The philosophy of accounting is the conceptual framework for the professional preparation and auditing of financial statements and accounts. The issues which arise include the difficulty of establishing a true and fair value of an enterprise and its assets; the moral basis of disclosure and discretion; the standards and laws required to satisfy the political needs of investors, employees and other stakeholders. It is based on the reasonable man principle.
The term "GAAP" is an abbreviation for Generally Accepted Accounting Principles (GAAP). GAAP is a codification of how CPA firms and corporations prepare and present their business income and expense, assets and liabilities on their financial statements. GAAP is not a single accounting rule, but rather the aggregate of many rules on how to account for various transactions. The basic principles underlying GAAP accounting are set forth below.
When preparing financial statements using GAAP, most American corporations and other business entities use the many rules of how to report business transactions based upon the various GAAP rules. This provides for consistency in the reporting of companies and businesses so that financial analysts, banks, shareholders and the SEC (Securities & Exchange Commission) can have all reporting companies preparing their financial statements using the same rules and reporting procedures. This allows for an "apples to apples" comparison of any corporation or business entity with another. Thus, if company A reports $1,000,000 of net income, using GAAP, then the public and other users of financial statements can compare that net income to another company that is reporting $500,000 of net income, using GAAP.
The rules and procedures for reporting under GAAP are complex and have developed over a long period of time. Currently there are more than 150 "pronouncements" as to how to account for different types of transactions, ranging from how to report regular income from the sale of goods, and its related inventory values, to accounting for incentive stock option distributions. By using consistent principles, all companies reporting under GAAP report these transactions on their financial statements in a consistent manner.
The various rules and pronouncements come from the Financial Accounting Standards Board (FASB) which is a non-profit organization that the accounting profession has created to promulgate the rules of GAAP reporting and to amend the rules of GAAP reporting as occasion requires. The more recent pronouncements come as Statements of the Financial Accounting Standards (SFAS). Changes in the GAAP rules can carry tremendous impact upon American business. For example, when FASB stopped requiring banks to mark their assets (loans) to the lower of cost or market (i.e. value of a foreclosed home loan), the effect on a bank's "net worth" as defined by GAAP can change dramatically. While generally neutral, there is some pressure on the FASB to yield to industry or political pressure when it makes its rules.
Nonetheless, since all companies report using the same set of rules, knowing the rules of GAAP reporting can tell the user of financial statements a great deal. The study of accounting, in large part, entails learning the many rules and promulgations set forth by FASB and how to apply those rules to actual business events.
Trend Towards a More Global Perspective
GAAP is slowly being phased out in favor of the International Financial Reporting Standards (IFRS) as global business becomes more pervasive. GAAP applies only to United States financial reporting and thus an American company reporting under GAAP might show different results if it was compared to a British company that uses the International Standards. While there is close similarity between GAAP and the international rules, the differences can lead a financial statement user to believe incorrectly that company A made more money than company B simply because they report using different rules. The move towards International Standards seeks to eliminate this kind of disparity.
The Basic Principles
Principles derive from tradition, such as the concept of matching. In any report of financial statements (audit, compilation, review, etc.), the preparer/auditor must indicate to the reader whether or not the information contained within the statements complies with GAAP.

  • Principle of regularity: Regularity can be defined as conformity to enforced rules and laws.

  • Principle of consistency: This principle states that when a business has once fixed a method for the accounting treatment of an item, it will enter in exactly the same way all similar items that follow.

  • Principle of sincerity: According to this principle, the accounting unit should reflect in good faith the reality of the company's financial status.

  • Principle of the permanence of methods: This principle aims at allowing the coherence and comparison of the financial information published by the company.

  • Materiality concept: An item is considered material if its omission or misstatement will affect the decision making process of the users. Materiality depends on the nature and size of the item. Only items material in amount or in their nature will affect the true and fair view given by a set of accounts.

An error that is too trivial to affect anyone’s understanding of the accounts is referred to as immaterial. In preparing accounts it is important to assess what is material and what is not, so that time and money are not wasted in the pursuit of excessive detail.

  • Principle of non-compensation: One should show the full details of the financial information and not seek to compensate a debt with an asset, revenue with an expense, etc. (see convention of conservatism)

  • Principle of prudence: This principle aims at showing the reality "as is": one should not try to make things look prettier than they are. Typically, revenue should be recorded only when it is certain and a provision should be entered for an expense which is probable.

  • Principle of continuity: When stating financial information, one should assume that the business will not be interrupted. This principle mitigates the principle of prudence: assets do not have to be accounted at their disposable value, but it is accepted that they are at their historical value (see depreciation and going concern).

