Overview and Definition
The generally accepted accounting principles, commonly referred to as GAAP, are guidelines that help maintain consistency in the field of financial accounting. The Financial Accounting Standards Board’s (FASB) set of methods and practices are a guide-stone for the GAAP, and The American Institute of Certified Public Accountants (AICPA) are also consulted on the creation of these industry standards. GAAP provides a consistent vocabulary and methodology for financial accountants in the United States.
GAAP is needed to ensure that shareholders, regulators, and other investors or interested parties can easily understand each company's filings. Since every company follows GAAP guidelines, analysts can compare companies, and determine which companies are alike based on their fiscal similarities. Without a common accounting language, it would be difficult to determine relative corporate valuations.
Most state and local county governments, and their school districts are either fully, mostly, or somewhat compliant with GAAP. However, a full fourteen states are not GAAP compliant at all, equal to the number of full-compliance states. The United States federal government, on the other hand, requires that all publicly traded corporations file their financial statements according to GAAP guidelines. Thus, even if GAAP is not an absolute state requirement for accounting practices, it is required that you follow these principles and guidelines in order to maintain consistency in business practices. After all, if an investor is unable to apply a set of guidelines to a company's financial statements, they are unlikely to pursue business with them.
Where Does It Come From?
The GAAP principles are created by a hierarchy of organizations. At the top is the FASB and the AICPA. FASB is a private, independent agency that is recognized by the Securities and Exchange Commission as the standard-bearer for financial accounting. Since the State Boards of Accountancy recognize FASB as an authoritative body, GAAP is their defacto standard, too.
The AICPA's contribution to GAAP is equally important. Apart from their input on GAAP, they accredit accounting departments at the best universities, but they also create the CPA examination which is a chief requirement for licensure. After the NASB and AICPA, the GAAP standards are then created by sub-agencies such as FASB Technical Bulletins, AICPA Industry Audit, and Accounting Guides and Statements of Position.
When accountants have questions concerning the GAAP, they are instructed to first seek resolution with the top-tier agencies, the FASB and the AICPA. If they cannot find a satisfactory solution to their problem, FASB's Statement of Accounting Standards No. 162 is available. That document details the hierarchy of the GAAP.
Why Use GAAP?
One of the chief reasons to use the GAAP is that it is virtually required for all financial documentation. Accountants who provide financial accounting services to publicly traded companies must adhere to all rules and guidelines of the Securities and Exchange Commission. Even for those who create financial documentation for privately held corporations, any outside investor or auditor will expect GAAP compliance.
This is all because the GAAP provides a level of consistency among all financial filings, through which those documents find a common ground. Any investor, regulator, or accountant will find that GAAP-compliant documents follow a similar logic and structure. This standardization ostensibly creates a commonality in all financial reports. However, some argue that the GAAP creates opportunities for great inconsistency and unintended opacity, where transparency is sought.
Nonetheless, when analysts, creditors, investors, and other business people open a GAAP-compliant document, they recognize its elements immediately. Each will have a balance sheet, income statement, and cash flow statement, for instance. Then, each statement will use terms consistent with the other. For instance, each balance sheet will share an agreement as to what the terms long-term and short-term debt mean.
Ultimately, the GAAP is the accounting standard for all company's in the United States, especially public companies. Due to the fact that most accountants have attended AICPA-accredited accounting programs, even private companies use the standard. Creditors and potential acquisition targets are sure to demand the standard, as well.
What is Covered?
GAAP is a system for accounting that covers how financial documents are prepared. It also provides guidelines for specific areas of business, such as inventory systems, and how certain debts are handled. The principles it espouses function as both general ethical guidelines and specifics for how to report financial realities.
For instance, sometimes companies make sales on a credit basis. This is especially the case when the value of the relevant goods is in the tens of millions. The principle of recognition applies in this case because there is a question of how to account for this sale. That is, there is a contract that represents the account receivable, but the cash has not yet landed in the seller's accounts. Since the GAAP relies on accrual accounting, the sale is recognized on the balance sheet and as part of the company's overall value. However, it does not receive recognition on the cash flow statement because that sales revenue cannot yet be used to pay debts or regular bills.
One of the more evident aspects of GAAP reporting is how information is presented in a company's 10-Q or 10-K documentation. Regular readers of these documents often flip directly to these items easily, since they fall at specific points in the documentation.
Each of these documents must include three reports:
Top 10 Principles
The GAAP is founded on principles and guidelines more than strict rules. Above all, the GAAP intends to promote honest financial reporting that adheres to consistent vocabulary and guidelines.
Principle of Regularity:
This principle ensures that every accountant follows all GAAP guidelines. Since the GAAP is enforced through the Securities and Exchange Commission, regularity is assured.
Principle of Consistency:
When the same rules are followed throughout the accounting process, the consumers of financial information will have an easier time understanding financial statements.
