What is GAAP?

Accounting students and current professionals are expected to have a strong knowledge of generally accepted accounting principles (GAAP). These rules and standards are mandated for the creation of uniform financial reports by publicly traded companies. Private U.S. businesses are not required to follow GAAP, though many do.

Accountants adhere to GAAP for consistency, fairness, honesty and accuracy in measuring and disclosing financial information. A company’s fiscal reports have a significant impact on the decisions made by investors, employees and financial institutions; GAAP provides the set of foundational guidelines used to support these analyses.

History of GAAP

Without regulatory standards, companies would be free to present financial information in whichever format best suits their needs. With carte blanche to portray a company’s fiscal standing in the most ideal light, investors could be easily misled. The Great Depression in 1929, a financial catastrophe which caused years of hardship for millions of Americans, was primarily attributed to faulty and manipulative reporting practices among businesses. In response, the federal government, along with professional accounting groups, set out to create standards for the ethical and accurate reporting of financial information.

According to Stephen Zeff in The CPA Journal, GAAP terminology was first used in 1936 by the American Institute of Accountants (AIA). Federal endorsement of GAAP began with legislation like the Securities Act of 1933 and the Securities Exchange Act of 1934, laws enforced by the U.S. Securities and Exchange Commission (SEC) that target public companies. Today, the Financial Accounting Standards Board (FASB), an independent authority, continually monitors and updates GAAP.

Today, all 50 state governments prepare their financial reports according to GAAP. While a little less than half of U.S. states officially require local governments to adhere to GAAP, the Governmental Accounting Standards Board (GASB) estimates that approximately 70% of county and local financial offices do anyway.

GAAP Requirements by State

  • Fully GAAP Compliant Local and county governments and school districts are required to prepare financial reports under GAAP.
  • Mostly GAAP Compliant Two of three regulated state governing boards and districts must comply to GAAP.
  • Somewhat GAAP Compliant One of three regulated state governing boards and districts must comply to GAAP.
  • Not GAAP Compliant Local and county governments and school districts are not formally required to comply to GAAP.
Source: Government Accounting Standards Board

Who Determines GAAP?

While the federal government requires public companies to file financial reports in compliance with GAAP, they are not responsible for its creation or maintenance. Instead, a few independent boards serve as authorities on these principles, continually updating them to accommodate changing business practices and evolving organizations. For example, goodwill and interest rate swap standards are among several recent changes to provide alternatives for private companies. Below, we have created an overview of the boards that oversee GAAP pronouncements.

Financial Accounting Foundation (FAF) – This organization was formed in 1972 as the administrative corporation that oversees the Financial Accounting Standards Board (FASB) and the Governmental Accounting Standards Board (GASB) . The FAF is responsible for appointing board members and ensuring that these boards operate in a fair and transparent manner. Members of the public are invited to attend FAF organization meetings in person or through live webcasts.

Financial Accounting Standards Board

On the recommendation of the American Institute of CPAs (AICPA), the FASB was formed as an independent board in 1973 to take over GAAP determinations and updates. The board is comprised of seven full-time, impartial members, ensuring it works for the public’s best interest. In addition, the board is monitored by the 30-person Financial Accounting Standards Advisory Council (FASAC). FASB is responsible for the Accounting Standards Codification, a centralized resource where accountants can find all current GAAP.

The FASB Standards-Setting Process

  1. 1Identify current investor issues
  2. 2Draft issue agenda and hold public meetings
  3. 3Publish Exposure Draft for investor commentary
  4. 4Propose new standards and invite business feedback
  5. 5Weigh all public responses and revise accordingly
  6. 6Announce final revisions to the ASC

Major Projects in 2015

Governmental Accounting Standards Board

The GASB was established in 1984 as a policy board charged with creating GAAP for state and local government organizations. Many different parties rely on government financial statements, including constituents and lawmakers. Fairness and transparency are a priority of the GASB, and their own processes and communications are available for public review.

The GASB Standards-Setting Process

  1. 1Create an independent task force
  2. 2Conduct research on the subject of the new standard
  3. 3Engage the public through published commentary
  4. 4Create an Exposure Draft of planned standard
  5. 5Host public hearings before a standard is finalized

Major Projects in 2015

GAAP vs. Non-GAAP

While publicly-traded companies are required to follow GAAP for the creation of financial reports, they have the freedom to release additional reports prepared using non-GAAP principles. According to Investopedia, many businesses assert that non-GAAP earnings more accurately reflect their positions. The two approaches can lead to vastly different numbers, though, especially in the short term.

As The Wall Street Journal reported, 40 companies that had initial public offerings in 2014 reported losses under standard accounting rules, but showed profits using their own tailor-made measures, according to consulting firm Audit Analytics.

The main difference between preparing reports with GAAP versus without has to do with when revenue and expenses are recognized. GAAP requires that companies use accrual accounting, which differs from cash accounting in that related revenues and expenses are reported together at the time of transaction rather than simply when cash is exchanged. This is especially impactful for purchases made on credit or paid for over a long period of time. If a product is purchased on credit, cash accounting would call for recording the purchase once cash is received. This may be much later than the transaction itself. Accrual accounting under GAAP strives to more closely reflect a company’s financial position, regardless of cash-flow.

