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.
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
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
Securities Act of 1933
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
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.
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
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
1Identify current investor issues
2Draft issue agenda and hold public meetings
3Publish Exposure Draft for investor commentary
4Propose new standards and invite business feedback
5Weigh all public responses and revise accordingly
6Announce 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
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
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
1Create an independent task force
2Conduct research on the subject of the new standard
3Engage the public through published commentary
4Create an Exposure Draft of planned standard
5Host 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
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
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.
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
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
Global vs. Domestic
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
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
either partially or completely.
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
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.
Scott Taub at Compliance Week, this is true, in a way; the GAAP principles are governed by
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.
GAAP: Recommended that current and noncurrent asset and
liability categories are separated
IFRS: These categories are required to be separated
GAAP: Recognizes intangible assets at fair value
IFRS: Only examines intangible assets if they can be
associated with a future benefit
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
GAAP: Listed separately under new income
IFRS: 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: