The Principles of GAAP, and Which of Them Are Actually Rules

Type “principles of GAAP” into a search box and you get a list of ten, repeated almost word for word across hundreds of pages: the going concern principle, the consistency principle, the matching principle, the principle of prudence. The list is useful. It is also not where the rules live, and anyone who goes looking for those ten headings in the actual standards will not find them.

The documents that carry the authority are public, and reading them clears up several things at once: who decides what GAAP is, what makes a financial statement good rather than merely legal, and why two companies in the same industry can report profit differently and both be correct.

Where GAAP actually lives

Generally accepted accounting principles for nongovernmental entities in the United States are contained in the FASB Accounting Standards Codification. FASB states it directly in the front matter of its own concepts statements: the Codification “is the source of authoritative GAAP recognized by the FASB to be applied by nongovernmental entities.”^[1] Everything else, including the conceptual framework quoted later in this article, sits outside it. Even the update documents FASB publishes when the rules change say so on their cover page: an Accounting Standards Update “is not authoritative,” it is a description of how the Codification is being amended.^[3]

The authority to say so comes from securities law rather than from accounting. In a 2003 policy statement, the Securities and Exchange Commission said the standards set by the FASB are recognized as “generally accepted” under Section 108 of the Sarbanes-Oxley Act.^[4] The enforcement is in Regulation S-X, which puts a thumb firmly on the scale: financial statements filed with the Commission that are not prepared in accordance with generally accepted accounting principles “will be presumed to be misleading or inaccurate,” whatever the footnotes say.^[5]

The ten principles, and their real status

So what are the famous ten? They are a compression of ideas that run through the standards, taught because the Codification is enormous and students need a scaffold. Several of them do correspond to real requirements: going concern, for instance, carries specific disclosure duties when substantial doubt exists. Others, such as “prudence,” describe an attitude that the standards themselves treat with care, because deliberate understatement is its own form of misstatement.

Here they are as they are usually taught, next to the document that actually imposes the requirement each one gestures at:

Read down the right-hand column and the pattern is plain. Four of the ten are restatements of one idea, comparability, and three more are ways of saying that a report should be neutral. The list is not wrong. It is a mnemonic for a smaller set of ideas, plus one genuine Codification requirement about going concern.

FASB draws the line explicitly. Its concepts statements are “not part of the FASB Accounting Standards Codification,” and a concepts statement does not require a change in existing GAAP, amend the Codification, or justify interpreting it from personal readings of the concepts.^[1] The framework explains the reasoning; the Codification holds the rules.

The framework does define the vocabulary that the standards then use. An asset is “a present right of an entity to an economic benefit.” A liability is “a present obligation of an entity to transfer an economic benefit.”^[2] Those two sentences decide an enormous number of practical arguments, from whether a lease belongs on the balance sheet to whether a customer deposit is revenue. They are also the same two categories a household balance sheet runs on, which is the subject of the five account types and what a balance really is.

What the framework asks financial information to be

Instead of ten principles, the conceptual framework names two fundamental qualities and four that enhance them. Financial information must be relevant and must faithfully represent what it purports to represent. Usefulness is then enhanced if the information is comparable, verifiable, timely and understandable.^[1]

Comparability is the one that explains most of the rulebook’s bulk. Users choose between alternatives, so information about one entity is more useful when it can be set against the same entity last year and against a competitor this year. Getting there requires agreement on hundreds of small questions that have no single right answer, which is why GAAP is long.

Materiality is not a percentage

Auditors use rules of thumb, and no standard blesses any of them. The framework defines materiality by consequence rather than by size: an omission or misstatement is material “if, in light of surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying upon the report would have been changed or influenced.”^[1]

Two features of that definition matter. Materiality is entity-specific, so the same dollar amount can be trivial in one company and decisive in another. And it turns on influence on a decision, which means a small number can be material when it changes a trend, breaches a covenant, or turns a loss into a profit. FASB adds that no general standard of materiality could capture every circumstance, since those judgments can only be made by people who know the facts.^[1]

Accrual, and who is allowed to skip it

Accrual is the idea people usually mean by “the matching principle”: record revenue when it is earned and costs when they are incurred, rather than when cash moves. The clearest place to see the alternative spelled out is the tax code, because the IRS permits both. Under the cash method you report income in the year you receive it and deduct expenses in the year you pay them; under the accrual method you report income in the year you earn it “regardless of when payment is received.”^[7]

Not every business has to accrue. IRS Publication 538, in its January 2022 revision, lets a corporation or partnership use the cash method if it meets a gross receipts test, set there at average annual gross receipts of $26 million or less for the three prior tax years, indexed for inflation. Whichever method is chosen, it has to clearly reflect income and be applied the same way from year to year.^[7]

An accrual is an ordinary journal entry with no bank transaction behind it. The insurance premium billed once a year becomes a twelfth of itself every month, so the month it is paid stops looking like a disaster.

LumaLedger

Ledger

Accrual · Homeowners insurance · Sep 30

AccountTypeDebitCredit

DRInsurance expenseExpense200.00

CRAccrued liabilitiesLiability200.00

Balanced200.00200.00

The measures that are not GAAP

Read a quarterly press release and the number in the headline is often not a GAAP number. Adjusted earnings, adjusted EBITDA and similar measures start from a GAAP figure and remove things management considers unrepresentative. They are legal in SEC filings, under conditions.

Item 10(e) of Regulation S-K requires a registrant using a non-GAAP measure in a filing to present the most directly comparable GAAP measure “with equal or greater prominence,” together with a reconciliation between the two and a statement of why management believes the measure is useful. The same rule forbids adjusting a performance measure to smooth away items labelled non-recurring when a similar charge occurred in the past two years or is reasonably likely to recur within the next two.^[6]

That is GAAP doing its real job. It does not stop anyone from computing a favorite number, and it makes the comparable, rule-bound figure impossible to hide beside it.

What a household can borrow from it

GAAP is a reporting regime for entities that owe an account of themselves to outsiders. Nobody audits a household. Three of its ideas still survive the trip.

Consistency is the one people break without noticing: recategorize a year of groceries halfway through and your own trend line becomes fiction. Accrual is why an annual premium should be treated as a monthly cost, which for a household is the same arithmetic as setting money aside for irregular bills before they arrive.

The mechanism underneath all of it is double-entry, which is older than GAAP by four centuries and is what makes the statements tie out at all. If the phrase is unfamiliar, the case for keeping personal accounts the way businesses keep theirs covers the mechanics.

LumaLedger applies that mechanism to personal money. Every transaction becomes a balanced entry you can open on the Ledger, scheduled entries post recurring accruals such as loan interest on their own, and the reports are sums over those same lines rather than a separate set of figures.

The ten principles are worth knowing, as long as you know what they are: a summary of a way of thinking, written by teachers rather than by the board. The binding text is duller and more specific, and it says, in effect, that a number is only worth publishing when someone else could check it and would care about the answer.