GAAP (sometimes called U.S. GAAP) stands for Generally Accepted Accounting Principles and represents a detailed set of broadly agreed-upon accounting rules for U.S. businesses. These guidelines are maintained by the Financial Accounting Standards Board (FASB), a non-government, non-profit organization. These prescribed rules and processes intend to ensure better that accounting records furnished to investors, creditors, and regulators remain accurate, reliable, and consistent.
What is GAAP and why is it important?
Trust is the most critical ingredient needed for a healthy, active economy. After all, if investors or creditors can’t depend on the integrity and accuracy of the financial metrics that a given business is reporting, they’ll be much more reluctant to provide funding. Similarly, vendors might limit or reject sales orders if they aren’t confident that potential customers are in a sound enough financial position to pay.
To help build this confidence, various accounting guidelines and best practices have been developed over the years. From its founding in the early 20th century, the U.S. Securities Exchange Commission (SEC) has made establishing official, national standards for U.S.-based businesses a priority, and, in the early 2000s, the SEC mandated that all publicly-traded organizations in the U.S. regularly file GAAP-compliant financial statements and reports.
GAAP vs. IFRS
While GAAP focuses on U.S.-based businesses, those organizations operating across borders will want to accommodate alternate guidelines. The International Financial Reporting Standards (IFRS) are easily the most commonly used global accounting processes employed by more than 100 countries and regions, including the European Union, Australia, Canada, and Japan.
Altogether, GAAP and IFRS share many commonalities — with GAAP typically offering more detail. The two standards do vary in areas related to:
- Inventory costs
- Investment income
- Research and development costs
- Write-downs
Similar to GAAP, IFRS is controlled by an outside governing body, the International Accounting Standards Board (IASB) based in London, England. While all publicly traded businesses in the U.S. must comply with GAAP, the SEC only requires that U.S.-based companies that are traded or operate internationally meet IFRS requirements. Typically, these businesses will employ a dual reporting strategy to prepare financial statements according to both rules. Conversely, foreign-owned companies registered in the U.S. can ignore GAAP if they comply with IFRS.
The 10 key GAAP principles
1. Principle of Regularity
GAAP is all or nothing. If you comply with GAAP, then your company and accountants abide by all established rules and regulations for your reports and financial operations — no exceptions.
2. Principle of Consistency
To help avoid record discrepancies and related errors, once an accounting or reporting process is established, it should match across and between accounting periods with no alterations. In those rare cases when a process or policy must be modified or adjusted, that alteration must be documented and thoroughly explained in the footnotes of any affected records.
3. Principle of Sincerity
Accuracy in reporting is paramount, meaning that accountants are obligated to render honest, unbiased analysis and documentation of the business’s current, real-world financial health.
4. Principle of Permanence of Methods
Similar to the Principle of Consistency, this principle establishes the same continuity standard across accounting periods but is exclusively focused on the structure and composition of the documentation for financial reports. A given report from this year should look virtually identical to any corresponding report from any of the past several years.
5. Principle of Non-Compensation
When disclosing financial information, the business’s positives and negatives should be covered. As such, accountants should not modify financial statements to provide offsets, such as compensating for an expense with a revenue or a debt with an asset.
6. Principle of Prudence
Speculation doesn’t belong in your reporting efforts. Any figures recorded in formal financial reports should be fact-based and developed using concrete, real-world data. Forecasting and speculation have their role in a business, but your financial statements should never consider these efforts.
7. Principle of Continuity
Regardless of a business’s fiscal health and status — even including instances where the company is expecting to shutter its operations — accountants are mandated to handle reporting under the assumption that the organization will continue to operate.
8. Principle of Periodicity
The schedule and scope of released financial reports should remain consistent, routine, and regular. Specifically, these reports should cover only the details relevant to a specific accounting period, typically a fiscal quarter or fiscal year. Any preceding or following reports should cover corresponding periods — no combining of quarters or shifting reporting dates to appear more profitable.
9. Principle of Materiality
In performing their functions, accountants must perform their due diligence to ensure that any reports or statements fully and accurately disclose an organization’s financial standing. Therefore, investigations and information-gathering efforts should be thorough — for example, confirming that assets are being valued at actual market cost.
10. Principle of Utmost Good Faith
Honesty isn’t just the best policy — it’s the only policy, according to GAAP. Anyone connected to any accounting efforts for a given business must behave ethically and act in “good faith” in all financial dealings and reporting efforts.
Additional GAAP principles and constraints
GAAP reflects a broad range of guidelines — so many that the term “principle” quickly becomes overused. For example, beyond the ten core principles are four additional principles, sometimes called constraints, that must be considered to comply with general standards.
1. Principle of Recognition
Omissions are not permitted in GAAP-compliant reporting efforts. Any statements should be thorough and clear, accurately reflecting a company’s assets, expenses, liabilities, and other financial commitments.
2. Principle of Measurement
Any generated financial statement should be created and distributed in compliance with GAAP standards. Admittedly, the specifics may vary from industry to industry, but all relevant standards should always be met.
3. Principle of Presentation
Building on the themes of consistency in the ten core principles, this supplemental principle outlines that any released financial report should include the following:
- Income statement
- Cash flow statement
- Balance sheet
- Statement of ownership or shareholder equity
4. Principle of Disclosure
When additional details are required to fully and accurately understand a financial report, this information should be thoroughly documented in the included notes or footnotes.
What is the hierarchy of GAAP?
With such a complex and nuanced standard, gray areas and questions should be expected. But when considering the multiple organizations and government offices connected with GAAP, finding the right answers and procedures can prove challenging as you shift through the plethora of instructional documentation these groups have generated to outline and explain guidelines.
To help add clarity, a hierarchy of GAAP was established — a four-tier framework that classifies the ranked authority of instructional sources. The highest tier typically addresses broader accounting issues, while the three corresponding tiers drill into more detailed or technical concerns. When considering these sources, you should always begin with the top tier, subsequently working your way through the preceding levels only if there are no relevant guidelines in the higher tier.
The four levels of the hierarchy are:
- Tier 1: Any statements from the FASB or any Accounting Research Bulletins and Accounting Principles Board opinions from the American Institute of Certified Public Accountants (AICPA)
- Tier 2: FASB Technical Bulletins and AICPA Statements of Position or Industry Audit and Accounting Guides
- Tier 3: Positions of the FASB Emerging Issues Task Force (EITF) and any topics discussed in Appendix D of EITF Abstracts along with Accounting Standards Executive Committee Practice Bulletins from the AICPA
- Tier 4: FASB implementation guides, Statements of Position not cleared by FASB, AICPA Accounting Interpretations, and any broadly accepted accounting practices
What does it mean to be GAAP compliant?
Simply put, being GAAP compliant means that your organization’s financial statements align with established GAAP guidelines and standards. But as previously noted, not all companies are required to meet GAAP standards, and many don’t. However, GAAP can still offer a fair number of advantages for businesses that fall outside of the SEC mandate.
When compliant, anyone — inside and outside of your organization — can easily compare the health and status of your business against other companies active in the same market sector or region. The ability to directly compare operations makes it easier to attract investor or lender interest, fine-tune internal business processes, and successfully pass external audits.
Similarly, if you consider taking your organization public, having GAAP standards in your accounting department will make life much less complicated when you finally act. Plus, the well-defined structure and consistency of reporting metrics help to avoid bookkeeping errors that can have a negative, cascading effect on your company.
What are non-GAAP measures?
Sometimes, you want to present more detailed or nuanced metrics than would be tolerated in standard GAAP-compliant reports. And for certain cases, you can add these figures to your statements. However, when these non-GAAP metrics are added, they should be clearly labeled as not conforming with GAAP and only provided supplementaly — not being swapped out for GAAP-required metrics.
Is GAAP here to stay?
For the foreseeable future, the answer is yes. But with the steady, world-flattening increase of international business, the demand for an official global reporting standard backed by the U.S. government has only increased. In 2010, the SEC stated that it planned to migrate national guidelines to comply with IFRS. However, in 2017, the federal agency shifted its position, stating that it was no longer considering the migration to a new standard, meaning that the two sets of guidelines will continue to exist alongside one another for the present and immediate future.
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