Principle of Sincerity:
This principle requires accuracy with regard to the company's finances. Thus, accountants are held to a sort of honor code in their reporting.
Principle of Permanence of Methods:
Without consistency in accounting methods, there could be no way to understand or trust financial reporting. Further, when accountants from different companies use similar methodology, comparisons are easy to make.
Principle of Non-compensation:
Since accountants follow this principle, investors and creditors are assured full disclosure of positives and negatives.
Principle of Prudence:
This principle ensures that speculation is eradicated.
Principle of Continuity:
Through this principle, accountants assume that the company will continue its operations.
Principle of Periodicity:
This is vital for accurate and fair reporting in that it ensures that all revenues, losses, and other changes are recorded according to when they were received. Thus, revenue from one fiscal quarter cannot be held for reporting in order to bolster an under-performing period in the future.
Principle of Materiality / Good Faith:
To follow this principle, accountants must exercise full disclosure when reporting financial information.
Principle of Utmost Good Faith:
With millions of dollars at stake, this principle ensures honesty and fair dealing with regard to accounting, which is vital to the integrity of the financial system and the business community in general.
Advantages of Compliant Reports
A GAAP-compliant report is vital for all companies, whether public or private. Publicly held companies that are traded on public equity markets must adhere to GAAP standards as a condition of their being listed by the SEC. Their compliance lends consistency to all quarterly, annual, and other financial documents. This consistency helps analysts, investors, and creditors understand, process, and trust the information they find in these filings.
Furthermore, since there is a written standard for financial reporting, there is a level of accountability for all concerned accountants. That is, since good faith, honesty, and general truthfulness are required by the GAAP, and thus by the SEC, investors have recourse in case a company's financial operations are misrepresented.
Limitations of the GAAP
While the GAAP may seem to be the perfect tool to make accounting consistent across the board, it does have its limitations. Some of the chief limitations and criticisms of these principles is that they are not truly objective, don't reflect certain financial realities, and don't hold up in light of increasing globalization.
While the GAAP is seemingly designed to institute standards and principles that enforce objectivity and aim to provide maximum transparency and clarity, some argue that this is not the case. For instance, valuations for private companies can vary widely under the current GAAP rules. The guidelines for these companies might be applicable for well-established public companies, but new private firms are difficult to quantify. This ambiguity causes difficulties for analysts and investors who seek to find and distinguish comparable firms.
The GAAP is also reported to cause inaccuracies in the case of acquisitions. When a company purchases another, current standards allow the surviving company to add its target's revenue to its own. Thus, reporting will reflect a far larger increase in revenue than is actually the case. The GAAP does not insist on a complete reporting of these events, so investors can be led astray. When earnings spike, so do stock prices, but in these cases, reported earnings are not accurate. Only after a fiscal year has passed will reporting again reflect the true, organic growth of the company.
The GAAP is also limited with regard to the international business world. Since business is creating increasingly porous international borders, it is vital for businesses in the United States to provide accounting statements that meet international standards. Currently, the International Financial Reporting Standards (IFRS) is the standard being used by most companies outside of the United States. For many years, the SEC has considered switching to the IFRS but now it appears that they are seeking to integrate some IFRS standards into the GAAP.
While the GAAP does seem to have plenty of limitations, it is also a fluid and ever-mutable set of principles and standards. Much as companies shift their focuses over time, the GAAP is sure to adapt so as to address realities in the business world.
What’s the International Standard?
While the United States seeks accounting consistency via the GAAP, the rest of the world utilizes a different set of guidelines under the International Financial Reporting Standards (IFRS). The IFRS is the standard for all European Union companies and is likewise implemented throughout much of Asia. While the IFRS requires many of the same statements as the GAAP, such as the profit and loss statement, balance sheet, and cash flow statement; it does not include a statement of comprehensive income. Under the IFRS, companies must also provide transparency regarding their accounting policies. Further, a company must not only provide a reporting for itself, but for its subsidiary holdings as well. The IFRS and GAAP also differ when it comes to reporting inventory, income, and how liabilities are classified.
Another key difference between the IFRS and GAAP is found in how inventory is reported and handled. The IFRS does not allow Last In-First Out (LIFO) inventory practices. This inventory system lets companies sell their newest inventories first. Under the GAAP, companies can choose LIFO or FIFO (First In-First Out) practices as they see fit.
When it comes to documenting business practices, the IFRS also does not require a statement of comprehensive income. GAAP documents require that companies report both comprehensive income and other comprehensive income (OCI). OCI includes revenues from non-core business practices such as equity investments, interest income, and foreign currency transactions. Comprehensive income includes the net income found on the income statement as well as OCI.
Yet another difference between these two accounting standards is in how they classify liabilities. Under the GAAP, liabilities are classified as either short-term or long-term. Short-term liabilities are considered accounts payable in the United States. The IFRS, on the other hand, does not distinguish between the two sorts of liability. Thus, in an IFRS-compliant document, short-term and long-term liabilities are added together.