By DeVry University
December 2, 2021
5 min read
Generally Accepted Accounting Principles, more widely known as GAAP, are a set of guidelines and rules that all companies and accountants in the United States adhere to. These rules are set by the Financial Accounting Standards Board (FASB) in order to establish financial reporting standards and ensure that financial information is reported fairly and accurately. In this article, we will answer the question what are generally accepted accounting principles and explore the origins, uses, regulation and limitations of GAAP. Learn more about GAAP in the following sections:
Basic Accounting Principles
An important element behind gaining an understanding of what generally accepted accounting principles are, are the principles themselves. Each of the following 10 key principles of GAAP plays a vital role in the accurate reporting of a company's financial data, and the accounting industry as a whole.
Principle of Regularity
The principle of regularity requires that accountants use an established system for their reporting. This principle is critical as it prevents accountants from simply doing whatever feels convenient in the moment and leaving other parties to figure out the logic behind their reports.
Principle of Consistency
The principle of consistency requires that whatever system you choose is to be used universally across all of your accounting work. For instance, if a company selects one method of depreciating its assets, it must then consistently use that method, instead of changing methods each accounting period.
Principle of Sincerity
This principle ensures that the accountant preparing the report is not trying to trick or mislead anyone by misrepresenting the data. It requires that all the data in the report is – to the best of the accountant's knowledge – accurate and impartial.
Principle of Permanence of Methods
This principle requires accountants to treat accounting like a science, so that one person’s work should be replicable by another party using the same method. The principle of permanence of methods ensures that the work can be double-checked with relative ease and efficiency.
Principle of Non-Compensation
The principle of non-compensation promises that you will not use offsetting accounts to cover up or hide any facts. In particular, it prohibits hiding debts behind assets and costs behind revenue. This principle requires that corporations utilize full disclosure when presenting their financial statements.
Principle of Prudence
This principle asserts that accountants should only report facts. Accounting does not operate in the realm of conjecture or speculation and should only include concrete data in reports.
Principle of Continuity
The principle of continuity states that the accountant preparing a report should assume that the business will continue to operate as it has been operating for the foreseeable future.
Principle of Periodicity
This principle ensures that accountants only report revenue within standard intervals, such as quarterly or yearly. This provides businesses with an accurate financial status from that timeframe so they can use the information to make decisions about the future.
Principle of Materiality
The principle of materiality states that all financial data should be laid out in a report that is GAAP compliant. It primarily exists to make sure that no information is omitted from the report.
Principle of Utmost Good Faith
Finally, the principle of utmost good faith requires that an accountant will always tell the truth and operate in good faith as part of their duties.
Who Developed GAAP?
To provide a more thorough answer to the question of what the generally accepted accounting principles are, it’s a good idea to explore the origins of GAAP. To do that, we need to go back nearly a century, to the days following the stock market crash of 1929. With the help of information from Investopedia and the Securities and Exchange Commission (SEC), here is a timeline of how GAAP came to be the standard financial reporting measure for the United States:
- 1933: In the aftermath of the stock market crash, the United States government attributes some of the causes of the crash to less-than-above board practices by publicly-traded companies. Looking for ways to regulate the accounting practices of these companies and other major participants in the market, it enacts the Securities Act.
- 1934: The Securities Exchange Act establishes the SEC and grants it the authority to set standards on accounting practices. Citing the expertise and resources of the accounting profession, the SEC then delegates the responsibility of leadership and standard-setting to the private sector.
- 1939: The American Institute of Accountants (the forerunner of the American Institute of Certified Public Accountants) creates the Committee on Accounting Procedure (CAP).
- 1959: CAP is replaced by the Accounting Principles Board (APB) and it begins issuing opinions about major accounting topics to be adopted by business accountants, which could then be imposed on publicly traded companies by the SEC.
- 1973: The APB gives way to the Financial Accounting Standards Board (FASB). The FASB has been the major policymaking body on acceptable accounting practices ever since. Other governmental and non-governmental groups influence FASB decisions, but the FASB is responsible for issuing opinions and rendering judgments. Members of the FASB are appointed by an oversight body comprised of investors, businesspeople and accountants.
What is GAAP Used For?