  • Principle of periodicity: Each accounting entry should be allocated to a given period, and split accordingly if it covers several periods. If a client pre-pays a subscription (or lease, etc.), the given revenue should be split to the entire time-span and not counted for entirely on the date of the transaction.

  • Principle of Full Disclosure/Materiality: All information and values pertaining to the financial position of a business must be disclosed in the records.

  • Principle of Utmost Good Faith: All the information regarding to the firm should be disclosed to the insurer before the insurance policy is taken.

In the U.S., Generally Accepted Accounting Principles are accounting rules used to prepare, present, and report financial statements for a wide variety of entities, including publicly traded and privately held companies, non-profit organizations, and governments. The term is usually confined to the United States; hence it is commonly abbreviated as US GAAP or simply GAAP. However, in the theoretical sense, Generally Accepted Accounting Principles encompass the entire industry of accounting, and not only the United States. Outside the academic context, GAAP means US GAAP.
Similar to many other countries practicing under the common law system, the United States government does not directly set accounting standards, in the belief that the private sector has better knowledge and resources. US GAAP is not written in law, although the U.S. Securities and Exchange Commission (SEC) requires that it be followed in financial reporting by publicly traded companies. Currently, the Financial Accounting Standards Board (FASB) is the highest authority in establishing generally accepted accounting principles for public and private companies, as well as non-profit entities. For local and state governments, GAAP is determined by the Governmental Accounting Standards Board (GASB), which operates under a set of assumptions, principles, and constraints, different from those of standard private-sector GAAP. Financial reporting in federal government entities is regulated by the Federal Accounting Standards Advisory Board (FASAB).
Setting GAAP

These organizations influence the development of GAAP in the United States.

The SEC was created as a result of the Great Depression. At that time there was no structure setting accounting standards. The SEC encouraged the establishment of private standard-setting bodies through the AICPA and later the FASB, believing that the private sector had the proper knowledge, resources, and talents. The SEC works closely with various private organizations setting GAAP, but does not set GAAP itself.

In 1939, urged by the SEC, the AICPA appointed the Committee on Accounting Procedure (CAP). During the years 1939 to 1959 CAP issued 51 Accounting Research Bulletins that dealt with a variety of timely accounting problems. However, this problem-by-problem approach failed to develop the much needed structured body of accounting principles. Thus, in 1959, the AICPA created the Accounting Principles Board (APB), whose mission it was to develop an overall conceptual framework. It issued 31 opinions and was dissolved in 1973 for lack of productivity and failure to act promptly. After the creation of the FASB, the AICPA established the Accounting Standards Executive Committee (AcSEC). It publishes:

  1. Audit and Accounting Guidelines, which summarizes the accounting practices of specific industries (e.g. casinos, colleges, airlines, etc.) and provides specific guidance on matters not addressed by FASB or GASB.
  2. Statements of Position, which provides guidance on financial reporting topics until the FASB or GASB sets standards on the issue.
  3. Practice Bulletins, which indicate the AcSEC's views on narrow financial reporting issues not considered by the FASB or the GASB.

Realizing the need to reform the APB, leaders in the accounting profession appointed a Study Group on the Establishment of Accounting Principles (commonly known as the Wheat Committee for its chair Francis Wheat). This group determined that the APB must be dissolved and a new standard-setting structure be created. This structure is composed of three organizations: the Financial Accounting Foundation (FAF, it selects members of the FASB, funds and oversees their activities), the Financial Accounting Standards Advisory Council (FASAC), and the major operating organization in this structure the Financial Accounting Standards Board (FASB). FASB has 4 major types of publications:

  1. Statements of Financial Accounting Standards - the most authoritative GAAP setting publications. More than 150 have been issued to date.
  2. Statements of Financial Accounting Concepts - first issued in 1978. They are part of the FASB's conceptual framework project and set forth fundamental objectives and concepts that the FASB use in developing future standards. However, they are not a part of GAAP. There have been 7 concepts published to date.
  3. Interpretations - modify or extend existing standards. There have been around 50 interpretations published to date.
  4. Technical Bulletins - guidelines on applying standards, interpretations, and opinions. Usually solves some very specific accounting issue that will not have a significant, lasting effect.

In 1984 the FASB created the Emerging Issues Task Force (EITF) which deals with new and unusual financial transactions that have the potential to become common (e.g. accounting for Internet based companies). It acts more like a problem filter for the FASB - the EITF deals with short-term, quickly resolvable issues, leaving long-term, more pervasive problems for the FASB.