What Are Generally Accepted Accounting Principles (GAAP)?

Understanding GAAP is essential for anyone involved in finance or accounting. Learn the key principles and their significance in this complete guide.

Generally Accepted Accounting Principles are a set of accounting rules for companies based in the United States. While the federal government only mandates that publicly traded companies file GAAP-compliant statements, many banks and financial institutions also require private companies to follow GAAP if they want to apply for a loan.

In this guide, we cover the basics of GAAP and why GAAP compliance matters for U.S. businesses of all sizes.

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What is GAAP?

GAAP stands for Generally Accepted Accounting Principles and consists of a common set of accounting rules, requirements and practices. This guidance is issued by the Financial Accounting Standards Board (FASB) and the Governmental Accounting Standards Board (GASB), which means that GAAP applies to businesses in the United States. The purpose of GAAP is to standardize procedures and provide clear, consistent information about accounting.

Where is GAAP used?

Only public companies in the U.S. are legally mandated to follow GAAP, but many private companies do so as well. Not only does GAAP make financial statements easy to understand, but many banks also require organizations to provide GAAP-compliant financial statements in order to receive a loan, even if they’re private businesses. This is why most U.S. accounting software such as QuickBooks has GAAP rules automatically integrated.

GAAP is mostly used in the United States, since it’s defined and enforced by U.S. agencies. The International Financial Reporting Standards are typically used in countries outside the U.S. instead of GAAP. We’ll compare GAAP and IFRS in more depth in the final section.

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Key principles of GAAP

GAAP is based on 10 core accounting concepts, called principles. The 10 GAAP principles are:

  • Principle of regularity: The organization’s accounting practices follow the standards laid out by GAAP.
  • Principle of consistency: The organization’s accounting practices remain consistent and comparable every reporting period.
  • Principle of sincerity: The organization’s accounting captures the financial information accurately and correctly.
  • Principle of permanence of methods: The organization’s accounting practices remain constant from one financial period to the next.
  • Principle of non-compensation: All aspects of the organization’s financial performance, both positive and negative, are reported with no expectation of debt compensation.
  • Principle of prudence: All accounting entries are timely and realistic, not influenced by speculation.
  • Principle of continuity: Assets’ valuations are based on the assumption that the organization will continue to stay in business.
  • Principle of periodicity: The organization follows a regular and routine schedule for accounting periods, such as fiscal quarters or fiscal years.
  • Principle of materiality: The organization fully and truthfully discloses its monetary situation in financial reports, valuing assets at cost.
  • Principle of utmost good faith: All individuals involved in the accounting process are assumed to be acting honestly and truthfully.

Importance of GAAP

The ultimate goal of GAAP is to ensure that an organization’s financial statements are complete and accurate. GAAP compliance is almost always necessary for a company to become publicly traded or to receive financial funding such as loans. GAAP fosters trust in both companies’ financial statements and financial markets at large. It also makes it easier to analyze the financial health of a company and compare it to others, since the statements follow a common format and rules.

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Compliance with GAAP

Businesses that have stock publicly traded on a stock exchange in the U.S. must adhere to GAAP, as laid out by the U.S. Securities and Exchange Commision (SEC). Publicly traded companies must regularly file GAAP-compliant finance statements to remain publicly listed. External audits by certified public accounting firms ensure ongoing GAAP compliance.

Many lenders and creditors also require that business loan applicants must submit GAAP-compliant finance statements in order to receive a loan. And this doesn’t apply only to banks: Many venture capitalists and other sources of funding also expect financial statements to follow GAAP principles. If accounting (whether double-entry or single-entry) and financial statements aren’t prepared according to GAAP standards, that will give many investors and lenders pause and may even cause them to reject the application.

Limitations of GAAP

While GAAP is the standard inside the United States, it isn’t globally recognized by the International Accounting Standards Board (IASB). This means that global companies will likely need to prepare their financial reports in a different format for other countries. While a globally unified set of standards are in the works, they aren’t currently available, leaving international companies to follow both GAAP and IFRS.

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GAAP is also less flexible than IFRS and takes a one-size-fits-all approach to accounting guidance. For this reason, some small businesses and companies in certain industries may struggle to correctly integrate all GAAP principles. In fact, many small businesses find it costly to achieve and maintain GAAP compliance.

GAAP vs. IFRS

Although 100 countries all over the globe use IFRS, GAAP is only used in the United States. GAAP is typically more rules-based and less flexible, whereas IFRS focuses more on principles instead of rigid guidelines. Rather than spelling everything out, IFRS asks accountants and finance employees to make judicial decisions about how IFRS principles apply in their companies’ specific situation.

Another notable difference between the two is that GAAP allows for both first in, first out and last in, first out inventory accounting methods. In contrast, the international standards ban the LIFO method and only allows inventory to be accounted for with either FIFO or the weighted average cost method. There are also additional, smaller differences, such as what order assets are listed in and what section dividends and interest are placed in.

Creating GAAP-compliant financial statements by hand can be time consuming and frustrating for small businesses. Fortunately, most popular accounting and bookkeeping software already have GAAP rules built in to ensure compliance and accuracy.

Source: https://www.techrepublic.com/article/generally-accepted-accounting-principles/