What are Generally Accepted Accounting Principles (GAAP)?
When a public company issues a financial statement, everything needs to be clear and well-understood by everyone reading it. To ensure this, it’s paramount to have a baseline for reporting. That’s where Generally Accepted Accounting Principles (GAAP) come in. GAAP represents methods, rules and practices that provide guidelines and procedures—as well as objective standards—for financial data and statements. In short: GAAP standardizes accounting for all companies, so the data they’re reporting is universally understood and cross-comparable.
GAAP-compliance is a major implication for companies reporting financial information to shareholders. It’s mandated by the Securities and Exchange Commission (SEC) for all public companies, and good practice even for private companies. GAAP reporting shows a willingness to adhere to universally accepted accounting standards. It’s beneficial to companies and shareholders alike.
Who Sets the Standard for GAAP?
It’s the duty of two organizations to establish and enforce GAAP standards: the Financial Accounting Standards Board (FASB) and Securities and Exchange Commission (SEC). As an impartial, independent, non-government entity, FASB sets the standards for Generally Accepted Accounting Principles. It reviews these standards annually and updates them via Accounting Standards Codification.
The SEC can also set accounting standards, codifying them as part of GAAP in cooperation with FASB. Once established, the SEC enforces Generally Accepted Accounting Principles standards for all public companies. This can include fining companies that fail to disclose financial records in accordance with GAAP. A famous example of this occurred in 2019, when the SEC fined car rental company Hertz (OTCMKTS: HTZZ) $16 million for reporting non-GAAP figures.
Principles, Assumptions and Constraints
To understand the fundamental function and execution of GAAP, it’s important to review the principles, assumptions and constraints of the framework. These rules are the governing basis for Generally Accepted Accounting Principles and apply universally to all companies.
These are the principles that govern the GAAP framework. They’re universally recognized as the core, fundamental pillars of Generally Accepted Accounting Principles and its practices.
- Historical cost principle. Companies report assets and liabilities acquisition costs.
- Revenue recognition principle. Companies record transactions at origination.
- Matching principle. Expenses match revenues within the same period.
- Full disclosure principle. Companies need to disclose information within context.
These are universal assumptions every business makes as it reports its financial information. These assumptions are present across all company filings.
- Business entity. The business must remain separate from its owners and stakeholders.
- Going concern. The business will operate indefinitely, independent of any person.
- Monetary units. The business reports financials in a stable, consistent unit of currency.
- Time periods. The business will file its financial reports across regular time periods.
These are the absolute rules that a company must follow when reporting its financial information to remain in alignment with Generally Accepted Accounting Principles standards.
- Objectivity principle. Financial statements should be based on objective evidence.
- Materiality principle. The significance of an item should be considered when reported.
- Consistency principle. The company uses the same accounting principles across periods.
- Conservatism principle. Companies should anticipate future losses but strive for gains.
- Cost constraints. The benefit of reporting financials should outweigh the cost.
GAAP vs. IFRS
It’s important to remember that GAAP is a United States standard for accounting. While many multinational companies practice Generally Accepted Accounting Principles for transparency’s sake, global companies also adhere to International Financial Reporting Standards (IFRS). While there are subtle differences between the two standards, GAAP and IFRS are, for all intents and purposes, the same thing.
The only real difference is that GAAP is rules-based and IFRS is principles-based. This can manifest difficulties in some areas of accounting—such as recordkeeping for inventory. However, both standards have roots in the same practice of disclosing and contextualizing reported figures. Often, comparing Generally Accepted Accounting Principles and IFRS statements is straightforward.
The GAAP Hierarchy
What happens in a situation where there isn’t a specific guideline or procedure for GAAP reporting? Accountants defer to the GAAP hierarchy. This framework of credible resources helps guide compliance even in situations where there’s no explicit rule. The hierarchy largely revolves around guidance from the Financial Accounting Standards Board (FASB) and American Institute of Certified Public Accountants (AICPA). The hierarchy is as follows:
- FASB Statements of Financial Accounting Standards and Interpretations, FASB Staff Positions and AICPA Accounting Research Bulletins and Accounting Principles Board Opinions not superseded by actions of the FASB.
- FASB Technical Bulletins and AICPA Industry Audit and Accounting Guides and Statements of Position.
- AICPA Accounting Standards Executive Committee Practice Bulletins, consensus positions of the FASB Emerging Issues Task Force (EITF), and Topics discussed in Appendix D of EITF Abstracts.
- Implementation guides (Q&As) published by the FASB staff, AICPA Accounting Interpretations, AICPA Industry Audit and Accounting Guides and Statements of Position not cleared by the FASB, and widely recognized and prevalent practices.
If an accountant travels all the way down the list and can’t find a suitable accounting standard to guide reporting, they’re encouraged to defer to widely accepted and followed accounting practices. Though rarely needed for any substantial reporting, this hierarchy is important for determining uniformity even beyond GAAP.
GAAP Exists to Help Companies and Investors Alike
When companies report financial information to a universal standard, it provides clarity and comprehension for anyone paying attention to them. For companies, it’s a great way to benchmark their performance against a standard. For investors, it means having clear insight into the health and financial performance of a company. Above all, it prevents a level of obfuscation that might harm both parties.
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GAAP may be a mandated practice, but it’s one that every company should want to adhere to—public or private. And, even in a situation without GAAP standardization, this framework provides the groundwork for best practices in financial reporting. In short: GAAP levels the playing field and ensures everyone is playing by the same rules.