What are the generally accepted accounting principles?
Generally Accepted Accounting Principles (GAAP) refers to a common set of accounting principles, standards and procedures published by the Financial Accounting Standards Board (FASB). Public companies in the United States must follow GAAP when their accountants prepare their financial statements.
GAAP is a combination of authoritative standards (established by policy boards) and generally accepted methods for recording and reporting accounting information. GAAP aims to improve the clarity, consistency and comparability of financial reporting.
GAAP can be compared to pro forma accounting, which is a non-GAAP financial reporting method. Internationally, the equivalent of GAAP in the United States is called International Financial Reporting Standards (IFRS). IFRS are applied in more than 120 countries, including those in the European Union (EU).
GAAP helps to govern the world of accounting according to general rules and guidelines. It attempts to standardize and regulate the definitions, assumptions and methods used in accounting in all industries. GAAP covers topics such as revenue recognition, balance sheet classification and materiality.
The ultimate goal of GAAP is to ensure that a company’s financial statements are complete, consistent and comparable. This makes it easier for investors to analyze and extract useful information from the company’s financial statements, including trend data over a specific time period. It also facilitates the comparison of financial information between different companies.
These 10 general concepts can help you remember the main mission of GAAP:
1. Principle of regularity
The accountant has adhered to GAAP rules and regulations as a standard.
2. Principle of consistency
Accountants are committed to applying the same standards throughout the reporting process, from period to period, in order to ensure financial comparability between periods. Accountants are required to disclose and fully explain the reasons for any change or update to the standards in the footnotes of the financial statements.
3. Principle of sincerity
The accountant strives to provide an accurate and unbiased description of a company’s financial position.
4. Principle of permanence of methods
The procedures used in financial reporting must be consistent, allowing a comparison of the company’s financial information.
5. Principle of non-compensation
Negative and positive points should be reported transparently and without expectation of debt compensation.
6. Principle of prudence
It is about emphasizing a factual representation of financial data that is not obscured by speculation.
7. Principle of continuity
While valuing assets, it must be assumed that the business will continue to operate.
8. Principle of periodicity
Registrations must be spread over the appropriate periods. For example, the income must be declared in the corresponding accounting period.
9. Principle of materiality
Accountants should strive to fully disclose all financial data and accounting information in financial reports.
10. Principle of the greatest good faith
Derived from the Latin expression “uberrimae fidei ” used in the insurance industry. It presupposes that the parties remain honest in all transactions.
If a company’s shares are publicly traded, its financial statements must follow rules set by the United States Securities and Exchange Commission (SEC). The SEC requires publicly traded companies in the United States to regularly file GAAP-compliant financial statements in order to remain publicly traded. Compliance with GAAP is ensured by the opinion of an appropriate auditor, resulting from an external audit carried out by an accounting firm (CPA).
Although not mandatory for unlisted companies, GAAP is viewed favorably by lenders and creditors. Most financial institutions will require annual financial statements in accordance with GAAP as part of their covenants when issuing business loans. As a result, most companies in the United States follow GAAP.
If a financial statement is not prepared in accordance with GAAP, investors should be careful. Without GAAP, it would be extremely difficult to compare the financial statements of different companies, even within the same industry, making it difficult to compare apples to apples. Some companies may report both GAAP and non-GAAP measures when reporting their financial results. GAAP regulations require that non-GAAP measures be identified in financial statements and other public information, such as press releases.
The GAAP hierarchy is designed to improve financial reporting. It consists of a framework for selecting the principles that public accountants should use in preparing financial statements in accordance with US GAAP. The hierarchy breaks down as follows:
- Statements by the Financial Accounting Standards Board (FASB) and the Accounting Research Bulletins and Opinions of the Accounting Principles Board of the American Institute of Certified Public Accountants (AICPA)
- FASB Technical Bulletins and AICPA Industry Accounting and Auditing Guides and Position Statements
- AICPA Accounting Standards Executive Committee Practice Bulletins, FASB Emerging Issues Working Group (EITF) Positions, and Topics Covered in Appendix D of EITF Summaries
- FASB Implementation Guides, AICPA Accounting Interpretations, AICPA Industry Audit and Accounting Guides, Statements of Position not approved by the FASB, and widely accepted and followed accounting practices
Accountants are advised to consult sources at the top of the hierarchy first, and then move to lower levels only if there is no relevant statement at a higher level. FASB Statement of Financial Accounting Standards No. 162 provides a detailed explanation of the hierarchy.
GAAP vs IFRS
GAAP focuses on the accounting and financial reporting of American businesses. The Financial Accounting Standards Board (FASB), an independent, not-for-profit organization, is responsible for establishing these accounting and financial reporting standards. The international alternative to GAAP are International Financial Reporting Standards (IFRS), established by the International Accounting Standards Board (IASB).
The IASB and FASB have been working on the convergence of IFRS and GAAP since 2002. As a result of the progress made in this partnership, the SEC in 2007 removed the requirement for non-U.S. Companies registered in America to reconcile their financial reports to GAAP if their accounts were already in compliance with IFRS. This was a great achievement because prior to the decision, non-US companies trading on US stock exchanges had to provide GAAP-compliant financial statements.
Some differences that still exist between the two accounting rules include:
- LIFO inventory: Although GAAP allows companies to use the last in, first out (LIFO) method as the cost of inventory method, this is prohibited under IFRS.
- Research and development costs: These costs should be expensed as they are incurred under GAAP. Under IFRS, costs can be capitalized and amortized over multiple periods if certain conditions are met.
- Cancellation of depreciation: GAAP specifies that the amount of depreciation of an inventory or a fixed asset cannot be reversed if the market value of the asset subsequently increases. The depreciation can be reversed under IFRS.
As companies increasingly must navigate global markets and operate globally, international standards are becoming increasingly popular at the expense of GAAP, even in the United States. Almost all companies in the S&P 500 report at least one non-GAAP earnings measure in 2019.
GAAP is just a set of standards. Although these principles are intended to improve the transparency of financial statements, they do not provide any guarantee that a company’s financial statements are free from errors or omissions intended to mislead investors. There is plenty of room in GAAP for unscrupulous accountants to twist the numbers. So even when a company uses GAAP, you still need to review its financial statements.
Frequently Asked Questions
Where are generally accepted accounting principles (GAAP) used?
GAAP is a set of procedures and guidelines used by companies to prepare their financial statements and other accounting information. The standards are prepared by the Financial Accounting Standards Board (FASB), which is an independent, not-for-profit organization. The purpose of GAAP standards is to help ensure that financial information provided to investors and regulators is accurate, reliable and consistent with one another.
Why is GAAP important?
GAAP is important because it helps maintain confidence in the financial markets. Without GAAP, investors would be more reluctant to trust information presented to them by companies because they would have less confidence in its integrity. Without this confidence, we could see fewer transactions, which could lead to higher transaction costs and a less robust economy. GAAP also helps investors analyze businesses by making it easier to make “apple-to-apples” comparisons between one company and another.
What are the non-GAAP measures?
Companies are still allowed to submit certain numbers without complying with GAAP guidelines, as long as they clearly identify those numbers as non-GAAP compliant. Companies sometimes do this when they feel that GAAP rules are not flexible enough to grasp certain nuances about their operations. In this situation, they may provide specially designed non-GAAP measures, in addition to other information required under GAAP. Investors should be skeptical of non-GAAP measures, however, as they can sometimes be used in a misleading manner.