What Are Generally Accepted Accounting Principles (GAAP)?
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Why Is GAAP Important?
GAAP combines standards set by boards, such as the Financial Accounting Standards Board (FASB), and commonly used methods of recording and compiling accounting data. The Securities and Exchange Commission (SEC) recommends public companies, government offices, and nonprofit organizations in the United States use GAAP when they file their financial reports[1]. This makes reading, interpreting, and communicating financial reports more accessible and transparent, which can also protect investors from fraud or misleading information.
Though all U.S. states comply with GAAP, the degree of compliance varies[2]. Whatever the case, adherence to GAAP is not legally required, though it still offers benefits to businesses. For example, companies with GAAP-compliant financial records have higher trust ratings among investors[3], which means they are more confident about the company’s financial data accuracy.
An external audit from a certified public accountant (CPA) can check for GAAP compliance on a company’s financial statements. This external audit, also known as auditor’s opinion, is a certification that verifies the procedures and information on a company’s reports and determines any error or irregularity.
Note that for companies outside the U.S., their financial reports may comply with the International Financial Reporting Standards (IFRS) instead of GAAP. There are key differences between the two, as this article will explain later.
10 principles make up the Generally Accepted Accounting Principles, detailed below.
10 Principles of GAAP
The Generally Accepted Accounting Principles are broken down into ten separate concepts that, together, build a framework for a more accurate rendering of financial reports.
1. Principle of Regularity
The principle of regularity refers to the adherence of the accountant to GAAP standards.
2. Principle of Consistency
Under this principle, accountants need to be consistent with GAAP standards in all accounting processes, from the most basic procedure to the most complex. This principle also serves as a reminder to accountants to practice transparency; should the standards be changed for any reason in the report, the accountant should disclose all the necessary changes and updates that have occurred.
3. Principle of Sincerity
This principle requires accountants to depict the actual financial situation of the organization as accurately as they could.
4. Principle of Permanence of Methods
Similar to the second principle, the permanence of method principle promotes using a standard procedure in financial reporting. This allows the comparison of relevant financial information.
5. Principle of Non-Compensation
A financial report’s negatives and positives should be accurately represented in the report without the expectation of debt compensation or revenue.
6. Principle of Prudence
This principle encourages data-driven conclusions based on empirical evidence and not based on speculation.
7. Principle of Continuity
When writing and compiling the report, the accountant should take the position that the business will continue to operate.
8. Principle of Periodicity
This principle enforces that entries in the financial report are subdivided into their appropriate and corresponding time periods. Revenues, for example, should be reported in its accounting period. The principle of periodicity attempts to minimize erroneous data entry that may significantly affect the truth about the company’s current financial situation.
9. Principle of Materiality
The principle of materiality requires the full disclosure of financial data and accounting records in the report.
10. Principle of Utmost Good Faith
The principle of utmost good faith presumes that all parties are acting in good faith, i.e., all parties involved in the report are honest in all transactions.
IFRS vs. GAAP
The International Financial Reporting Standards is similar to GAAP in that it aims to standardize a common accounting language across financial reports. Where GAAP is endorsed by the FASB, the IFRS is advocated by the International Accounting Standards Board (IASB). The difference is that GAAP is primarily used in the U.S., while other international bodies use the IFRS. To date, more than 144 countries around the world have adopted the IFRS[4].
One major difference between the two is that GAAP is more detailed (based on rules) while the IFRS takes a more “broad strokes” approach, and some parts of one do not always correspond to the other[5]. Specific procedures in IFRS also differ from GAAP. For instance, IFRS allows write-down reversals while prohibiting Last In First Out Inventory (LIFO). On the other hand, GAAP does the opposite; it prohibits write-downs (as it does not adhere to the principle of consistency) while allowing LIFO (as it adheres to the principle of periodicity).
When a company already follows IFRS, it is no longer required to comply with GAAP as the IASB-FASB collaboration allows comparison of certain financial statements whether they were done in IFRS or GAAP[6]. However, an organization should use only one or the other, as problems may arise during external auditing if they mix GAAP and IFRS standards.
Takeaways
The Generally Accepted Accounting Principles provide a common way to interpret and report accounting standards and procedures across U.S. organizations. It plays a significant role in accounting, specifically reading and comparing financial reports. While it is not required by law, the SEC recommends publicly listed companies, government entities, and nonprofits in the United States to use it. Compliance with GAAP improves trust ratings and allows a more transparent review by external auditors.
GAAP is encapsulated in 10 principles, which serve as guidelines that can help accountants and auditors alike from making errors and dishonest claims regarding an organization’s financial situation. However, it is best for companies to choose either GAAP or the IFRS when making their reports, as they have different standards; most U.S. firms, however, use the former.
Sources
- Securities and Exchange Commission. (2020.) Regulation S-K. Retrieved from https://www.sec.gov/divisions/corpfin/guidance/regs-kinterp.htm
- Financial Accounting Foundation. (n.d.) Section 2. GAAP and State and Local Governments. Retrieved from https://www.accountingfoundation.org/jsp/Foundation/Page/FAFBridgePage&cid=1176164539408#section_2
- Kappel, M. (2018.) GAAP: Your Accounting Rulebook. Patriot Software. Retrieved from https://www.patriotsoftware.com/blog/accounting/gaap-your-accounting-rulebook/
- International Financial Reporting Standards. (2018.) Use of IFRS Standards around the world. Retrieved from https://cdn.ifrs.org/-/media/feature/around-the-world/adoption/use-of-ifrs-around-the-world-overview-sept-2018.pdf
- Securities and Exchange Commission (2011.) A Comparison of U.S. GAAP and IFRS. Section II.D., “General Observations and Clarifications”. Retrieved from https://www.sec.gov/spotlight/globalaccountingstandards/ifrs-work-plan-paper-111611-gaap.pdf
- Financial Accounting Standards Board. (2014.) IASB and FASB Issue Converged Standard on Revenue Recognition. Retrieved from https://www.fasb.org/jsp/FASB/FASBContent_C/NewsPage&cid=1176164075286
