Generally accepted accounting principles, or GAAP, are standards 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 releasing financial statements to the public and companies publicly traded on stock exchanges and indices to follow GAAP guidelines. GAAP incorporates the following 10 concepts:
10 GAAP Principles
- 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 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.
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What Are the Basic Principles of Accounting?
GAAP incorporates three components that eliminate misleading accounting and financial reporting practices: 10 accounting principles, FASB rules and standards, and generally accepted industry practices.
These components create consistent accounting and reporting standards, which provide prospective and existing investors with reliable methods of evaluating an organization's financial standing. Without GAAP, accountants could use misleading methods to paint a deceptive picture of a company or organization's financial standing.
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, matching, revenue recognition, professional judgment, and conservatism.
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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 the federal government implemented following the 1929 stock market crash that triggered the Great Depression.
Generally Accepted Industry Practices
All organizations do not follow the GAAP model. Rather, particular businesses follow industry-specific best practices designed to reflect the nuances and complexities of different business areas. For example, banks operate using different accounting and financial reporting methods than those used by retail businesses.
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History of GAAP
Without regulatory standards, companies would be free to present financial information in whichever format best suits their needs. With the ability to portray a company's fiscal standing in a favorable light, investors could be easily misled.
The Great Depression in 1929, a financial catastrophe that 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.
The Governmental Accounting Standards Board (GASB) estimates that about half of the states officially require local and county governments to adhere to GAAP.
According to accounting historian Stephen Zeff in The CPA Journal, GAAP terminology was first used in 1936 by the American Institute of Accountants (AIA). Federal endorsem*nt of GAAP began with legislation like the Securities Act of 1933 and the 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 GAAP.
All 50 state governments prepare their financial reports according to GAAP. The Governmental Accounting Standards Board (GASB) estimates that about half of the states officially require local and county governments to adhere to GAAP.
Who Came Up With Generally Accepted Accounting Principles?
Even though the U.S. federal government requires public companies to abide by GAAP, the government takes no part in developing these principles. Instead, independent boards assume the responsibility of creating, maintaining, and updating accounting principles.
As GAAP issues or questions arise, these boards meet to discuss potential changes and additional standards. For instance, when the COVID-19 pandemic hit, the board members met to address how governments and businesses must report the financial effects of the pandemic.
To ensure the boards operate responsibly and fulfill their obligations, they fall under the supervision of the Financial Accounting Foundation.
Financial Accounting Foundation (FAF)
FAF formed in 1972 as the administrative corporation that oversees the Financial Accounting Standards Board (FASB) and the Governmental Accounting Standards Board (GASB).
The FAF is responsible for appointing board members and ensuring that these boards operate fairly and transparently. Members of the public can attend FAF organization meetings in person or through live webcasts.
Financial Accounting Standards Board
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 comprises seven full-time, impartial members, ensuring that it works for the public's best interest.
The 35-member Financial Accounting Standards Advisory Council (FASAC) monitors the FASB. FASB is responsible for the Accounting Standards Codification (ASC), a centralized resource where accountants can find all current GAAP.
The FASB Standards-Setting Process
- Identify current investor issues
- Draft issue agenda and hold public meetings
- Publish exposure draft for investor commentary
- Propose new standards and invite business feedback
- Weigh all public responses and revise accordingly
- Announce final revisions to the ASC
Recent Major Projects
- Insurance - Effective Date: This project addressed a prior update on the requirements for long-duration contracts. The board decided to provide public companies a one-year extension on the effective date for the requested changes, allowing them time to implement requirements more effectively.
- Revenue Recognition - Practical Expedient for Private Company Franchisors: Although the federal government does not require private companies to follow GAAP, many choose to follow the standards. With this project, the FASB allows private franchisors to separate the franchise license and pre-opening services in their financial reports.
- Simplifications to Accounting for Income Taxes: Since reporting income taxes can be a complicated process for businesses, the FASB simplified the process with this project. They removed several requirement exceptions and streamlined the overall accounting process.
- Nonprofit Reporting of Gifts-in-Kind: For this project, the FASB met to update a standard created the previous year concerning nonprofit entities and their nonfinancial assets. The board decided that a nonprofit organization must list gifts-in-kind separately and include additional information.
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 groups rely on government financial statements, including constituents and lawmakers. GASB prioritizes fairness and transparency. The board's processes and communications are available for public review.
