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What are 'Generally Accepted Accounting Principles - GAAP'

Generally accepted accounting principles (GAAP) refer to a common set of accounting principles, standards and procedures that companies 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.

Compliance

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.

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.

Notes

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.

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