The Generally Accepted Accounting Principles (GAAP) comprise a consistent set of accounting standards and procedures established and periodically revised by recognized authorities. Public companies in the U.S. are mandated to adhere to GAAP when creating their financial statements to ensure accuracy and uniformity, although these principles are widely utilized in governmental accounting as well.
Key Takeaways
- GAAP guidelines are enforced by the Financial Accounting Standards Board (FASB) and must be followed by U.S. companies for financial statements.
- The primary objective of GAAP is to provide comprehensive, consistent, and comparable financial statements.
- GAAP stands in contrast to pro forma accounting, a non-GAAP reporting methodology.
- The U.S. predominantly uses GAAP, whereas most countries follow the International Financial Reporting Standards (IFRS).
- Government entities in the U.S., including states and municipal administrations, also implement GAAP for their financial disclosures.
Understanding GAAP
GAAP comprises a blend of authoritative criteria established by policy bodies alongside widely recognized accounting approaches. Topics under GAAP include revenue recognition, balance sheet classification, and the concept of materiality.
The core objective of GAAP is to assure stakeholders that financial statements are exhaustive, consistent, and amenable for comparison. This framework facilitates investors in evaluating and extracting valuable insights from financial reports, including trend analysis over time. It also streamlines comparative analysis of financial data across different corporations.
GAAP contrasts with pro forma accounting, which eschews standard regulations. Globally, GAAP’s counterpart is the IFRS, which is currently utilized in 168 jurisdictions.
In the U.S., GAAP is integral to financial statement preparation by governmental entities. As cited by the Financial Accounting Foundation, GAAP is observed by all 50 states and is often mandated for local bodies like counties and school districts.
Compliance With GAAP
Publicly traded companies in the U.S. must conform to regulations from the Securities and Exchange Commission (SEC). The SEC insists that these entities file GAAP-compliant financial reports to uphold their public listings. Compliance to GAAP is typically validated through an independent audit, yielding an auditor’s opinion formulated by a certified public accounting firm.
Although non-public companies aren’t legally bound to follow GAAP, adherence is viewed favorably by creditors and lenders. Seldom will financial institutions grant business loans without annual GAAP-compliant financial statements, rendering GAAP the de facto standard.
Caution is advised if financial statements deviate from GAAP, as comparing different companies’ statements can become problematic, even within the same sector. Some businesses use both GAAP and non-GAAP metrics in their financial reporting, but GAAP stipulates that non-GAAP figures must be clearly identified in financial statements and public disclosures.
GAAP vs. IFRS
The International Financial Reporting Standards (IFRS) set by the International Accounting Standards Board (IASB) offer a global alternative to GAAP. Key differences exist between how GAAP and IFRS treat specific accounting practices. For instance, GAAP allows last-in, first-out (LIFO) inventory accounting, while IFRS prohibits it; however, both standards accept first-in, first-out (FIFO) and the weighted average-cost method.
The FASB and IASB have collaborated since 2002 to harmonize GAAP and IFRS. Significant strides in this convergence led to the SEC in 2007, dropping the requirement for non-U.S. firms to reconcile their accounts with GAAP, facilitating smoother operations for global companies.
Why GAAP Are Important?
GAAP plays a crucial role in sustaining investor confidence in the financial markets. It enables uniform comparison across different businesses, thus fostering informed decision-making by investors. Without GAAP, data inconsistencies could deter investment and lead to great inefficiencies in financial exchanges, upping operational costs and making markets less dynamic.
What Are Non-GAAP Measures?
Companies might present specific figures under non-GAAP guidelines if they believe these provide better insights into their operations. Though permissible, these figures are required to be explicitly labeled as non-GAAP. Even so, investors should remain cautious, as non-GAAP measures might be leveraged to present a misleading financial picture.
The Bottom Line
While GAAP intends to enhance financial transparency and uniformity, it doesn’t fully preclude the potential for errors or misleading reporting. Stakeholders must still diligently review financial statements, even when GAAP standards are applied.
Related Terms: FASB, IFRS, CPA, financial statements, auditor’s opinion, pro forma accounting.
References
- Financial Accounting Standards Board. “About the FASB”.
- International Financial Reporting Standards. “Who Uses IFRS Standards?”
- Financial Accounting Foundation. “GAAP and State and Local Governments”.
- U.S. Securities and Exchange Commission. “Regulation S-K”.
- U.S. Securities and Exchange Commission. “Non-GAAP Financial Measures”.
- International Financial Reporting Standards. “Who We Are”.
- Harvard Business School Online. “GAAP vs. IFRS: What Are the Key Differences and Which Should You Use?”
- Financial Accounting Standards Board. “Comparability in International Accounting Standards: A Brief History”.
- U.S. Securities and Exchange Commission. “Acceptance From Foreign Private Issuers of Financial Statements Prepared in Accordance With International Financial Reporting Standards Without Reconciliation to U.S. GAAP”. Pages 7-8.
- Harvard Law School Forum on Corporate Governance. “SEC Scrutiny of Non-GAAP Financial Measures”.
