Generally accepted accounting principles (GAAP) is a set of standard rules that govern the legalities of business accounting. Businesses in the U.S. need to abide by GAAP guidelines when they release their financial reports. Every publicly listed company in the U.S. also needs to adopt GAAP for its accounting needs.
But what exactly does it entail for businesses? What makes it so popular that even the Financial Accounting Standards Board (FASB) has mandated its use? Let’s figure that out in this comprehensive guide.
What Are Generally Accepted Accounting Principles (GAAP)?
GAAP brings together different authoritative standards put in force by policy boards. Over the years, they have become the standard norm for reporting and recording accounting data. When you implement GAAP, you can expect better clarity and consistency in your company’s financial information.
GAAP is different from pro forma accounting, which does not comply with standards enlisted by GAAP. Almost every business in the United States uses the US GAAP accounting principles for their financial needs. The GAAP equivalent for the rest of the world is International Financial Reporting Standards (IFRS), which is used in around 166 countries globally.
GAAP will help you standardize your accounting process based on its general guidelines. You can expect regulated and standardized definitions that streamline your financial operations irrespective of your industry. GAAP covers wide-ranging topics like balance sheet classification and revenue recognition.
The History of GAAP
The 1929 stock market crash proved a catalyst for the establishment of GAAP, and the Great Depression that followed soon after further accelerated its introduction. It was widely believed that the Great Depression was caused by malpractices in financial reporting by publicly-listed companies, so new regulations were demanded.
The federal government worked with professional accounting groups to create consistent and accurate accounting and auditing procedures. It was the Securities Act of 1933 and the Securities Exchange Act of 1934 when the GAAP began gaining ground. Since then, GAAP has evolved tremendously based on various new accounting standards and concepts.
What Are the Principles of GAAP?
Here are the 10 GAAP accounting principles that highlight its mission.
- Principle of Regularity
- Principle of Consistency
- Principle of Sincerity
- Principle of Permanence of Methods
- Principle of Non-Compensation
- Principle of Prudence
- Principle of Continuity
- Principle of Periodicity
- Principle of Materiality
- Principle of Utmost Good Faith
Accountants need to accept GAAP rules as a standard practice.
Accountants need to commit to using consistent GAAP standards across the reporting process. They should enable reporting consistency for better financial comparability across periods. In cases of deviation regarding new and updated accounting standards used, accountants should mention the differences in footnotes.
Accountants should offer a clear and accurate picture of the company’s financial standing.
Financial reporting methods should follow a consistent standard that enables a fair comparison of a company’s financial records.
Accountants should report all positive and negative company outcomes with complete transparency. They should not compensate, or offset, debts with assets.
Accountants must highlight financial data backed by raw facts and not leave anything for judgment.
Businesses must assume that they will continue to operate when valuing their assets.
Each entry should be distributed across the relevant time period.
Accountants should disclose all accounting and financial information transparently in reports.
All the involved parties must remain honest and transparent in their transactions.
Who Uses Generally Accepted Accounting Principles?
GAAP is used by businesses that have public listings in the US. When you see that a company filed its taxes using US GAAP, you know that they have used the same standards as other companies in its industry. This makes it easier for investors to compare different companies within the same industry.
GAAP is used across all industries. However, it is especially helpful for companies that sell goods or services on credit. The money owed to the company needs consistent reporting so that investors can understand how well their investment is doing. Investors use this information when deciding whether or not to invest in certain businesses, so it must be accurate.
Why Are Generally Accepted Accounting Principles Important?
Here are several reasons why GAAP accounting principles are essential for companies in the US.
- Provide Consistency
- Facilitate Comparability
- Minimize risk
GAAP ensures that financial reporting is reliable, understandable, and useful for investors who use financial reports to make investment decisions. This standardization helps investors compare companies’ performance over time.
GAAP enables consistency in reporting across all publicly traded companies in a given industry. Investors can compare one company to another on an apples-to-apples basis. While there may be minor differences between how each company implements GAAP, the overall methodologies are similar enough to allow for meaningful comparisons.
Investors get accurate information about their investments in public companies through audited financial statements prepared according to GAAP principles.
Applications of Generally Accepted Accounting Principles
Each company that has adopted GAAP needs to abide by its applicable laws. Here are the different applications of GAAP accounting principles:
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Companies should use the accrual basis principle to create and maintain complete records of financial transactions. There should be complete accuracy in financial reports and statements. The reports should also comply with Farm Credit Administration. Exceptions can only be made if necessitated by regulatory norms.
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Companies should create financial reports and statements by abiding by the GAAP principles. Other documents under their purview include financial reports for the board of directors, investors, shareholders, Farm Credit Administration, etc.
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Records and books should enable reconciliation with financial statements and reports that originate from them.
US GAAP Compliance
The US Securities and Exchange Commission (SEC) requires publicly traded corporations to file GAAP-compliant financial statements. Companies need to do this regularly to have their listings stay relevant on the stock exchange. Certified public accounting firms can conduct external audits to check a company’s GAAP compliance measures.
Most lenders and creditors prefer to see a company’s financial statements prepared in accordance with GAAP. They will generally require annual GAAP-compliant financial statements as a part of their debt covenants, which is why most companies in the US have adopted GAAP.
