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The GAAP Hierarchy
Category: Accounting
Subcategory: GAAP

 

Recently the FASB, or the Financial Accounting Standards Board, was in the news for publishing a draft that brought to the public’s attention a hierarchy of the generally accepted accounting principles. This hierarchy is currently defined in a standard form by the AICPA (American Institute of Certified Public Accounts), and ranks the authority of the accounting principles issued from multiple standards.
 
GAAP is the standard structure of regulations for financial accounting. This framework includes the accounting conventions, standards, and rules for recording and summarizing transactions and making financial statements. Considering the importance GAAP holds in the commercial world, the FASB has proposed to codify and retrieve projects that will integrate the existent US GAAP into a single source, resulting in the creation of a single authoritative codification of GAAP for the accounting community.
 
This proposal from the FASB shifts the responsibility for the GAAP hierarchy for non-governmental entities from the auditing literature to the accounting literature. Earlier, the GAAP hierarchy was hugely criticized for being targeted towards the auditors rather than the reporting entity, in charge of choosing the accounting principles. The relevant changes can be viewed at www.fasb.org. In addition, the FASB is expected to issue the final standard of the GAAP hierarchy in the latter part of this year.
 
However, the AICPA has also issued a draft against the FASB’s draft. This exposure draft has introduced a proposed statement on the auditing standards that is applicable only to the non-governmental entities. The AICPA has also noted that FASB may employ more hierarchy changes. The changed projects of GAAP hierarchy have reduced the number of accounting literature to two, namely authoritative and non-authoritative. And the board claims that these two literatures are sufficient in themselves to address the role of the FASB concept statements in the hierarchy.
 
Since so much has been talked about GAAP hierarchy let us examine some of the fundamental points of this hierarchy.
  
Basic objectives:
 
Financial reporting as per GAAP should provide information that is useful to:
 
Present and potential creditors and investors for making rational investments, credit, and other financial decisions
 
Present and potential creditors and investors in assessing the amount, timing, and uncertainty of prospective cash receipts.
 
And about the economic resources, their claims on those resources, and the effected changes in them
 
Now let’s see what GAAP’s fundamental qualities are through which it aims to achieve those objectives:
 
To be helpful and useful, financial statements must have the following features:
 
Relevant information: It makes a great difference in taking the right decision. It also helps to forecast about past, present and future events. Relevant information also helps users in confirming and correcting prior expectations, provided the information is available on time.
 
Reliable information: This should be substantiated, unbiased, and illustrate representational faithfulness.
 
Comparable: Although the data may be different for each kind of industry, but they should be measured and reported in a similar manner, because this allows the financial statements to be compared between various companies.
 
 
Consistent: The accounting methods which are applied for each period should be the same, and if they are changed, the changes should be justified and explained.
  
And finally, to achieve the objectives and implement the fundamental qualities, GAAP uses four basic assumptions, four basic principles, and four basic constraints.
 
Four Basic Assumptions:
 
Economic entity assumption
 
Going concern assumption
 
Monetary Unit assumption
 
Periodic Reporting Assumption
 
Four Basic Principles:
 
Historical cost principle
 
Revenue recognition principle
 
Matching principle
 
And the Full disclosure principal
 
Four Basic Constraints:
 
Cost benefit relationship
 
Materiality
 
Industry practices
 
Conservatism
 
The guidelines of GAAP are not specified in law, but the US Securities and Exchange Commission requires every publicly traded company that does financial reporting to follow the rules. Presently, the GAAP accounting principles are somewhat different from the International Financial Accounting Standards, but FASB is making efforts to reconcile both.