What are Generally Accepted Accounting Principles - GAAP
Generally accepted accounting principles (GAAP) refer to a common set of accepted accounting principles, standards, and procedures that companies and their accountants must follow when they compile their financial statements. GAAP is a combination of authoritative standards (set by policy boards) and the commonly accepted ways of recording and reporting accounting information. GAAP improves the clarity of the communication of financial information.
BREAKING DOWN Generally Accepted Accounting Principles - GAAP
GAAP is meant to ensure a minimum level of consistency in a company's financial statements, which makes it easier for investors to analyze and extract useful information. GAAP also facilitates the cross comparison of financial information across different companies.
These 10 general principles can help you remember the main mission and direction of the GAAP system.
1.) Principle of Regularity
The accountant has adhered to GAAP rules and regulations as a standard.
2.) Principle of Consistency
Professionals commit to applying the same standards throughout the reporting process to prevent errors or discrepancies. Accountants are expected to fully disclose and explain the reasons behind any changed or updated standards.
3.) Principle of Sincerity
The accountant strives to provide an accurate depiction of a company’s financial situation.
4.) Principle of Permanence of Methods
The procedures used in financial reporting should be consistent.
5.) Principle of Non-Compensation
Both negatives and positives should be fully reported with transparency and without the expectation of debt compensation.
6.) Principle of Prudence
Emphasizing fact-based financial data representation that is not clouded by speculation.
7.) Principle of Continuity
While valuing assets, it should be assumed the business will continue to operate.
8.) Principle of Periodicity
Entries should be distributed across the appropriate periods of time. For example, revenue should be divided by its relevant periods.
9.) Principle of Materiality / Good Faith
Accountants must strive for full disclosure in financial reports.
10.) Principle of Utmost Good Faith
Derived from the Latin phrase “uberrimae fidei” used within the insurance industry. It presupposes that parties remain honest in transactions.
GAAP must be followed when a company distributes its financial statements outside of the company. If a corporation's stock is publicly traded, the financial statements must also adhere to rules established by the U.S. Securities and Exchange Commission (SEC).
GAAP covers such things as revenue recognition, balance sheet item classification and outstanding share measurements. If a financial statement is not prepared using GAAP, investors should be cautious. Also, some companies may use both GAAP and non-GAAP compliant measures when reporting financial results. GAAP regulations require that non-GAAP measures are identified in financial statements and other public disclosures, such as press releases.
The hierarchy of GAAP is designed to improve financial reporting. It consists of a framework for selecting the principles that public accountants should use in preparing financial statements in line with U.S. GAAP. At the top of the GAAP hierarchy are statements by the Financial Accounting Standards Board (FASB) and opinions by American Institute of Certified Public Accountants (AICPA). The next level consists of FASB Technical Bulletins and AICPA Industry Audit and Accounting Guides and Statements of Position. On the third level are AICPA Accounting Standards Executive Committee Practice Bulletins and positions of the FASB Emerging Issues Task Force (EITF). Also included are Topics discussed in Appendix D of EITF Abstracts. On the lowest level are FASB implementation guides, AICPA Accounting Interpretations, AICPA Industry Audit and Accounting Guides and Statements of Position not cleared by the FASB. Also included are practices that are widely recognized.
Accountants are directed to first consult sources at the top of the hierarchy and then proceed to lower levels only if there is no relevant pronouncement at a higher level. The FASB's Statement of Accounting Standards No. 162 provides a detailed explanation of the hierarchy.
GAAP vs. IFRS
GAAP is focused on the practices of U.S. companies. The Financial Accounting Standards Board (FASB) issues GAAP. The international alternative to GAAP is the International Financial Reporting Standards (IFRS) set by the International Accounting Standards Board (IASB). The IASB and the FASB have been working on the convergence of IFRS and GAAP since 2002. Due to the progress achieved in this partnership, the SEC, in 2007, removed the requirement for non-U.S. companies registered in America to reconcile their financial reports with GAAP if their accounts already complied with IFRS. This was a big achievement, because prior to the ruling, non-U.S. companies trading on U.S. exchanges had to provide GAAP-compliant financial statements.
Some differences that still exist between both accounting rules include:
- LIFO Inventory - While GAAP allows companies to use the Last In First Out (LIFO) as an inventory cost method, it is prohibited under IFRS.
- Costs of Development - These costs are to be charged to expense as they are incurred under GAAP. Under IFRS, the costs can be capitalized and amortized over multiple periods.
- Write-Downs - GAAP specifies that the amount of write-down of an inventory or fixed asset cannot be reversed if the market value of the asset subsequently increases. The write-down can be reversed under IFRS.
As corporations increasingly need to navigate global markets and conduct operations worldwide, international standards are becoming increasingly popular at the expense of GAAP, even in the U.S. As the chart below shows, in 2004, almost all North American companies reported their earnings using GAAP metrics. By 2016 that number had fallen to less than half.
GAAP is only a set of standards. Although these principles work to improve the transparency in financial statements, they do not provide any guarantee that a company's financial statements are free from errors or omissions that are intended to mislead investors. There is plenty of room within GAAP for unscrupulous accountants to distort figures. So, even when a company uses GAAP, you still need to scrutinize its financial statements.
(Want to know more about GAAP? Read more about The Impact of Combining the U.S. GAAP and IFRS.)