GAAP

What is GAAP in Accounting?

GAAP in accounting is an acronym that stands for generally accepted accounting principles. It refers to a set of widely adopted rules and standards for financial reporting. The Financial Accounting Standards Board (FASB) is responsible for issuing and regularly updating these principles.

How Does GAAP in Accounting Work?

GAAP in accounting is a multi-step process that aims to ensure that public companies in the US are compiling and reporting their financial statements accurately and completely. That way, potential investors, creditors, regulators, and other interested parties can efficiently review public companies’ financial health, confident that the information portrayed is trustworthy, complete, and true.

So, what does GAAP in accounting mean in practice? Essentially, companies that fall under GAAP must generate annual financial reports that meet specific, standardized requirements. The main financial documents that fall under GAAP are as follows: balance sheet, income statement, cash flow statement, and statement of stockholders’ equity.

Of course, a public company cannot simply say that they are GAAP compliant. Their status must be verified by a third-party auditor, who will meticulously analyze a company’s financial statements to ensure tried and true compliance with GAAP principles.

Should a company be found at odds with compliance, there are several negative consequences, ranging from large monetary fines to legal action to damaged credibility. As a result, even though meeting GAAP compliance takes effort, it is always a better idea to incorporate GAAP guidelines from the get-go rather than try to meet compliance retrospectively and risk the fallout of human error.

What’s the Importance of GAAP?

GAAP is crucial to building and maintaining trust in the US financial markets. Without it, investors and banks would have little means of verifying the information presented by public companies.

Beyond that, though, GAAP also helps businesses themselves in several ways, including:

Improve accuracy and planning: GAAP supports strategic planning by providing an accurate overview of business transactions and revenue.
Ensure uniformity: GAAP promotes consistency across your financial statements, making it easier to evaluate your financial data.
Prevent fraud: GAAP’s controls directly help to spot, detect, and mitigate fraud.
Unlock competitor insights: GAAP helps you to compare your financial performance against competitors, so you can uncover potential areas for improvement.
Wiser spending: GAAP gives you a detailed overview of business expenditure, empowering you to enhance decision-making with regard to spending while finding new cost efficiencies.

Principles of GAAP

GAAP in accounting is defined by the following 10 principles:

1. Principle of consistency

GAAP mandates that businesses use the same accounting methods year on year. Say, for example, a company uses the straight-line method to calculate an asset’s depreciation. They will be expected to apply this method not only to all their assets but to all their assets every year.

The underlying aim of this principle is twofold. Firstly, consistent reporting makes it straightforward for stakeholders and potential investors to compare different reports. Secondly, it stops companies from concealing financial information by leaning on different accounting methods each year.

2. Principle of permanent methods

The principle of permanent methods is aimed at e-commerce organizations. Like the consistency principle, it mandates that public companies must use the same ecommerce accounting methods year in and year out, be it accrual or cash basis, to ensure transparency and consistency.

3. Principle of non-compensation

This principle dictates that organizations must report all financial details, both positive and negative, to give a fair and accurate representation of their financial health. Prohibiting companies from offsetting debts with assets.

4. Principle of prudence

The principle of prudence reinforces the importance of building reports based on tried and true data without estimates or hyperbole. In practice, this means businesses should not overestimate their revenue or undervalue their expenses.

5. Principle of regularity

The principle of regularity states that accountants responsible for GAAP reporting in the organization will follow the rules consistently and without deviation.

6. Principle of sincerity

This principle centers around mitigating the risks of bribery and bias. It mandates that accountants are honest and transparent about the ways they report financial information.

7. Principle of good faith

The principle of good faith is similar to the principle of sincerity. However, it extends its remit to all those involved in the reporting process, including business owners and third parties. It requires everyone who partakes in GAAP to be honest, truthful, and transparent.

8. Principle of materiality

The principle of materiality helps organizations decide what data is relevant enough to be included in financial reporting. It states that any item or data that could influence a third party’s financial decisions must be included.

9. Principle of continuity

This principle states that accountants must base their valuations on the mindset that a company will remain in operation and operate as it always has. The principle mitigates the risk of a company’s under or over-valuing their stock based on what might happen in the future

10. Principle of periodicity

The principle of periodicity dictates that companies will share their reports within commonly accepted time frames: monthly, annually, or quarterly.

In addition to the 10 general principles, public U.S. companies following GAAP are required to adhere to four additional guidelines that enhance the consistency and precision of financial statements.

Recognition: Reports must include, without exemption, detailed overviews of all business assets, revenue, liabilities, and expenses.
Measurement: Financial statements must adhere to GAAP standards.
Presentation: Final statements must include the following: income statement, balance sheet, cash flow statement, and a summary of shareholder equity or ownership.
Disclosure: Financial reporting should include relevant notes and descriptions to ensure reports make complete sense as standalone documents.

Examples of GAAP in Accounting

Thus far, we’ve looked at GAAP in accounting in an abstract way. To contextualize things, here’s an example of how GAAP can support private companies in reaching their business goals.

Suppose you are the owner of a young but fast-growing e-commerce business. You’re a small team of two, and you’re not familiar with GAAP. You know you need to track your expenses over the year, though, so do so in a simple way, classifying all your expenses as general expenses, whether they’re for marketing, purchasing stock, paying your technology platform providers, or general utilities.

Under GAAP, you would be required to record expenses more granularly. This, in turn, would give you a more concise, reliable overview of what expenses related to product development and sales and what relates to day-to-day operations.

However, because you only have an overview of your general expenses, it’s impossible for you to gauge your business’ profitability accurately. Should you look to procure a loan or go for investment, you’ll likely meet several obstacles because you’re not compliant with GAAP.

GAAP vs. IFRS

GAAP is a US-based set of principles. In many other countries, the equivalent is the International Financial Reporting Standards (IFRS), which is used in 168 jurisdictions, including the EU, Australia, Canada, and India. If your company is based in the US but conducts a lot of international business, complying with both standards is advised.

Here’s a look at the major differences:

The GAAP framework is enforced by law and requires third-party audits to meet compliance. In that sense, it is considered rule-based. IFRS, on the other hand, is considered ‘soft law’. It is principle-based, and the penalties for non-compliance are softer.
GAAP’s principles are comprehensive and prescriptive. IFRS rules are more flexible.
There are several further differences specifically relating to how GAAP and IFRS reports are presented, including:
- US GAAP mandates three presenting periods, while there are only two for IFRS.
- US GAAP assets are listed in decreasing order of liquidity. On the other hand, IFRS assets are listed in increasing order of liquidity.
- With GAAP, inventory costs can be calculated using either the Last-In-First-Out (LIFO) or First-In-First-Out (FIFO) cost methods. IFRS does not allow this.
- GAAP groups development costs as expenses, but IFRS puts these under the bracket of capital investment.