Investors should be wary of companies that do not use GAAP for their financial statements. An absence of GAAP makes it difficult to compare the financial statements of different companies, and could lead to misinterpretation of a company’s performance.
Some companies disclose a non-GAAP measure when reporting their financial results. The non-GAAP measures need identification in financial statements and related public disclosures.
Generally Accepted Accounting Principles Requirement by State
GAAP’s hierarchy facilitates improvements in financial reporting. It offers a framework to principles that accountants should use to create financial reports and statements. Here is an overview of the hierarchy:
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The Financial Accounting Standards Board (FASB) and the American Institute of Certified Public Accountants (AICPA) statements need to come first.
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Next comes the AICPA Industry Audit and Accounting Guides and Statements of Position, and FASB Technical Bulletins.
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Then come Appendix D of EITF Abstracts topics, FASB Emerging Issues Task Force (EITF) positions, and American Institute of Certified Public Accountants (AICPA) bulletins.
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Finally, come AICPA Accounting Interpretations, FASB implementation guides, AICPA Industry Audit, Statements of Position not cleared by the FASB, etc.
GAAP Vs. IFRS: What’s the Difference?
GAAP focuses on streamlining the accounting and financial processes of US-based companies. These standards are created by the Financial Accounting Standards Board (FASB). IFRS is the global alternative to GAAP. The International Accounting Standards Board (IASB) is responsible for creating and maintaining the IFRS standards.
Both GAAP and IFRS dictate how businesses report their numbers on their financial statements, such as income statements and balance sheets. However, there are some key differences between these two accounting standards.
| GAAP | IFRS | |
|---|---|---|
| LIFO Inventory | GAAP-compliant companies can use Last In First Out (LIFO) as an inventory cost method. | IFRS prohibits the use of LIFO. |
| Research and Development Costs | Companies need to charge these costs as expenses. | Companies can capitalize and amortize these costs over different periods by meeting specified conditions. |
| Reversing Write-Downs | GAAP does not allow reversing the market value of an asset if its market value increases. | IFRS enables reversing the value of assets when their market worth increases. |
What Are Alternative Accounting Principles (Non-GAAP)?
IFRS is one of the popular alternatives to GAAP. Companies may present some figures that do not conform to GAAP rules. However, they must clearly state that those figures are not in compliance with GAAP and instead focus on IFRS. Businesses may do this when they think the GAAP rules do not capture enough details about their financial processes.
Besides making disclosures about non-GAAP measures, businesses may also list the non-GAAP metrics used for reports and statements. Investors need to be wary as these measures may misrepresent the company’s financials.
How Does a Company Benefit From Generally Accepted Accounting Principles?
Here are the different ways a business benefits from adopting GAAP principles:
- Enables Better Planning
- Helps Maintain Consistency
- Prevents Risks
- Wins Shareholder Trust
GAAP helps businesses plan effectively by allowing them to predict the future based on past financial information. For example, if a company’s revenue rises every year and the company plans to continue its growth pattern, it can use GAAP standards to predict revenue for the next five years.
GAAP helps businesses maintain consistency by providing a common language and standard practices for recording transactions and reporting results. It also requires companies to follow some rules when preparing financial statements and reports.
GAAP helps businesses reduce fraud by providing comprehensive accounting principles designed to ensure the reliability of financial reporting. It helps companies comply with applicable laws and regulations in their respective jurisdictions. GAAP also offers financial information about a business to help management make informed decisions about future investments.
GAAP helps businesses gain shareholder trust as it ensures that financial statements are accurate and reliable. Organizations that follow GAAP can show their investors and regulators that they are being honest about their finances. They can also prove that they use accepted standards to measure their performance.
Limitations of Generally Accepted Accounting Principles
While there are several advantages of GAAP, a couple of limitations do exist:
- No Global Recognition
- No Diversified Approach
GAAP is not globally recognized, which means it has limited application outside the US. For example, it is not recognized by the International Accounting Standards Board (IASB), which has established International Financial Reporting Standards (IFRS). In contrast to GAAP, IFRS finds use in most countries, including European ones.
Companies are forced to use the same accounting rules and principles regardless of their industry or size. This is a problem because different industries have different needs for financial reporting. Some aren’t served by GAAP, making it a problematic affair.
FAQs About Generally Accepted Accounting Principles
What are the rules of GAAP?
Financial Accounting Standards Board (FASB) maintains the GAAP rules to protect the interests of companies, investors, and customers. The rules include guidelines on how to keep your company’s books, and procedures to follow when recording financial transactions.
What is GAAP revenue?
GAAP revenue is the income revenue statement that will be a part of the company’s financial statements and reports. It must comply with the GAAP rules.
What are the 4 principles of GAAP?
Revenue, cost, matching, and disclosure are the four guiding principles of GAAP. Asset costs should be the cost to obtain the asset, and not actual market value. Revenue needs to be reported when realised and earned, not when payment is received.
Matching refers to enabling expense consistency in revenue and financial statements. Disclosure is the communication of information that investors need, so they can make a suitable judgment about a company’s financial position.
Why is GAAP important?
GAAP is important because it allows investors to make informed decisions about their investments. If a company isn’t following GAAP standards, it could be hiding bad debts or poor management practices from its investors.
What is an example of GAAP?
GAAP examples can include the guidelines to file income statements, financial periods to include, and steps to report cash flow.
