principles. So what are they and why are they used? That's what you're going to learn in this article. Thankfully, there are only 4 of them. Once you understand these 4 principles, you’ll understand the framework from which all other accounting practices are built.

The Principle of Historical Cost

Assets owned by the company should be based on what they actually cost and not an estimated value. Suppose a company purchased land for $10,000. The land may be valued at $18,000 if it was sold, but the company can only claim the $10,000 they actually paid for it. The reason for the cost principle is to reduce the guesswork and adhere to a stricter means of accounting for assets. This tightens the value placed on assets to a level not based on opinion.

The Principle of Accrual

Accrual deals with reporting income and expenses. Most individuals report income the moment cash is received, but businesses are a different story. The accrual principle doesn't necessarily rely on cash being received in order to claim income. It depends on when the income was earned. What’s the difference? Some businesses can perform the necessary work and present a bill to the customer. They have therefore "earned" the income before being paid.

On the other hand, customers can pay first before work has been performed. That business could not claim income until they have delivered on the product or service that earns the income itself. Deductions for expenses work in a similar way. They must be "incurred" expenses. In essence, the events that led to the expense must occur before it can be accounted for in that time period. This principle accounts for actual work done and ignores work that has not been performed yet.

The Principle of Matching

This principle seeks to match expenses in the same time period as the revenue they generate. The idea is to relate expenses more closely to how they affect money coming into the business. Depreciation is one expression of this principle. For example, when equipment depreciates, it gives an actual number of how much of a loss came from using that piece of equipment. Another expression of this principle is the cost of goods sold. Businesses that purchase and resell items can directly relate the cost to the income.

The Principle of Disclosure

Enough information should be presented to give an accurate picture of the financial status of the business. However, this principle must balance accuracy against cost. The business needs to avoid causing the wrong conclusions to be drawn, yet they should not go to extraordinary lengths that would place a financial burden to account for it.

GAAP provides standards for accounting in every industry. It makes sure that how things are assessed is standardized in every accounting office.

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