The generally accepted accounting principles (GAAP), also sometimes referred to as generally accepted accounting practice, provide guidance that helps maintain consistency in the field of financial accounting. The Financial Accounting Standards Board (FASB) offer a set of methods and practices act as a path for the GAAP to follow, and The American Institute of Certified Public Accountants (AICPA) are also consulted on the creation of the updated framework of these industry standards. The GAAP provides a consistent vocabulary and methodology for financial accountants in the U.S. These control basic topics including performance analysis, investment, revenue recognition and measurement, procedures, and other data and concepts.
GAAP is needed to ensure that shareholders, regulators, and other interested parties can easily understand the foundation of each company's filings. Since various companies agree to follow GAAP guidelines, analysts can compare one organization in the market to another and determine which are alike based on their fiscal similarities. Without a common accounting language, it would be difficult to determine relative corporate valuations and grasp the comparative income of an entity.
Most state and local county governments and their school districts are either fully, mostly, or somewhat follow GAAP rules. However, a full fourteen states are non-GAAP compliant, about matching the number of full-compliance states. Federal governmental rules, on the other hand, require that all publicly traded corporations file their financial statements, records, and transactions in accordance with GAAP. Thus, even if GAAP rules are not an absolute state requirement for accounting practices, it is required that you follow these principles in order to maintain consistency in professional business practices. After all, if a stakeholder is unable to apply guidance to a company's financial statements, they are unlikely to work with them due to the higher exposure to risk.
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Where Does GAAP Come From?
The GAAP principles are created by a hierarchy of organizations that are responsible for independent accounting standards codification. At the top is the FASB and the AICPA. FASB is an independent agency that is recognized by the Securities and Exchange Commission (SEC) as the standard-bearer for financial accounting. Since the State Boards of Accountancy recognize FASB as an authoritative body, GAAP is their defacto standard, too.
The AICPA's contribution to GAAP is equally important. Included in their work and separate from their input on GAAP, their team accredits accounting departments at the best universities and they also create the CPA examination, which is a chief requirement for licensure to defend taxpayer's reports that they disclose to the IRS. After the main groups of the NASB and AICPA, the GAAP standards are then created by sub-agencies such as FASB Technical Bulletins, AICPA Industry Audit, and Accounting Guides and Statements of Position.
When accounting professionals have questions concerning the GAAP, they are instructed to first seek resolution with the top-tier agencies, the FASB and the AICPA, who can make many decisions and answer your questions. If they cannot find a satisfactory definition or solution to their issues, FASB's Statement of Accounting Standards No. 162 is available. That document details the hierarchy of the GAAP for those who have an interest in further exchanges on the subject.
Why Use GAAP?
One of the chief reasons to use the GAAP is that it is virtually required for all financial documentation. Those who provide financial accounting services to publicly traded companies must adhere to all rules of the Securities and Exchange Commission. Even for those who create financial documentation or do research for privately held corporations, any outside investor or auditor will expect GAAP compliance in any special project or presentations. Many firms, even in non-compliant states, have a policy that all staff working for them and every legal or economic form follow GAAP rules.
This is all because the GAAP provides a level of consistency among all financial filings, through which those documents find a common ground. Any regulator or accountant will find that GAAP-compliant documents follow a similar logic and structure. This standardization ostensibly creates a commonality in all financial reports. However, some reason that the GAAP creates opportunities for great inconsistency and unintended opacity, where transparency is sought.
Nonetheless, when analysts, creditors, and others open a GAAP-compliant document, they recognize its elements immediately. Each will have a balance sheet, income statement, and cash flow statement, for instance. Then, each statement will use terms consistent with the other. For example, each balance sheet will share an agreement as to what the terms long-term and short-term debt mean, making experience or practice with software and the content of documents transferrable to a new position.
Ultimately, the GAAP is the accounting standard for all company's in the United States, especially public companies. Due to the fact that most accountants have attended AICPA-accredited accounting programs, most companies use the standard. Creditors, donors, and potential acquisition targets are sure to demand the standard, as well.
What is Covered?
GAAP is a system for accounting that covers how financial documents are prepared. It also provides guidance for specific areas of economic reports, such as inventory systems, and how certain debts are handled. The principles it espouses function as both general ethical rules and specifics for how to report financial realities.
For instance, sometimes companies make sales on a credit basis. This is especially the case when the value of the relevant goods is in the tens of millions. The principle of recognition applies in this case because there is a question of how to account for this sale. That is, there is a contract that represents the account receivable, but the cash has not yet landed in the seller's accounts. Since the GAAP relies on accrual accounting, the sale is recognized on the balance sheet and as part of the company's overall value. However, it does not receive recognition on the cash flow statement because that sales revenue cannot yet be used to pay debts or regular bills.
One of the more evident aspects of the GAAP is how information is presented in a company's 10-Q or 10-K documentation. Regular readers of these documents often flip directly to these items easily, since they fall at specific points in the documentation.
Each of these documents must include three reports:
- Income Statement: Details the company's total revenues, expenses, cost of sales, and other income.
- Balance Sheet: Details the overall value of the company; assets, liabilities, accounts payable, and accounts receivable are all on the balance sheet. Investors can look to the balance sheet to determine the company's current liquidity.
- Cash Flow Statement:
This shows how the company operates on a day-to-day basis. From this statement, an investor can determine how management deals with the company's debts, bills, assets, and revenues. It not only shows how much money a company has generated, but how it was generated. Some of the cash may have come from the sales of goods in the company's core line of business, but other funds may have come from the one-time sale of a hard asset, equity positions, or a debt security offering.