According to Investopedia, the combination of authoritative standards and commonly accepted methods of recording and reporting accounting information known as GAAP are an attempt to standardize and regulate the definitions, assumptions and methods used in accounting across all industries.
Investopedia also notes that GAAP’s ultimate goal is to ensure a company’s financial statements are complete, consistent and comparable. This makes it easier for investors to analyze and extract useful information from a company’s financial statements and make an apples-to-apples comparison of financial information across different companies.
Why is GAAP Important for Businesses?
GAAP is important for businesses because it sets a standard for how financial reports are organized and how reporting is carried out by accountants. Without a standard set of expectations, accountants could present reports in whatever format they please, including formats of their own design. This would make it difficult to verify whether the information was factual.
Additionally, the Generally Accepted Accounting Principles prevent accountants from breaking reporting laws at the behest of their clients, superiors or others within their company. GAAP standards also make it significantly more difficult for a rogue accountant to get away with misreporting information, as the standardized reporting method makes it easier to identify areas where data is missing or where facts have been misrepresented.
How is GAAP Regulated?
The collective decisions passed down from APB and FASB form GAAP. In addition to the FASB, the American Institute of Certified Public Accountants (AICPS), the SEC and the Governmental Accounting Standards Board (GASB) are the core organizations that influence GAAP.
The responsibility for enforcement of GAAP and shaping GAAP’s standards falls to the SEC and the FASB. Under the Securities Exchange Act of 1934, the SEC has the authority to both set and enforce accounting standards, while the FASB, which is a non-governmental and independent body tasked by the SEC, can only set standards. The FASB sets standards by way of something called the Accounting Standards Codification (ASC), a centralized resource where all accountants can find all current GAAP.
The FASB standards-setting process for ASC consists of 7 steps:
- The board identifies financial reporting issues based on stakeholder requests/recommendations.
- Based on staff-prepared analysis of issues, FASB decides whether to add the project to the technical agenda.
- The board deliberates the various reporting issues at one or more public meetings.
- The board issues an Exposure Draft to solicit broad stakeholder input.
- The board holds a public roundtable meeting on the Exposure Draft, if needed.
- Staff analyzes comment letters, public roundtable discussion and other information obtained, and Board redeliberates proposed provisions carefully considering stakeholder input.
- The board issues an Account Standards Update describing amendments to the ASC.
GAAP vs. IFRS
Both GAAP and the International Financial Reporting Standard (IFRS) are widely accepted systems of accounting principles that enable internal and external bodies to quickly understand the work that the accountant has performed. In general, these two systems set out to accomplish similar goals, but they do have a few differences.
One of the first and most notable differences is where each system is used. GAAP is used primarily within the U.S., while the IFRS is used in the European Union and some countries in Asia and South America.
Beyond that difference, GAAP is more rules-based while IFRS is more principle-based. This typically becomes more obvious when looking at each framework. For instance, the IFRS guidelines are generally less specific or detailed than GAAP’s, but the consistency of the principles behind IFRS may give a more accurate picture of economic transaction within the business world.
No matter which accounting system is being used, both GAAP and IFRS play a crucial role in financial reporting standards worldwide.
Limitations of GAAP
While GAAP is widely used in the United States, it does have a few limitations. In the U.S., if a corporation’s stock is publicly traded, its financial statements must adhere to rules established by the SEC. That means regularly filing GAAP-compliant financial statements to remain listed on the stock exchanges. Non-publicly-traded companies are not required by law to use GAAP, but since most financial institutions require GAAP-compliant financial statements to be submitted as part of their lending process, most companies in the United States do follow GAAP.
Another overall limitation lies in the very nature of GAAP, as it is only a set of standards. Although GAAP generally improve transparency in financial statements, they don’t guarantee the accuracy of those statements, or that they are free of errors or omissions that may be intended to mislead investors. For this reason, investors need to remain vigilant in their scrutiny of financial statements.
According to Investopedia, companies are still allowed to present certain figures in their financial statements without following GAAP rules, provided that they clearly identify them as non-GAAP conforming. Why would companies do this? If they believe the GAAP rules aren’t flexible enough to capture certain nuances about their financial operations, they might provide specific non-GAAP metrics along with the other disclosures that GAAP requires. Investors, however, would have good reason to be skeptical about non-GAAP measures, as they could be used in a misleading manner.
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