GAAP Principles

Why This Matters

In Intermediate Financial Accounting, you're not just learning rules—you're learning why financial statements look the way they do and how accountants make judgment calls that affect every number you see. GAAP principles form the conceptual backbone of financial reporting, and exam questions will test whether you understand the reasoning behind accounting treatments, not just the mechanics. These principles explain everything from why we depreciate assets over time to why companies can't record revenue the moment a customer shows interest.

The principles you'll study here fall into distinct categories: some govern when transactions get recorded, others determine how much gets recorded, and still others ensure what information reaches financial statement users. When you encounter a tricky scenario on an exam—say, a company facing potential bankruptcy or a questionable revenue transaction—these principles tell you how to handle it. Don't just memorize definitions; know which principle applies to which situation and why it exists in the first place.

---

Timing and Recognition Principles

These principles answer a fundamental question in accounting: when should we record transactions? The timing of recognition directly affects reported income, assets, and liabilities—making these principles essential for understanding how financial statements capture economic reality.

Accrual Basis Principle

• Revenues and expenses are recognized when earned or incurred—not when cash changes hands, which separates economic events from cash flow timing
• Foundation of GAAP reporting that distinguishes accrual accounting from cash-basis accounting used by small businesses and individuals
• Enables meaningful period-to-period comparisons by capturing all economic activity within the reporting period, regardless of payment timing

Revenue Recognition Principle

• Revenue is recognized when realized (or realizable) and earned—the two-part test you'll apply repeatedly in intermediate accounting problems
• ASC 606's five-step model now governs recognition: identify contract, identify obligations, determine price, allocate price, recognize when satisfied
• Critical for exam scenarios involving multi-element arrangements, bill-and-hold transactions, and long-term contracts

Matching Principle

• Expenses must be recorded in the same period as the revenues they generate—this is why we depreciate equipment rather than expense it immediately
• Drives adjusting entries for items like prepaid expenses, accrued wages, and depreciation that students often find tricky
• Directly affects net income calculations and is frequently tested through scenarios asking when to recognize costs

---

Measurement and Valuation Principles

These principles govern how much to record. When you're deciding what dollar amount goes on the balance sheet or income statement, these principles provide the guardrails that keep financial reporting objective and reliable.

Cost Principle (Historical Cost)

• Assets are recorded at their original acquisition cost—the amount actually paid in an arm's-length transaction
• Provides objectivity and verifiability since historical cost is documented and not subject to estimation or opinion
• Trade-off with relevance because historical cost may not reflect current market value, which is why fair value measurements exist for certain assets

Conservatism Principle

• When uncertainty exists, choose the option that understates assets/income—recognize losses immediately but defer gains until certain
• Drives lower-of-cost-or-market rules for inventory and impairment testing for long-lived assets
• Asymmetric treatment means bad news hits financial statements faster than good news, protecting users from overly optimistic reporting

Objectivity Principle

• Financial data must be based on verifiable, unbiased evidence—invoices, contracts, bank statements, not management's hopes
• Supports audit function by requiring documentation that external parties can independently confirm
• Limits use of estimates to situations where objective measurement isn't possible, and even then requires reasonable basis

---

Disclosure and Transparency Principles

These principles ensure that financial statement users receive complete and relevant information. They govern what must be communicated beyond the basic numbers—the context, explanations, and details that make financial statements useful.

Full Disclosure Principle

• All information that could influence user decisions must be disclosed—either in the statements themselves or in the notes
• Drives extensive footnote disclosures covering accounting policies, contingencies, related-party transactions, and subsequent events
• Protects companies legally while providing stakeholders the transparency needed for informed decision-making

Materiality Principle

• Only information significant enough to affect decisions requires disclosure—immaterial items can be simplified or aggregated
• Requires professional judgment since materiality depends on both quantitative thresholds and qualitative factors
• Practical application allows accountants to expense low-cost assets immediately rather than capitalizing and depreciating them

---

Consistency and Comparability Principles

These principles ensure financial statements remain useful over time and across companies. Without consistency, trend analysis becomes meaningless; without comparability, benchmarking against competitors falls apart.

Consistency Principle

• Same accounting methods must be applied period to period—you can't switch between FIFO and LIFO to manipulate income
• Changes require disclosure and justification including retrospective application and explanation of why the new method is preferable
• Enables trend analysis so users can meaningfully compare this year's results to prior years

Going Concern Principle

• Financial statements assume the business will continue operating indefinitely—not liquidate tomorrow
• Affects asset valuation because going concern values (based on future use) differ from liquidation values (fire-sale prices)
• Management must assess annually whether substantial doubt exists about continuing operations for at least 12 months

---

Quick Reference Table

---

Self-Check Questions

1. A company purchases equipment for $50,000$ but its market value rises to $75,000$ the following year. Which two principles explain why the equipment remains on the books at $50,000$?

2. Compare and contrast the matching principle and the accrual basis principle. How do they work together, and what distinct purpose does each serve?

3. A retailer discovers that a $200$ office supply purchase was expensed immediately rather than capitalized. Which principle justifies this treatment, and what factors would change that conclusion?

4. If an FRQ presents a company with significant doubt about its ability to continue operations, which principle is being tested, and how would this affect the valuation of inventory and fixed assets?

5. A company switches from straight-line to double-declining depreciation without disclosure. Which principle has been violated, and what specific disclosures would be required if the change were properly handled?