The GASB Standards-Setting Process
- Create an independent task force
- Conduct research on the subject of the new standard
- Engage the public through published commentary
- Create an exposure draft of the planned standard
- Host a public hearing before the standard is finalized
Recent Major Projects
- Omnibus: For this project, the GASB addressed several technical issues brought to their attention by various governments. The board reviewed areas including post-employment benefits transfers, lease standards, and reinsurance recoveries.
- Subscription-Based Information Technology Arrangements: With the increase of subscription-based information technology sales, the board adopted new standards regarding cloud computing arrangements. The board also discussed potential changes in the reporting guidelines for intangible assets.
- COVID-19 and CARES Act Technical Bulletin: The GASB worked to create new guidelines for governments affected by the COVID-19 pandemic. The new standards covered how to report any expenses from COVID-related closures and revenue or liabilities from the CARES Act.
- Postponement of the Effective Dates of Certain Authoritative Guidance: This project addressed several complaints from government officials across the U.S. about their inability to complete GASB authoritative guidance due to COVID-19 closures. The board approved an extension to give the officials more time.
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Non-GAAP Reporting
Many businesses believe that GAAP accounting does not accurately reflect their company's success. Some companies include non-GAAP earnings in addition to those that follow GAAP methods.
The table below presents IBM's fourth-quarter earnings report from 2016. These figures provide an excellent example of how the inclusion of non-GAAP earnings can affect the overall representation of a company's success. The first column indicates GAAP earnings, the middle two note non-GAAP adjustments, and the final column shows the non-GAAP totals. With non-GAAP metrics applied, the gross profit, income, and income margin increase, while the expenses decrease.
Many companies support non-GAAP reporting because it provides an in-depth look at their financial performance. Some companies claim that it gives a more accurate overview. However, the non-GAAP numbers include pro forma figures, which do not include one-time transactions. Companies can use this information to their advantage and present totals that predict how their businesses will perform in the future.
While non-GAAP reports may show more accurate figures for companies that experienced unusual one-time transactions, other businesses often list repeated earnings as one-time figures. Even though they appear transparent, non-GAAP figures can create confusion for investors and regulators.
International Business Machines Corporation (IBM) U.S. GAAP to Operating (Non-GAAP) Results Reconciliation (Unaudited)
(Dollars in millions, except per share amounts)
| Twelve Months 2016 Continuing Operations | ||||
|---|---|---|---|---|
| GAAP | Acquisition-related adjustments | Retirement-related adjustments | Operating (Non-GAAP) | |
| Gross Profit | $38,294 | $494 | $316 | $39,104 |
| Gross Profit Margin | 47.9% | 0.6Pts | 0.4Pts | 48.9% |
| Selling, General & Administrative Expenses | 21,069 | (501) | (253) | 20,315 |
| Research, Development & Engineering | 5,751 | – | (29) | 5,722 |
| Other (Income) and Expense | 145 | (7) | – | 138 |
| Total Expense & Other (Income) | 25,964 | (508) | (282) | 25,174 |
| Pretax Income from Continuing Operations | 12,330 | 1,003 | 598 | 13,931 |
| Pretax Income Margin from Continuing Operations | 15.4% | 1.3Pts | 0.7Pts | 17.4% |
| Provision for/(Benefit) from Income Taxes | 449 | 268 | 183 | 900 |
| Effective Tax Rate | 3.6% | 1.7Pts | 1.2Pts | 6.5% |
| Income from Continuing Operations | 11,881 | 735 | 415 | 13,031 |
| Income Margin from Continuing Operations | 14.9% | 0.9Pts | 0.5Pts | 16.3% |
| Diluted Earnings per Share: Continuing Operations | $12.39 | $0.77 | $0.43 | $13.59 |
Limitations of GAAP
While GAAP accounting 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
GAAP may seem to take a "one-size-fits-all" approach to financial reporting that does not adequately address issues faced by distinct industries. For example, state and local governments may struggle with implementing GAAP due to their unique environments. New GAAP hierarchy proposals may better accommodate these government entities.
Small businesses may also struggle with implementing GAAP. These standards may be too complex for their accounting needs, and hiring personnel to create GAAP definition reports can be expensive. As a result, the FASB works with the Private Company Council to update GAAP with private company exceptions and alternatives.
Timeframe
Due to the 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 reports.
Global vs. Domestic
GAAP is not the international accounting standard, which 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. IFRS is used in the European Union, Australia, Canada, Japan, India, and Singapore.
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What Is IFRS?
The IFRS began almost 50 years ago under a different name. Starting in 1973, the board of the International Accounting Standards Committee (IASC) released a series of International Accounting Standards (IAS) to create more uniform accounting methods throughout the European Union.
In 2001, the International Accounting Standards Board (IASB) replaced the IASC and began publishing the IFRS, which is now used in 166 jurisdictions. This count includes the United States, even though the country has not fully conformed to the IFRS.
While the United States does not require IFRS, over 500 international SEC registrants follow these standards. Domestic public companies must use GAAP exclusively.
Since the U.S. does not fully comply with IFRS, global companies face challenges when creating financial statements. Even though the FASB and IASB created the Norwalk Agreement in 2002, which promised to merge their unique set of accounting standards, they have made minimal progress. In an effort to move towards unification, the FASB aids in the development of IFRS.
What's the Difference Between IFRS and U.S. GAAP?
The FASB and IASB want to merge their standards because they share the goal of pursuing accounting integrity. While each financial reporting framework aims to provide uniform procedures and principles to accountants, there are notable differences between them.
The main distinction appears in their overall organization. U.S. GAAP prioritizes rules and detailed guidelines, while the IFRS provides general principles to follow. Accountants following the IFRS may interpret the standards differently, leading to added explanatory documents. However, businesses that use GAAP may feel confined by the lengthy rules.
With such a prominent difference in approach, dozens of other discrepancies surface throughout the standards. The chart below includes only a couple of the variations that may affect how a business reports its financial information.
| GAAP | IFRS | |
|---|---|---|
| Balance Sheet - Presentation of debt as current versus noncurrent | In certain situations, debt covenant violations may be listed as noncurrent | Unless lender agreement came before the creation of the balance sheet, all debt covenant violations must appear as current |
| Intangible Assets | Recognizes intangible assets at fair value | Only examines intangible assets if they can be associated with a future benefit |
| Income Statement - Classification of expenses | Not required to list expenses by function or nature | Must document expenses by either function or nature |
| Inventory Write Downs | Inventory write-down reversals are not permitted | Inventory write-down reversals are possible under some conditions |
| Extraordinary Items | Listed separately under new income | Included with other items on the income statement |
Further Reading
These investor reports from major publicly traded companies provide high-level examples of financial filings that follow GAAP:
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Frequently Asked Questions About GAAP
What are the 10 generally accepted accounting principles?
The 10 generally accepted accounting principles include the following: - Principle of Regularity- Principle of Consistency- Principle of Sincerity- Principle of Permanence of Method- Principle of Non-Compensation- Principle of Prudence- Principle of Continuity- Principle of Periodicity- Principle of Full Disclosure- Principle of Utmost Good Faith
What is GAAP used for?
Governments and public companies abide by these accounting principles to ensure all documents present consistent, accurate, and clear reports. GAAP results in straightforward and understandable financial reports that investors and regulators can easily use to assess a business's financial standing.
Why is GAAP important?
The importance of GAAP lies in the uniformity, comparability, and transparency of financial documents. Without these standards and practices, businesses could publish their reports differently, creating discrepancies, confusion, and potential opportunities for fraud.
What is an example of GAAP?
The GAAP standards cover financial reporting as a whole. For example, GAAP stipulates how to file income statements, what financial periods to include, and how to report cash flow.
Are all companies required to follow GAAP?
Not all companies need to follow GAAP. Only regulated and publicly traded businesses must adhere to GAAP. However, about one third of private companies choose to comply with these standards to provide transparency.
Reviewed by:
Lizzette Matos, CPA
Lizzette Matos is a certified public accountant in New York state. She earned a bachelor of science in finance and accounting from New York University.
Lizzette began her career at Ernst & Young, where she audited a diverse set of companies, primarily in consumer products and media and entertainment. She has worked in the private industry as an accountant for law firms and ITOCHU Corporation, an international conglomerate that manages over 20 subsidiaries and affiliates. Lizzette stays up to date on changes in the accounting industry through educational courses.
She is a paid member of Red Ventures Education's freelance review network.
