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Generally accepted accounting principles, or GAAP, are a set of rules that encompass the details, complexities, and legalities of business and corporate accounting. The Financial Accounting Standards Board (FASB) uses GAAP as the foundation for its comprehensive set of approved accounting methods and practices.
U.S. law requires businesses that release financial statements to the public and companies that are publicly traded on stock exchanges and indices to follow GAAP guidelines, which incorporate 10 key concepts:
Principle of Regularity: GAAP-compliant accountants strictly adhere to established rules and regulations.
Principle of Consistency: Consistent standards are applied throughout the financial reporting process.
Principle of Sincerity: GAAP-compliant accountants are committed to accuracy and impartiality.
Principle of Permanence of Methods: Consistent procedures are used in the preparation of all financial reports.
Principle of Non-Compensation: All aspects of an organization’s performance, whether positive or negative, are fully reported with no prospect of debt compensation.
Principle of Prudence: Speculation does not influence the reporting of financial data.
Principle of Continuity: Asset valuations assume the organization’s operations will continue.
Principle of Periodicity: Reporting of revenues is divided by standard accounting time periods, such as fiscal quarters or fiscal years.
Principle of Materiality: Financial reports fully disclose the organization’s monetary situation.
Principle of Utmost Good Faith: All involved parties are assumed to be acting honestly.
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GAAP compliance makes the financial reporting process transparent and standardizes assumptions, terminology, definitions, and methods. External parties can easily compare financial statements issued by GAAP-compliant entities and safely assume consistency, which allows for quick and accurate cross-company comparisons.
Because GAAP standards deliver transparency and continuity, they enable investors and stakeholders to make sound, evidence-based decisions. The consistency of GAAP compliance also allows companies to more easily evaluate strategic business options.
What Are the Basic Principles of Accounting?
Beyond the 10 principles, GAAP compliance is built on three rules that eliminate misleading accounting and financial reporting practices. These rules create consistent accounting and reporting standards, which provide prospective and existing investors with reliable methods of evaluating an organization’s financial standing. Without these rules, accountants could use misleading methods to paint a deceptive picture of a company or organization’s financial standing.
These three rules are:
Basic Accounting Principles and Guidelines
These 10 guidelines separate an organization’s transactions from the personal transactions of its owners, standardize currency units used in reports, and explicitly disclose the time periods covered by specific reports. They also draw on established best practices governing cost, disclosure, going concern, matching, revenue recognition, professional judgment, and conservatism.
Rules and Standards Issued by the FASB and Its Predecessor, the Accounting Principles Board (APB)
The FASB issues an officially endorsed, regularly updated compendium of principles known as the FASB Accounting Standards Codification. The compendium includes standards based on the best practices previously established by the APB. These organizations are rooted in historic regulations governing financial reporting, which were implemented by the federal government following the 1929 stock market crash that triggered the Great Depression.
Generally Accepted Industry Practices
There is no universal GAAP model followed by all organizations across every industry. Rather, particular businesses follow industry-specific best practices designed to reflect the nuances and complexities of different areas of business. For example, banks operate using a different set of accounting and financial reporting methods than those used by retail businesses.
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.
Dark Blue = Fully GAAP Compliant: Local and county governments and school districts are required to prepare financial reports under GAAP.
Blue = Mostly GAAP Compliant: Two of three regulated state governing boards and districts must comply to GAAP.
Green = Somewhat GAAP Compliant: One of three regulated state governing boards and districts must comply to GAAP.
Orange = Not GAAP Compliant: Local and county governments and school districts are not formally required to comply to GAAP.
Who Came Up with 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.
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
Identify current investor issues
Draft issue agenda and hold public meetings
Publish Exposure Draft for investor commentary
Propose new standards and invite business feedback
Weigh all public responses and revise accordingly
Announce final revisions to the ASC
Major Projects in 2015
Liabilities & equity – targeted improvements: This update will simplify the complex reporting standards used in accounting for certain financial instruments with down round features, particularly with regard to liabilities and equity.