The method used for preparing financial reports matters most to investors when it comes to earnings per share (EPS) reported by companies. Non-GAAP methods for calculating EPS often seek to more closely reflect cash flow, so EPS tends to be higher under these methods than under GAAP. EPS values prepared under non-GAAP are often referred to as “adjusted” earnings.

The example below shows the degree to which earnings for one company can differ depending on whether or not they are prepared using GAAP:

GAAP vs. Non-GAAP Case Study: Pegasystems 2010-11

$ in '000s 2010 GAAP 2010 non-GAAP 2011 GAAP 2011 non-GAAP
Total Revenue$336,599$348,236$416,675$420,652
Operating Income$(2,580)$37,491$10,494$38,466
Net Income$(5,891)$22,498$10,108$28,402
Basic Earnings per Share$(0.16)$0.57$0.26$0.72

Source: Pegasystems Inc. All $ amounts in thousands, except per share data.

There is some discrepancy in reported revenue when comparing GAAP and non-GAAP values. The real difference between the two methods shows up in operating income. Operating income is everything that is left after operating expenses have been subtracted. For both years, the non-GAAP values are considerably higher than the GAAP values, and GAAP operating income is even negative in one year. The large difference is likely because the non-GAAP calculation did not include several expenses, either because they are not recurring or because the company is not matching related revenues and expenses. The discrepancy between GAAP and non-GAAP operating income leads to very different EPS, which is largely thought of as the most important determinant of a share’s price. Clearly, whether EPS was calculated using GAAP principles or not can greatly impact an investor’s decision.

While the SEC prohibits false or misleading information in all financial reports, GAAP and non-GAAP methods can still lead to different valuations. For investors, it is important to check footnotes to see how reports were prepared.

The 10 Basic Tenets of GAAP

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.

Limitations of GAAP

While GAAP strives to alleviate incidents of inaccurate reporting, it is by no means comprehensive. Companies can still suffer from issues beyond the scope of GAAP depending on their size, business categorization, location and global presence.

Diverse Types of Companies

Oftentimes, GAAP seems to take a “one-size-fits-all” approach to financial reporting, however this can do little to reduce issues faced by distinct industries. For example, state and local governments have struggled with implementing GAAP due to their unique environments. This has resulted in new GAAP hierarchy proposals to better accommodate these government entities.

Small businesses have also struggled with implementing GAAP. These standards may be too complex for their accounting needs and hiring personnel to create GAAP reports can be expensive. As a result, the FASB has been working with the Private Company Council to update the GAAP with private company exceptions and alternatives.

Timeframe

Due to the extremely thorough standards-setting process of the GAAP policy boards, it can take months or even years to finalize a new standard. These wait times may not work to the advantage of companies complying with GAAP, as pending decisions can affect their reports.

Global vs. Domestic

GAAP is not the international accounting standard, and this is a developing challenge as businesses become more globalized. The International Financial Reporting Standards (IFRS) is the most common set of principles outside of the United States and used in places such as the European Union, Australia, Canada, Japan, India and Singapore. In order to reduce some of the tension between these two major systems, the FASB and International Accounting Standards Board (IASB) have been working together to converge standards.

IFRS: An Alternative to GAAP

While public companies in the United States are currently required to follow GAAP standards when filing financial statements, private companies are still free to choose their preferred standards system. This may soon change depending on an upcoming decision from the SEC, which has been deliberating on whether to move forward with recommending global standards, either partially or completely.

According to Bloomberg BNA, SEC Chief Accountant James Schnurr “stressed that the IFRS-as-supplemental-reporting approach would be simply one alternative to full adoption of the standards issued by the International Accounting Standards Board.” Wide acceptance of the IFRS standards has yet to happen in the United States. The FASB and IASB are still working together to agree on and set standards that can be applied domestically and internationally.

GAAP vs. IFRS

Many sources state that the biggest difference between GAAP and IFRS reporting standards is the number of rules behind the principles. According to Scott Taub at Compliance Week, this is true, in a way; the GAAP principles are governed by more detailed rules and guidelines than IFRS. However, both sets of standards are in place to ensure that accountants remain honest on the job. The following is a look at what is required when reporting under the GAAP principles versus the IFRS standards.

Balance Sheet

  • GAAP: Recommended that current and noncurrent asset and liability categories are separated
  • IFRS: These categories are required to be separated

Intangible Assets

  • GAAP: Recognizes intangible assets at fair value
  • IFRS: Only examines intangible assets if they can be associated with a future benefit

Documentation

  • GAAP: A Statement of Comprehensive Income is required
  • IFRS: A Statement of Comprehensive Income is not required

Inventory Write Downs

  • GAAP: Inventory write down reversals are not permitted
  • IFRS: Inventory write down reversals are possible under some conditions

Extraordinary Items

  • GAAP: Listed separately under new income
  • IFRS: Included with other items on the income statement

Further Reading

Examples of Financial Reports

These investor reports from major publicly traded companies give a high-level example of financial filings that follow GAAP:

Reference Tools