The Accounting Cycle

Why This Matters

Imagine every company prepared financial statements differently:

• Company A records revenue when contracts are signed

• Company B records revenue when work is completed

• Company C records revenue when payment is received

An investor comparing the three gets meaningless data. It's like comparing temperatures in Celsius to Fahrenheit—different scales, impossible comparison.

GAAP is the rulebook that ensures all companies use the same scale.

Without GAAP, financial statements would be chaos. With GAAP, investors can compare Apple to Microsoft, banks can assess loan risk, and markets function.

What Is GAAP?

GAAP

= Generally Accepted Accounting Principles

The standardized rules and procedures that accountants must follow when preparing financial statements.

Who sets GAAP?

US: FASB (Financial Accounting Standards Board)
International: IASB → IFRS
Enforced by: SEC for public companies

Why it exists:

Without GAAP, every company would have its own rules, and financial statements would be incomparable and unreliable.

GAAP doesn't exist to constrain accountants. It exists to protect everyone who relies on financial statements.

The Foundation: Four Assumptions

Before the principles, GAAP starts with four fundamental assumptions:

The Framework: Two Constraints

Before applying principles, GAAP also recognizes two constraints:

Materiality

Only matters if it's significant enough to affect decisions.

Company buys staplers for $50 → Expense immediately (immaterial)

Company buys building for $5M → Capitalize as asset (material)

Implication: Professional judgment about what matters.

Cost-Benefit

The cost of accounting shouldn't exceed the benefit to users.

✗ Tracking every pencil used (benefit: minimal, cost: high)

✓ Tracking total office supplies expense (benefit: significant, cost: low)

Implication: Accounting must be practical, not perfectionist.

The 10 Core Principles

How the Principles Work Together

The 10 principles aren't independent—they work as a system:

Going Concern: Assume business continues → value assets for long-term use

Cost Principle: Record assets at historical cost (objective, not inflated)

Revenue Recognition: Recognize when earned (not when convenient)

Matching Principle: Expenses matched to period revenue earned

Full Disclosure: Disclose how all these principles were applied

Consistency: Apply the same way every year

Result: Comparable, reliable financial statements

Why Each Principle Exists: Fraud Prevention

Principle	Fraud Risk	How It Prevents
Business Entity	Owner using company assets personally	Separate personal from business
Cost	Inflating asset values	Record at cost, not guessed value
Revenue Recognition	Recording sales too early	Record only when earned
Matching	Mismatching revenues/costs	Match to same period
Full Disclosure	Hiding problems	Require transparency
Objectivity	Subjective manipulations	Use verifiable facts
Consistency	Changing methods to manipulate	Use same method always
Conservatism	Optimistic overstatement	Record lower profit when uncertain

GAAP vs. IFRS: The Global Difference

The US uses GAAP. Most of the world uses IFRS (International Financial Reporting Standards).

GAAP (Rules-Based)

✓ Specific, detailed, less ambiguity
✗ Can be gamed (follows letter, not spirit)

IFRS (Principles-Based)

✓ Flexible, emphasizes substance over form
✗ Requires more judgment, less comparable

Reality: Both are legitimate. Choice depends on jurisdiction. IFRS used in 140+ countries.

Who Enforces GAAP?

FASB

Sets the standards

Issues Accounting Standards Codification (ASC)

SEC

Enforces compliance

Requires public companies to use GAAP

AICPA

Professional standards

Enforces ethical standards for CPAs

Real-World: How GAAP Prevents Fraud

Key Takeaway

GAAP (Generally Accepted Accounting Principles) is the standardized framework that ensures all companies prepare financial statements using the same rules. Built on four assumptions, constrained by materiality and cost-benefit considerations, and governed by ten core principles, GAAP creates comparable, reliable financial statements. Each principle addresses a specific fraud risk and ensures that financial statements reflect economic reality fairly.

Test Your Understanding

Which assumption states that a business will continue operating in the foreseeable future?

The Cost Principle states that assets should be recorded at:

Which principle requires disclosing all information important to financial statement users?

The Matching Principle is violated when:

True or False: GAAP allows companies to switch between accounting methods each year to show better results.

Ready to Practice?

You now understand the authoritative framework that governs all accounting. Apply GAAP principles to complex scenarios and identify principle violations.

Try the Practice Lab

GAAP Principles