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Summary GAAP Theory Summarized
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- Accounting
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- 12
GAAP Theory all summarized in detail
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Grade 12 Theory Notes: GAAPGenerally Accepted Accounting Practice (GAAP)
The accounting process and the preparation of financial statements are traditionally based on several
principles which are referred to as fundamental accounting concepts. These concepts express the
basic assumptions which directly affect and to a large extent determine what is known as Generally
Accepted Accounting Practice.
To analyse and interpret financial statements it is necessary to know and understand these
fundamental accounting concepts. These concepts may not always be self-evident but have such
general acceptance worldwide that their observance is presumed unless otherwise stated. The fact
that all businesses report their financial position in accordance with GAAP allows stakeholders,
investors, and other interested parties to easily compare different company’s financial reports and
assist them in making important business decisions.
Fundamental accounting concepts
The business entity concept
The financial affairs of the business are kept separate from the financial affairs of the owners. The
reasons for this rule are:
1. The business has a life distinct from that of its owner.
2. The financial performance of the business will not get muddled up with occurrences of a
personal nature. This is particularly relevant when calculating the net profit of the business.
Despite the business being separate from the owner, the owner is still liable for the debts of the
business in respect of sole proprietorships and partnerships should the business be declared
insolvent.
The historical cost concept
This concept refers to the actual cost of the asset which is used when calculating annual
depreciation. The general rule is that assets are to be valued at historical cost, that is, at the amount
which was originally paid for them. This rule prevents manipulation of the value of assets which could
unfairly inflate the net worth of a business if the assets were to be overvalued.
The going concern concept
The going concern concept is based on the normal expectations of management and investors,
assuming that a business expects to continue its operations indefinitely and that in the absence of
any evidence to the contrary there will be no necessity for liquidation in the foreseeable future.
Should it become necessary to close the business then the assets would be valued at market value
or realizable value which will be different to the historical cost value of the assets. All fixed assets,
investments and current assets are valued in accordance with the historical cost rule, less normal
wear, and tear and not the “forced sale” basis i.e. what the assets would realize if they were sold on
liquidation.
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