When a public company publishes a financial statement, everything should be clear and understood by all who read it. To ensure this, it is essential to have a baseline for reporting. This is where generally accepted accounting principles (GAAP) come in. GAAP represents methods, rules and practices that provide guidelines and procedures, as well as objective standards, for data and financial statements. In short: GAAP standardizes accounting for all businesses, so the data they report is universally understood and comparable.
Compliance with GAAP is a major implication for companies that communicate financial information to shareholders. It is mandated by the Securities and Exchange Commission (SEC) for all public companies, and good practice even for private companies. GAAP reports show a willingness to adhere to universally accepted accounting standards. It is beneficial for both companies and shareholders.
Who sets the standard for GAAP?
It is the duty of two organizations to establish and apply GAAP standards: the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC). As an impartial, independent and non-governmental entity, the FASB sets standards for generally accepted accounting principles. It reviews these standards annually and updates them via Codification of accounting standards.
The SEC may also set accounting standards by codifying them under GAAP in cooperation with the FASB. Once established, the SEC applies the standards of generally accepted accounting principles for all public companies. This may include imposing a fine on companies that fail to disclose their financial records in accordance with GAAP. A famous example occurred in 2019, when the SEC fined car rental company Hertz $ 16 million (OTCMKTS: HTZZ) for the presentation of non-GAAP figures.
Principles, assumptions and constraints
To understand the fundamental function and execution of GAAP, it is important to examine the principles, assumptions and constraints of the framework. These rules form the basis of generally accepted accounting principles and apply universally to all businesses.
These are the principles that govern the GAAP framework. They are universally recognized as the fundamental pillars of generally accepted accounting principles and their practices.
- Principle of historical cost. Companies report the costs of acquiring assets and liabilities.
- Principle of revenue recognition. Companies record transactions at the origin.
- Principle of reconciliation. Expenses correspond to income during the same period.
- Principle of full disclosure. Companies must disclose information in context.
These are universal assumptions that every business makes when it publishes its financial information. These assumptions are present in all documents filed by companies.
- Business entity. The business must remain separate from its owners and stakeholders.
- In the process of worrying. The business will operate indefinitely, independent of anyone.
- Currency units. The company presents its financial statements in a stable and consistent monetary unit.
- Periods of time. The company will file its financial reports on regular periods.
These are the absolute rules that a company must follow when communicating its financial information to remain in compliance with the standards of generally accepted accounting principles.
- Principle of objectivity. Financial statements must be based on objective evidence.
- Principle of materiality. The importance of an item should be taken into account when reporting.
- Principle of consistency. The company uses the same accounting principles from period to period.
- Principle of conservatism. Businesses must anticipate future losses but strive to make gains.
- Cost constraints. The benefit of reporting financial data should outweigh the cost.
GAAP vs IFRS
It is important to remember that GAAP is an American accounting standard. While many multinational companies practice generally accepted accounting principles for the sake of transparency, global companies also adhere to International Financial Reporting Standards (IFRS). While there are subtle differences between the two standards, GAAP and IFRS are, for all intents and purposes, the same thing.
The only real difference is that GAAP is rules-based and IFRS is principle-based. This may manifest difficulty in some areas of accounting, such as keeping records for inventory. However, both standards have their roots in the same practice of disclosing and contextualizing reported numbers. Often, the comparison of generally accepted accounting principles and IFRS statements is straightforward.
The GAAP hierarchy
What happens in a situation where there is no specific guideline or procedure for GAAP reporting? Accountants rely on the GAAP hierarchy. This framework of credible resources helps guide compliance even in situations where there is no explicit rule. Much of the hierarchy revolves around the guidelines of the Financial Accounting Standards Board (FASB) and the American Institute of Certified Public Accountants (AICPA). The hierarchy is as follows:
- FASB Statements of Financial Accounting Standards and Interpretations, FASB Staff Positions and AICPA Accounting Research Bulletins and Accounting Principles Board Opinions not replaced by FASB actions.
- Technical bulletins from FASB and AICPA Industry Audit and Accounting Guides and Statements of Position.
- AICPA Accounting Standards Executive Committee Practice Bulletins, FASB Emerging Issues Working Group (EITF) consensus positions, and topics covered in Appendix D of EITF Summaries.
- Implementation Guides (Q&A) issued by FASB staff, AICPA Accounting Interpretations, AICPA Industry Audit and Accounting Guides and Statements of Position not approved by the FASB, and widely recognized and widely used practices.
If an accountant goes through the entire list and cannot find an appropriate accounting standard to guide reporting, they are encouraged to rely on widely accepted and followed accounting practices. While rarely necessary for substantial reporting, this hierarchy is important in determining consistency even beyond GAAP.
GAAP exists to help businesses and investors
When companies publish financial information to a universal standard, it provides clarity and understanding to anyone who pays attention. For businesses, it’s a great way to benchmark their performance against a standard. For investors, this means having a clear view of the health and financial performance of a business. Importantly, it prevents a level of obscuration that could harm both parties.
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GAAP may be a mandatory practice, but it’s a practice every business should want to join, public or private. And, even in a situation without GAAP standardization, this framework provides the foundation for best practice in financial reporting. In short: GAAP level the playing field and ensure that everyone follows the same rules.