Generally Accepted Accounting Principles (GAAP)

Generally accepted accounting principles (GAAP) refer to a common set of accounting principles, standards, and procedures issued by the Financial Accounting Standards Board (FASB). Public companies in the U.S. must follow GAAP when their accountants compile their financial statements. GAAP aims to improve the clarity, consistency, and comparability of the communication of financial information. The ultimate goal of GAAP is to ensure a company's financial statements are complete, consistent, and comparable.

The U.S. Securities and Exchange Commission (SEC) requires that publicly traded companies in the U.S. regularly file GAAP-compliant financial statements in order to remain publicly listed on the stock exchanges. GAAP compliance is ensured through an appropriate auditor's opinion, resulting from an external audit by a certified public accounting (CPA) firm. Although it is not required for non-publicly traded companies, GAAP is viewed favorably by lenders and creditors. Most financial institutions will require annual GAAP-compliant financial statements as a part of their debt covenants when issuing business loans.

Ten Principles of GAAP

1. Principle of Regularity: The accountant has adhered to GAAP rules and regulations as a standard.
2. Principle of Consistency: Accountants commit to applying the same standards throughout the reporting process, from one period to the next, to ensure financial comparability between periods. Accountants are expected to fully disclose and explain the reasons behind any changed or updated standards in the footnotes to the financial statements.
3. Principle of Sincerity: The accountant strives to provide an accurate and impartial depiction of a company’s financial situation.
4. Principle of Permanence of Methods: The procedures used in financial reporting should be consistent, allowing a comparison of the company's financial information.
5. Principle of Non-Compensation: Both negatives and positives should be reported with full transparency and without the expectation of debt compensation.
6. Principle of Prudence: This refers to 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 reported in its relevant accounting period.
9. Principle of Materiality: Accountants must strive to fully disclose all financial data and accounting information 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 all transactions.

GAAP vs. IFRS

As discussed above, GAAP is focused on the accounting and financial reporting of U.S. companies while the Financial Accounting Standards Board (FASB) is an independent non-profit organization, responsible for establishing these accounting and financial reporting standards. The international alternative to GAAP is the International Financial Reporting Standards (IFRS), set by the International Accounting Standards Board (IASB). The IASB and the FASB have been working on the convergence of IFRS and GAAP since 2002.

There are some differences still exist including LIFO inventory; research and development costs; and reversing write-downs. IFRS prohibits the Last In First Out (LIFO) as an inventory cost method. Under IFRS, research and development costs can be capitalized and amortized over multiple periods if certain conditions are met. The write-down can be reversed under IFRS while GAAP specifies that the amount of write-down of an inventory or fixed asset cannot be reversed if the market value of the asset subsequently increases.

Summary

GAAP is a set of procedures and guidelines used by companies to prepare their financial statements and other accounting disclosures. The GAAP standards help to ensure that the financial information provided to investors and regulators is accurate, reliable, and consistent with one another. GAAP is important because it helps maintain trust in the financial markets. If not for GAAP, investors would be more reluctant to trust the information presented to them by companies because they would have less confidence in its integrity. GAAP also helps investors analyze companies by making it easier to perform ‘apples to apples’ comparisons between one company and another.