Basic Accounting Principles - GAAP: An Overview

Basic accounting principles are the fundamental bedrock concepts of the accountant's profession. Imagine a world where any company could produce a set of financial statements (accounts) without any rules or regulations to govern their preparation. Not exactly a recipe for success you'd say.

GAAP

So the world has what are known as basic "Generally Accepted Accounting Principles" or GAAP for short. 

And in most countries, company law dictates that all organisations must prepare their financial statements based on the GAAP applicable to them. Just take a browse in the business accounting section of your local book shop and you'll find not one, but many books covering these basic accounting principles. 

And that's partly because there are such varying types of entities out there. So you could end up having different financial statements for charities (also called not-for-profit organisations), governments, large companies, small companies, public & private companies. 

GAAP Exceptions

Our simple assertion is that the basic accounting principles should apply to all of them, but of course there are exceptions to every rule. As long as certain parties agree, it is possible to prepare the finacial statements without using GAAP - yes, they should still conform to most of the basic accounting principles - but ultimately it's the users of the financial statements that will decide this. These "users" are the "certain parties" we are referring to.

But for the vast majority pf public companies they have no choice but to follow GAAP. And if they stray from them, don't disclose that and somehow trick the auditors into missing it (surely not...Enron for anyone??) then the full force of the law could be brought against them.

Principles vs Rules

A key area to understand with GAAP is that - as principles - they are open to interpretation. Another way of looking at it is that while the basic accounting principles will be well known to the accountants they are still only guidelines. Accountants still have to make estimates as to the value of certain items on the balance sheet.

For example, take a company that supplies food to supermarkets. It maintains stock (the food) that it's try to sell to supermarkets. When the company has to prepare its financial statements it has to estimate the value of the stock it still has in its warehouses. Simplistically, you could say that it should be what they paid for it. But what if it's been lying around for a long time? Can they still sell it? If not, then surely the value is less than what they paid for it. That's when the accountant's judgment will come in. Basic accounting principles will tell you to value at the lesser of cost or what you can really sell it for.

And of course this is where the expression "creative accounting" was born from. Taking plain, basic accounting principles and applying them in an unethical way so as to make your financial statements look different from what they should have. And that tricks shareholders, investors, employees and anyone who relies on the accounts into make decisions based on false information. And they can lose a lot of money in the process.