What is the definition of generally accepted accounting principles (GAAP)?
The Financial Accounting Regulations Board (FASB) publishes a collection of accounting rules, regulations, and procedures known as generally accepted accounting principles (GAAP). U.S. public corporations’ accountants must follow GAAP when preparing financial statements.
GAAP is rules-based and based on ten principles. Some connect it to the principles-based International Financial Reporting Standards (IFRS). Recent initiatives are underway to switch GAAP reporting to IFRS, a more worldwide standard.
Knowing generally accepted accounting principles (GAAP)
Policy board-set rules and standardized accounting data recording and reporting methods comprise GAAP. GAAP clarifies, standardizes, and compares financial information.
GAAP differs from pro forma accounting, a non-GAAP financial reporting approach. International Financial Reporting Standards (IFRS) are the counterpart of U.S. GAAP. 166 jurisdictions utilize IFRS.
GAAP governs accounting through broad principles and recommendations. The goal is to standardize and control accounting terminology, assumptions, and practices across sectors. GAAP addresses revenue recognition, balance sheet categorization, and materiality.
The main objective of GAAP is to guarantee complete, uniform, and comparable financial reporting for companies. This helps investors examine and extract meaningful information from the company’s financial statements, including trend data. It helps compare financial data between firms.
The Top 10 generally accepted accounting principles (GAAP)
Ten general ideas define GAAP’s objective.
1. Regularity Principle
The accountant followed GAAP.
2. Consistency Principle
Accountants agree to adopt the same standards throughout reporting periods to guarantee financial comparability. Accounting professionals must explain the reasons for the new rules in financial statement footnotes.
3. Sincerity Principle
Accountants aim to accurately and impartially report a company’s finances.
4. Method Permanence Principle
Financial reporting practices should be consistent to compare the company’s finances.
5. Non-Compensation Principle
Report problems and positives transparently, without debt compensation.
6. Prudence Principle
This means stressing fact-based financial facts without guesswork.
7. Continuity Principle
When evaluating assets, presume business continuity.
8. Periodicity Principle
Divide entries into relevant timeframes. For instance, report revenue in its applicable accounting period.
9. Materiality Principle
Accountants must provide all financial and accounting facts in financial reports.
10. Highest Good Faith
It comes from the Latin word “uberrimae fidei,” used in the insurance sector. The system assumes honesty in all dealings.
Corporations with publicly traded shares must follow SEC standards for financial statements. U.S. publicly traded corporations must file GAAP-compliant financial statements with the SEC to stay listed on stock exchanges.CPA firms conduct external audits to guarantee GAAP compliance.
Although non-publicly listed firms are not compelled to use GAAP, bankers and creditors prefer it. Business loans from most financial institutions require annual GAAP-compliant financial statements as part of their debt covenants. Thus, most U.S. corporations adopt GAAP.
Investors should be wary of non-GAAP financial statements. A true apples-to-apples comparison of financial accounts would be difficult without GAAP, even within the same industry. Some firms report financial performance using GAAP and non-GAAP measurements. Financial statements and press releases must disclose non-GAAP metrics per GAAP.
GAAP Principle Selection
The GAAP hierarchy aims to enhance financial reporting. It provides a platform for public accountants to choose U.S. GAAP-compliant financial statement principles. Following is the hierarchy:
- Accounting Standards Board (FASB) statements, Accounting Research Bulletins, and Accounting Principles Board views by the AICPA
- Technical Bulletins, AICPA Industry Audit and Accounting Guides, and Position Statements
- AICPA Accounting Standards Executive Committee Practice Bulletins, FASB Emerging Issues Task Force (EITF) stances, and Appendix D of EITF Abstracts subjects
- FASB implementation guidelines, AICPA Accounting Interpretations, Industry Audit and Accounting guidelines, Statements of Position not certified by the FASB, and generally recognized accounting practices
Accountants should consult top-level sources first, then lower-level sources if no relevant pronouncements exist. FASB Statement of Financial Accounting Standards No. 162 details the hierarchy.
GAAP focuses on U.S. company accounting and reporting. The independent nonprofit Financial Accounting Standards Board (FASB) sets these accounting and financial reporting standards. The International Accounting Standards Board (IASB) sets the International Financial Reporting Standards (IFRS) as an alternative to GAAP.
Since 2002, the IASB and FASB have collaborated on IFRS and GAAP convergence. In 2007, the SEC abolished the need for non-U.S. corporations registered in America to reconcile their financial reports with GAAP if they already used IFRS due to this partnership’s development. This was significant because, before the verdict, non-U.S. corporations trading on U.S. markets had to furnish GAAP-compliant financial statements.
Existing disparities in accounting rules include:
- Under GAAP, corporations can employ the Last In, First Out (LIFO) inventory cost technique, but IFRS prohibits it.
- Under GAAP, research and development expenses are subject to expense charges. IFRS allows the capitalization and amortization of costs in specific situations.
- GAAP prohibits reversing write-downs of inventories or fixed assets if their market value improves. You can reverse the write-down under IFRS.
International standards are replacing GAAP in the U.S. as firms negotiate global markets and operate globally. Almost all S&P 500 corporations disclosed non-GAAP results in 2019.
The treatment of accounting entries under GAAP and IFRS differs significantly. Inventory handling is a big challenge. IFRS prohibits LIFO inventory accounting. GAAP allows LIFO. Both systems support FIFO and weighted average cost. IFRS allows inventory reversals under specific scenarios, whereas GAAP does not.
A corporation must account for shares, bonds, and derivatives on its balance sheet and their value fluctuations. GAAP and IFRS require asset-type-based investment categorization. Recognizing investment income or profits under GAAP depends on the asset or contract’s legal structure, whereas under IFRS, it solely depends on cash flows.
Other variances exist for unusual items and discontinued operations. A global adoption of IFRS might benefit multinational firms and investors.
GAAP is just a set of standards. These principles promote financial statement openness but do not ensure that a company’s financial statements are error-free or misleading. GAAP allows dishonest accountants to manipulate numbers. You must examine a company’s financial accounts, even if it employs GAAP.
Where is GAAP used?
Companies use GAAP to create financial statements and other accounting disclosures. The independent, nonprofit Financial Accounting Standards Board (FASB) prepares the standards. GAAP standards help investors and regulators get accurate, dependable, and consistent financial information.
Why is GAAP important?
GAAP helps sustain financial market trust. Without GAAP, investors would doubt the veracity of company information. Fewer transactions may occur without trust, raising transaction costs and weakening the economy. GAAP simplifies “apples-to-apples” comparisons for investors.
What Is the Meaning of Non-GAAP Measures?
If they clearly state that their statistics are not GAAP-compliant, companies can present them. GAAP guidelines may not be flexible enough to capture some operational details; therefore, companies do so. They may give specially developed non-GAAP measures in addition to GAAP disclosures. However, non-GAAP metrics can be deceptive, so investors should be wary.
What distinguishes IFRS from GAAP?
GAAP is rule-based, while IFRS is principle-based. GAAP mainly applies in the U.S., whereas IFRS is a worldwide norm. The standards include inventories, investments, long-lived assets, exceptional items, and discontinued activities.
- U.S. corporations must follow FASB GAAP when preparing financial accounts.
- GAAP clarifies, standardizes, and compares financial information.
- Pro forma accounting differs from GAAP in financial reporting.
- GAAP aims to make financial statements complete, uniform, and comparable.
- The U.S. uses GAAP, while most other countries use IFRS.