What Are the Generally Accepted Accounting Principles (GAAP)?
The generally accepted accounting principles (GAAP) are a set of accounting rules, standards, and procedures issued and frequently revised by the Financial Accounting Standards Board (FASB). Public companies in the U.S. must follow GAAP when their accountants compile their financial statements. GAAP is also widely used in governmental accounting.
Key Takeaways
- GAAP is the set of accounting rules set forth by the Financial Accounting Standards Board (FASB) that U.S. companies are expected to follow when putting together their financial statements.
- The goal of GAAP is to ensure that a company's financial statements are complete, consistent, and comparable.
- GAAP may be contrasted with pro forma accounting, which is a non-GAAP financial reporting method.
- GAAP is used mainly in the U.S., while most other countries follow the International Financial Reporting Standards (IFRS).
- GAAP is also used by states and other government entities in the U.S. in preparing their financial statements.
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Understanding GAAP
GAAP is a combination of authoritative standards set by policy boards and the commonly accepted ways of recording and reporting accounting information. GAAP covers such topics as revenue recognition, balance sheet classification, and materiality.
The ultimate goal of GAAP is to ensure that a company's financial statements are complete, consistent, and comparable. This makes it easier for investors to analyze and extract useful information from financial statements, including trend data over a period of time. It also facilitates the comparison of financial information across different companies.
GAAP may be contrasted with pro forma accounting, which is a non-GAAP financial reporting method. In other countries, the equivalent to GAAP in the U.S. is the International Financial Reporting Standards (IFRS). IFRS is currently used in 168 jurisdictions around the world.
GAAP is also used in the preparation of financial statements by government entities. According to the Financial Accounting Foundation, all 50 states adhere to GAAP and many require that local entities, such as counties, cities, towns, and school districts, do so as well.
Compliance With GAAP
If a corporation's stock is publicly traded, its financial statements must follow rules established by the U.S. Securities and Exchange Commission (SEC). The 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. As a result, most companies in the U.S. do follow GAAP.
If a financial statement is not prepared using GAAP, investors should be cautious. Without GAAP, comparing financial statements of different companies would be extremely difficult, even within the same industry, making an apples-to-apples comparison hard. Some companies may use both GAAP and non-GAAP measures when reporting their financial results. GAAP regulations require that non-GAAP measures be identified in financial statements and other public disclosures, such as press releases.
GAAP vs. IFRS
As mentioned above, the International Financial Reporting Standards (IFRS), set by the International Accounting Standards Board (IASB), is an alternative to GAAP that is in wide use throughout the world.
There are some important differences in how accounting entries are treated in GAAP as opposed to IFRS. One major issue is the treatment of inventory. IFRS rules ban the use of last-in, first-out (LIFO) inventory accounting methods, while GAAP rules allow for LIFO. Both systems allow for the first-in, first-out method (FIFO) and the weighted average-cost method.
The IASB and the FASB have been working on the convergence of IFRS and GAAP since 2002. Due to the progress achieved in this partnership, the SEC, in 2007, removed the requirement for non-U.S. companies registered in the U.S. to reconcile their financial reports with GAAP if their accounts already complied with IFRS. This was a big achievement because prior to the ruling, non-U.S. companies trading on U.S. exchanges had to provide GAAP-compliant financial statements.
As corporations increasingly need to navigate global markets and conduct operations worldwide, international standards are becoming increasingly popular at the expense of GAAP, even in the U.S. Almost all S&P 500 companies reported at least one non-GAAP measure in their financial statements as of 2019.
Since much of the world uses the IFRS standard, aconvergence to IFRScould have advantages for international corporations and investors alike.
Some Key Differences Between IFRS and GAAP
Where Are Generally Accepted Accounting Principles (GAAP) Used?
GAAP is used primarily in the United States, while the International Financial Reporting Standards (IFRS) are in wider use internationally.
Why Is GAAP Important?
GAAP is important because it helps maintain faith in the financial markets. If not for GAAP, investors could be more reluctant to trust the information presented to them by public companies. Without that trust, we might see fewer transactions, potentially leading to higher transaction costs and a less robust economy. GAAP also helps investors analyze companies by making it easier to perform "apples to apples" comparisons between one company and another.
What Are Non-GAAP Measures?
Companies are still allowed to present certain figures without abiding by GAAP guidelines, provided that they clearly identify those figures as not conforming to GAAP. Companies sometimes do that when they believe the GAAP rules are not flexible enough to capture certain nuances about their operations. In such situations, they might provide specially designed non-GAAP metrics, in addition to the other disclosures required under GAAP. Investors should be skeptical about non-GAAP measures, however, as they can sometimes be used in a misleading manner.
The Bottom Line
While the rules established under GAAP work to improve the transparency in financial statements, they do not guarantee that a company's financial statements are free from errors or omissions meant to mislead investors. There is plenty of room within GAAP for unscrupulous accountants to distort figures. So even when a company uses GAAP, you still need to scrutinize its financial statements with care.