The GAAP also insists on full disclosure under the principles of materiality and good faith. That is, any potential problems must be reported. For instance, if the company is being investigated by a federal agency or if a civil lawsuit has been filed, investors have a right to this information under GAAP.
Top 10 Principles
The GAAP is founded on principles more than strict rules. Above all, the GAAP intends to promote honest financial reports that adheres to consistent vocabulary and certain protocols in the accounting process.
- Principle of Regularity:
This principle ensures that every financial professional follows all GAAP guidelines. Since the GAAP is enforced through the Securities and Exchange Commission, regularity is assured.
- Principle of Consistency:
When the same rules are followed throughout the accounting process, the consumers of financial information will have an easier time understanding financial statements and the costs a company has incurred.
- Principle of Sincerity:
This principle requires accuracy with regard to the company's finances. Thus, those who track these numbers are held to a sort of honor code, even when they claim independence from a larger corporation.
- Principle of Permanence of Methods:
Without consistency in accounting methods, there could be no way to understand or trust financial reports. When accountants from different companies use similar methodology, comparisons are easy to make.
- Principle of Non-compensation:
Since accountants follow this principle, investors and creditors are assured full disclosure of positives and negatives.
- Principle of Prudence:
This principle ensures that speculation is eradicated.
- Principle of Continuity:
Through this principle, accountants assume that the company will continue its operations.
- Principle of Periodicity:
This is vital for accurate and fair reporting in that it ensures that all revenues, losses, and other changes are recorded according to when they were received. Thus, revenue from one fiscal quarter cannot be held and reported as compensation to bolster any under-performing periods in the future.
- Principle of Materiality / Good Faith:
To follow this principle, accountants must exercise full disclosure when they report financial information.
- Principle of Utmost Good Faith:
With millions of dollars at stake, this principle ensures honesty and fair dealing with regard to accounting, which is vital to the integrity of the financial system and the business community in general.
Advantages of Compliant Reports, for Investors and Others
A GAAP-compliant report is vital for all companies. Publicly held companies that are traded on public equity markets must adhere to GAAP standards as a condition of their being listed by the SEC. Their compliance lends consistency to all quarterly, annual, and other financial documents. This consistency helps analysts, investors, and creditors understand, process, and trust the news they find in these filings on the company website.
Furthermore, since there is a written standard for financial reporting, there is a level of accountability for all concerned accountants. That is, since good faith, honesty, and general truthfulness are required by the GAAP, and thus by the SEC, investors have recourse in case a company's financial operations are misrepresented.
Limitations of the GAAP (IFRS)
While the GAAP may seem to be the perfect tool to make accounting consistent across the board, it does have its limitations. Some of the chief limitations and criticisms of these principles is that they are not truly objective, don't reflect certain financial realities, and don't hold up in light of increasing globalization stretching the need for accounting principles that cover other countries as well.
While the GAAP is seemingly designed to institute standards and principles that enforce objectivity and aim to provide maximum transparency and clarity, some argue that this is not the case. For instance, valuations for private companies can vary widely under the current GAAP rules. The rules might be applicable for well-established public companies, but new non-public firms are more difficult to quantify. This ambiguity causes difficulties for analysts who seek to find and distinguish comparable firms.
The GAAP is also reported to cause inaccuracies in the case of acquisitions. When a company purchases another, current standards allow the surviving company to add its target's revenue to its own. Thus, any report will reflect a far larger increase in revenue than is actually the case. The GAAP does not insist on a complete break down of these events, so investors can be led astray. When earnings spike, so do stock prices, but in these cases, reported earnings are not accurate. Only after a fiscal year has passed will public information again reflect the true, organic growth of the two companies after they join.
The GAAP is also limited with regard to the international business world. Since this includes increasingly porous international borders, it is vital for companies in the US to provide accounting statements that meet international standards. Currently, the International Financial Reporting Standards (IFRS) is the standard being used by most companies in other countries. For many years, the SEC has considered switching to the IFRS but now it appears that they are seeking to place some IFRS standards within the existing GAAP.
While the GAAP does seem to have plenty of limitations, it is also a fluid and ever-mutable set of principles and standards. Much as companies shift their focuses over time, the GAAP is free to adapt so as to address realities in the business world.
What’s the International Standard?
While the country seeks accounting consistency via the GAAP, the rest of the world utilizes a different set of rules under the International Financial Reporting Standards (IFRS). The IFRS is the standard for all European Union companies and is likewise implemented throughout much of Asia. While the IFRS requires many of the same statements as the GAAP, such as the profit and loss statement, balance sheet, and cash flow statement; it does not include a statement of comprehensive income. Under the IFRS, companies must also provide transparency regarding their accounting policies. Further, a company must not only provide a report for itself, but for its subsidiary holdings as well. The IFRS and GAAP also differ when it comes to documenting inventory, income, and how liabilities are classified.
Another key difference between the IFRS and GAAP is found in how inventory is reported and handled. The IFRS does not allow Last In-First Out (LIFO) inventory practices. This inventory system lets companies sell their newest inventories first. Under the GAAP, companies can choose LIFO or FIFO (First In-First Out) practices as they see fit.
Unlike the IFRS, GAAP documents require that companies report both comprehensive income (CI) and Other CI. OCI includes revenues from non-core business practices such as equity investments, interest income, and foreign currency transactions. CI includes the net income found on the income statement as well as the OCI.
Yet another difference between these two accounting standards is in how they classify liabilities. Under the GAAP, they are classified as either short-term or long-term. Short-term ones are considered accounts payable in the United States. The IFRS, on the other hand, does not distinguish between the two sorts of liability. Thus, in an IFRS-compliant document, short-term and long-term are added together.