Having a solid understanding of GAAP or Generally Accepted Accounting Principles is what will help to separate you as a bookkeeper from the rest of the pack. Demonstrating this knowledge in your day to day accounting activities shows that you take what you do as seriously as any good CPA. The more you learn, the better you become.
GAAP are the accounting rules followed by accountants and bookkeepers when entering transactions and preparing the various financial statements. They serve as a guideline in properly accounting for the financial activities of any business or non-profit organization. It is divided into different types of concepts such Assumptions, Principles, Basis of Accounting and Constraints.
Dictionary.com defines an assumption as “something taken for granted; a supposition.” One of the assumptions of Generally Accepted Accounting Principles or GAAP is the Business Entity Assumption. This identifies a business based on its activities in order to separate it from its shareholders, owners and other businesses or entities. Once this assumption is made, financial records for the business are recorded and kept separate from the personal financial transactions of its owners and shareholders and any other businesses they may have an interest in. If someone owns two businesses, the books of each business should be kept separate from the other.
Another of the assumptions found in GAAP is the Going Concern Assumption. This basically assumes that the business will have a long life and therefore will be able to pay for all expenses and liabilities it incurs. A business that is failing and will soon close is no longer a going concern and may not be able to pay all that it owes once it has shut down.
The Currency Assumption says that currency, such as the US Dollar or the British Pound, is the common factor used in business financial transactions and therefore the foundation of recording those transactions in the books.
The measurement of transactions by month or year is called the Time Period Assumption. This allows a business to measure its profitability. Without following such an assumption a business would not have a way of measuring its performance month to month or year to year. Following this assumption helps a business to evaluate its position and make changes to improve its position in the marketplace.
Dictionary.com defines a principle as “an accepted or professed rule of action or conduct.” Following the rules of GAAP enables bookkeepers to do their job with accuracy. The following principles serve as guides in our bookkeeping work.
The Matching Principle is use by a bookkeeper to match costs and expenses to the revenue they helped generate, as long as it is possible to do so. For example, a construction company will record the costs associated with a particular job to the revenue that job creates. A manufacturing company can match the costs of producing their product to the revenue that those products brought in. When money spent by a business is not directly connected with revenue it is entered as an expense in the period it was spent.
In keeping with accrual basis bookkeeping, the Revenue Recognition Principle dictates that revenue must be recorded at the time it has been fully earned, not when it is received.
The Cost Principle is used as a means of determining the value of costs, expenses, revenue and liabilities. Instead of giving a cost a current “fair market value” for example, it is valued at the historical value. This means that if a company producing widgets bought the materials for their products in January and sold them in April, they will be valued at the actual amount spent to purchase them in January, and not what they would cost in April or what the company “thinks” they should be valued at. This helps to keep things objective instead of subjective.
Basis of Accounting
Bookkeeping is done on either a cash or accrual basis. With Cash Accounting, revenue is recorded only when it is actually received. Likewise, expenses are only recorded when they are paid.
With Accrual Accounting revenue is recorded when it is earned and costs and expense are recorded when they are incurred. Accrual accounting requires the use of payable and receivable accounts and is also used in payroll accounting for recording payroll liabilities. This method of accounting can also track sales tax liabilities that are reported on an accrual basis.
It is important to use the Time Period Assumption to connect revenue with the costs and expenses that helped create that revenue. This is one of the reasons accrual accounting is considered the most accurate. Cash accounting usually cannot directly match costs and expenses with revenue for the same time period since they can occur at different time periods from each other.
Dictionary.com defines constraint as a “limitation or restriction.”
Any information that is used by a bookkeeper to create financial statements of any kind should only be based on real, objective evidence. This is called the Objectivity Principle and it dictates that financial statements be created from real transactions and real dollar amounts.
The Consistency Principle says that a business should use the same accounting and bookkeeping principles every year.
The principles discussed on this page are just a brief overview of GAAP. The overall subject of Generally Accepted Accounting Principles is a subject of great depth and can be quite interesting to anyone interested in the subjects of accounting and bookkeeping. Not only are they interesting topics for discussion, but should be used as a guide in what we do as bookkeepers.