What are generally accepted accounting principles?

Definition

Generally accepted accounting principles are the shared US ruleset for measuring, recording, and presenting a company's financial statements. They tell the books how to value inventory, when to record revenue, and how a reader should expect a Balance Sheet or Income Statement to be put together.

This is a body of standards and conventions, not one statute. Lenders, buyers, and CPAs treat it as the default way US statements are prepared so one company's numbers can be compared with another's.

Where it shows up

Balance Sheet: Related to how the statement is prepared under common US rules.

P&L: Related to how the statement is prepared under common US rules.

Cash flow: Related to how the statement is prepared under common US rules.

See also: Accrual Basis Accounting · Financial Statement Package · Audit

You will not find a line for this ruleset on any statement. The rules sit behind the statements: they decide what each line means and how it was measured.

When you open a Financial Statement Package, every report in the bundle is supposed to have been prepared the same way. That is why a hardware store's inventory on the Balance Sheet is cost, not the shelf price, and why the Income Statement's net income follows those same measurement rules.

A bank or a buyer who asks for statements under this ruleset is asking for this measurement, not for a different layout. Separate tax or cash books can still exist; they are just not this ruleset.

How it works

The ruleset covers recognition, measurement, presentation, and disclosure. Recognition is the decision of when an item belongs on the books, and measurement is the dollar amount assigned to it.

Presentation is how that amount is grouped and labeled on the statements. Disclosure is the extra explanation a reader needs when a number alone is not enough.

US companies that follow the ruleset record most activity in the general ledger using journal entries. Each debit and credit has to land in an account from the chart of accounts, and the measurement behind that landing follows the rules, not the owner's preference.

Revenue recognition is one of those measurement rules. Inventory is another: units on hand are carried at cost, not at what they might sell for.

At the end of an accounting period, adjusting journal entries bring the books onto the ruleset before the statements go out. A trial balance then lists every account so the bookkeeper can see that debits still equal credits after those adjustments.

The same ruleset applies whether the period is a month, a quarter, or a fiscal year. Statements after a month-end close and a year-end close follow the same measurement, even if the year-end package has more notes.

Internal controls help the books stay on the ruleset through approvals, source documents, and an audit trail from a reported number back to what happened. The ruleset is the standard; the controls are how the company tries to meet it.

Example

A neighborhood hardware store has $40,000 of goods on the shelf at retail ticket. The store paid $18,000 for those goods.

Under the common US ruleset, the CPA reports $18,000 of inventory at cost on the Balance Sheet. The $40,000 retail ticket is not a book amount; it is a price tag.

If the owner instead booked inventory at $40,000, assets and equity would both be inflated by $22,000. A lender would think the store holds $22,000 more in goods than it paid for.

The Income Statement would also be wrong later. When those goods sell, cost of goods sold has to come from the cost on the books, not from the ticket.

Starting at retail would understate the cost of what sold and overstate profit. That is the ruleset doing its job: same measurement, same statements, same reader expectation.

The store can still print shelf tags at $40,000. The books stay at $18,000 until a sale happens.

Common mix-ups

This ruleset versus tax books. Many small businesses keep a tax return on a different basis than the statements they show a bank, and the ruleset on this page is the one for financial statements, not the Internal Revenue Code.

This ruleset versus accrual basis accounting. Accrual basis is one method the ruleset usually requires, but the ruleset is bigger: it also covers inventory cost, presentation, and the notes a reader needs.

This ruleset versus an audit. An audit is an independent examination of whether the statements follow the ruleset; following the ruleset is the work of the books, and an audit is a later opinion about that work.

Related terms

• Accrual Basis Accounting: Recording revenue when earned and expenses when incurred.
• Revenue Recognition: The rules for deciding when earned revenue may be recorded.
• Materiality: The threshold at which an error or item is big enough to matter to a reader.
• Audit: An independent examination giving an opinion on whether statements are fairly stated.
• Financial Statement Package: The bundled set of statements and schedules delivered after a close.
• Inventory Valuation: The method used to assign cost to units held and units sold.
• Consolidation: Combining multiple entities into one set of financial statements.
• Review Engagement: A limited-assurance engagement based mostly on inquiry and analytics.