Accounting for goodwill impairment: The calculation of goodwill impairment losses, which cover financial technicalities regarding business acquisitions of subsidiary entities, are being modified from a two-step process to a simplified, quantitative one-step process.
Employee benefit plan master trust reporting: This project establishes guidelines for calculating an employee benefit plan’s current and projected ability to cover costs and distribute benefits following employee claims.
Determining the customer of the operation services in a service concession arrangement: In some cases, government organizations control when, to whom, and at what price infrastructure-related operating entities must provide services. This update establishes accounting practices for such situations.
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
Create an independent task force
Conduct research on the subject of the new standard
Engage the public through published commentary
Create an Exposure Draft of planned standard
Host public hearings before a standard is finalized
Major Projects in 2015
Financial reporting model: This project will improve the effectiveness and reliability of the financial reporting models used by state and local governments in their decision-making processes.
Revenue and expense recognition: This initiative will create a comprehensive framework for tracking and reporting revenue- and expense-related transactions that are not otherwise covered by existing models.
Capitalization of interest cost: This project will define standards for a new approach to calculating the capitalization of interest costs, which will simplify the financial reporting process.
Equity interest ownership issues: In some cases, stakeholders report their equity ownership interests in a business through separate entities. This project will improve the measurement of equity ownership positions when they are presented as units in separate entities.
What’s the Difference Between GAAP and Non-GAAP?
The table below represents the total revenues, net income, and diluted earnings per share for the 2014 and 2015 fiscal years of Pegasystems Incorporated. “Total revenues” refers to the total value of all goods and services sold by the company. “Net earnings” represents the company’s total income, minus the costs associated with sales and operations, taxes, and other expenses. “Diluted earnings per share” expresses how much money the company earned per outstanding share of common stock, accounting for dilution instruments such as warrants, options, and convertible securities.
GAAP vs. Non-GAAP Case Study: Pegasystems 2014-2015
According to the company’s disclosure, the discrepancies between the GAAP and non-GAAP figures arise from adjustments regarding acquisition and restructuring expenses, equities-based compensation expenses, amortization of acquired assets, and other technicalities impacting its current financial performance. The company believes that presenting both GAAP and non-GAAP data creates a complete picture of its past performance and is a useful predictor of future results.
The 10 Basic Tenets of GAAP
These 10 general principles can help you remember the main mission and direction of the GAAP system.
Principle of Regularity
The accountant has adhered to GAAP rules and regulations as a standard.
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.
Principle of Sincerity
The accountant strives to provide an accurate depiction of a company’s financial situation.
Principle of Permanence of Methods
The procedures used in financial reporting should be consistent.
Principle of Non-Compensation
Both negatives and positives should be fully reported with transparency and without the expectation of debt compensation.
Principle of Prudence
Emphasizing fact-based financial data representation that is not clouded by speculation.
Principle of Continuity
While valuing assets, it should be assumed the business will continue to operate.
Principle of Periodicity
Entries should be distributed across the appropriate periods of time. For example, revenue should be divided by its relevant periods.
Principle of Materiality / Good Faith
Accountants must strive for full disclosure in financial reports.
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.
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.
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.
GAAP is not the international accounting standard; this is a developing challenge as businesses become more globalized. The International Financial Reporting Standards (IFRS) is the most common set of principles outside the United States and is used in places such as the European Union, Australia, Canada, Japan, India, and Singapore. To reduce tension between these two major systems, the FASB and International Accounting Standards Board are working to converge standards.
What Are IFRS Standards?
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.
What’s the Difference Between IFRS and GAAP?
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.
Recommended that current and noncurrent asset and liability categories are separated
These categories are required to be separated
Recognizes intangible assets at fair value
Only examines intangible assets if they can be associated with a future benefit
A Statement of Comprehensive Income is required
A Statement of Comprehensive Income is not required
Inventory Write Downs
Inventory write down reversals are not permitted
Inventory write down reversals are possible under some conditions
Listed separately under new income
Included with other items on the income statement
Examples of Financial Reports
These investor reports from major publicly traded companies give a high-level example of financial filings that follow GAAP: