Key Principles of GAAP

Why This Matters

Generally Accepted Accounting Principles aren't just arbitrary rules—they're the foundation that makes financial statements meaningful and comparable. When you're analyzing a company's balance sheet or income statement, you're relying on GAAP to ensure that what you're seeing reflects economic reality, not creative interpretation. These principles govern everything from when revenue gets recorded to how assets are valued to what information must be disclosed.

Here's what you need to understand: exam questions rarely ask you to simply define a principle. Instead, you're being tested on when to apply each principle, how principles interact with each other, and what happens when principles conflict. Don't just memorize the names—know what problem each principle solves and how it shapes the financial statements you'll be analyzing throughout this course.

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Timing and Recognition Principles

These principles answer the fundamental question: when should transactions hit the financial statements? Getting timing right is essential because recording revenues or expenses in the wrong period distorts profitability and misleads decision-makers.

Accrual Basis Principle

• Revenues and expenses are recognized when earned or incurred—not when cash changes hands, which separates economic activity from cash flow
• Provides accurate period-by-period performance measurement by capturing all economic events within the reporting period
• Foundation for all other recognition principles; without accrual accounting, matching and revenue recognition wouldn't function

Revenue Recognition Principle

• Revenue is recognized when earned and realizable—meaning the company has fulfilled its performance obligation and collection is reasonably assured
• Five-step model under ASC 606 guides recognition: identify contract, identify obligations, determine price, allocate price, recognize when satisfied
• Prevents premature revenue recognition that could inflate reported earnings and mislead investors

Matching Principle

• Expenses must be recorded in the same period as the revenues they generate—this is why depreciation exists rather than expensing assets immediately
• Drives accrual adjustments like prepaid expenses, unearned revenue, and accrued liabilities at period-end
• Directly impacts net income calculations by ensuring costs align with their associated benefits

Time Period Principle

• Financial statements cover specific, defined intervals—monthly, quarterly, or annually—enabling periodic performance assessment
• Creates the need for adjusting entries since many transactions span multiple periods
• Supports comparability by standardizing when financial snapshots are taken

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Measurement and Valuation Principles

How do we assign dollar amounts to what we're recording? These principles establish the basis for putting numbers on assets, liabilities, revenues, and expenses.

Cost Principle (Historical Cost)

• Assets are recorded at original acquisition cost—the amount actually paid, providing an objective, verifiable basis
• Prevents subjective fair value estimates that could be manipulated or disputed
• Trade-off with relevance: historical cost is reliable but may not reflect current economic value, especially for long-held assets

Monetary Unit Principle

• All transactions are recorded in a stable currency unit—typically the company's functional currency (USD for U.S. companies)
• Ignores inflation effects, which means dollar amounts from different years aren't truly comparable in purchasing power
• Enables mathematical operations on financial data; you can add, subtract, and compare amounts meaningfully

Conservatism Principle

• Recognize potential losses immediately but defer gains until realized—when in doubt, err toward understating assets and income
• Drives lower-of-cost-or-market rules for inventory and impairment testing for long-term assets
• Protects stakeholders from overly optimistic reporting by building in a margin of safety

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Disclosure and Transparency Principles

What information must be communicated, and how much detail is enough? These principles ensure stakeholders have the complete picture needed for informed decisions.

Full Disclosure Principle

• All material information affecting user decisions must be reported—either in the statements themselves or in accompanying notes
• Covers contingent liabilities, related-party transactions, and accounting policy choices that impact interpretation
• Notes to financial statements often contain critical information not visible in the numbers alone

Materiality Principle

• Information is material if omitting or misstating it could influence user decisions—this is both a quantitative and qualitative judgment
• Provides practical flexibility by allowing immaterial items to be aggregated or simplified without full disclosure
• No bright-line test exists; auditors and accountants must exercise professional judgment based on context

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Comparability and Consistency Principles

How do we ensure financial statements can be meaningfully compared—across time and across companies?

Consistency Principle

• Same accounting methods must be applied period to period—you can't switch depreciation methods just to boost earnings one quarter
• Changes require disclosure and justification including the effect on financial statements and the reason for the change
• Enables trend analysis so users can track performance over time without methodology distortions

Economic Entity Principle

• Business transactions must be kept separate from owner's personal transactions—the company is a distinct reporting unit
• Applies to subsidiaries and related entities which may require consolidated or separate reporting depending on control
• Foundation for accountability; without entity separation, financial statements would be meaningless

Going Concern Principle

• Financial statements assume the business will continue operating indefinitely—not liquidate tomorrow
• Affects asset valuation since liquidation values often differ dramatically from going-concern values
• Management must assess and auditors must evaluate whether substantial doubt exists about continued operations

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Quick Reference Table

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Self-Check Questions

1. Which two principles work together to determine when expenses appear on the income statement, and how do they differ in focus?

2. A company wants to switch from FIFO to LIFO inventory valuation mid-year. Which principle is most directly affected, and what does GAAP require when such a change occurs?

3. Compare and contrast the Cost Principle and Conservatism Principle—under what circumstances might conservatism override historical cost?

4. If a company's owner pays personal expenses from the business checking account, which GAAP principle has been violated, and why does this matter for financial statement users?

5. An FRQ describes a company that received cash in December for services to be performed in January. Using specific GAAP principles, explain when revenue should be recognized and why.