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When a public company publishes a financial statement, everything must be clear and well understood by all who read it. To ensure this, it is essential to have a baseline for reporting. This is where generally accepted accounting principles (GAAP) come in. GAAP represents methods, rules and practices that provide guidelines and procedures, as well as objective standards, for data and financial statements. In short: GAAP standardizes the accounting of all companies, so that the data they report is universally understood and comparable.

GAAP compliance is a major implication for companies reporting financial information to shareholders. It is mandated by the Securities and Exchange Commission (SEC) for all public companies, and a good practice even for private companies. GAAP reports show a willingness to adhere to universally accepted accounting standards. This is advantageous for companies as well as for shareholders.

Who sets the standard for GAAP?

Two organizations are responsible for establishing and applying GAAP standards: the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC). As an impartial and independent non-governmental entity, the FASB sets standards for generally accepted accounting principles. It reviews these standards annually and updates them via Accounting Standards Codification.

The SEC can also establish accounting standards, codifying them as part of GAAP in cooperation with the FASB. Once established, the SEC applies the standards of generally accepted accounting principles for all public companies. This can include fines for companies that do not disclose their financial statements in accordance with GAAP. A famous example of this happened in 2019, when the SEC fines rental car company Hertz $16 million (OTCMKTS: HTZZ) for reporting non-GAAP figures.

Principles, assumptions and constraints

To understand the fundamental function and operation of GAAP, it is important to examine the principles, assumptions and constraints of the framework. These rules form the basis for generally accepted accounting principles and apply universally to all businesses.

GAAP principles

These are the principles that govern the GAAP framework. They are universally recognized as the fundamental pillars of generally accepted accounting principles and their practices.

  • Principle of historical cost. Companies declare the acquisition costs of assets and liabilities.
  • Principle of revenue recognition. Businesses record transactions at origin.
  • Principle of reconciliation. Expenses correspond to revenues during the same period.
  • Principle of full disclosure. Companies must disclose information in context.

GAAP assumptions

These are universal assumptions that every company makes when releasing its financial information. These assumptions are present in all the documents filed by the company.

  • Business entity. The business must remain separate from its owners and stakeholders.
  • Ongoing concern. The business will operate indefinitely, independent of anyone.
  • Currency units. The company presents its financial statements in a stable and consistent monetary unit.
  • Time periods. The company will file its financial reports on regular periods.

GAAP constraints

These are the hard and fast rules a business must follow when reporting its financial information to stay in compliance with the standards of generally accepted accounting principles.

  • Principle of objectivity. Financial statements must be based on objective evidence.
  • Principle of materiality. The significance of an item should be considered when reporting.
  • Principle of consistency. The company uses the same accounting principles from period to period.
  • Principle of conservatism. Businesses should anticipate future losses but look for gains.
  • Cost constraints. The benefit of presenting financial statements should outweigh the cost.

GAAP vs. IFRS

It is important to remember that GAAP is a US accounting standard. While many multinational companies follow generally accepted accounting principles for the sake of transparency, global companies also adhere to International Financial Reporting Standards (IFRS). Although there are subtle differences between the two standards, GAAP and IFRS are, for all intents and purposes, the same thing.

The only real difference is that GAAP is rules-based and IFRS is principle-based. This can manifest difficulties in certain areas of bookkeeping, such as keeping records for inventory. However, both standards have their roots in the same practice of disclosing and contextualizing reported figures. Often, the comparison of generally accepted accounting principles and IFRS statements is straightforward.

The GAAP Hierarchy

What happens in a situation where there is no specific guideline or procedure for GAAP reporting? Accountants defer to GAAP hierarchy. This framework of credible resources helps guide compliance even in situations where there is no explicit rule. The hierarchy largely revolves around the guidelines of the Financial Accounting Standards Board (FASB) and the American Institute of Certified Public Accountants (AICPA). The hierarchy is as follows:

  • FASB Statements of Financial Accounting Standards and Interpretations, FASB Staff Positions, and AICPA Accounting Research Bulletins and Accounting Principles Board Opinions not superseded by FASB actions.
  • FASB Technical Bulletins and AICPA Industry Audit and Accounting Guides and Statements of Position.
  • AICPA Accounting Standards Executive Committee Practice Bulletins, FASB Emerging Issues Task Force (EITF) Consensus Positions, and Topics Covered in Appendix D of EITF Summaries.
  • Implementation Guides (Q&As) issued by FASB staff, AICPA Accounting Interpretations, AICPA Industry Audit and Accounting Guides and Statements of Position not endorsed by the FASB, and widely accepted and widely accepted practices.

If an accountant scans the list and cannot find an appropriate accounting standard to guide reporting, they are encouraged to defer to widely accepted and followed accounting practices. Although rarely necessary for any substantive report, this hierarchy is important in determining consistency even beyond GAAP.

GAAP exists to help businesses and investors

When companies communicate financial information according to a universal standard, it brings clarity and understanding to anyone who pays attention. For businesses, it’s a great way to gauge their performance against a standard. For investors, this means having a clear view of a company’s health and financial performance. Above all, it prevents a level of obfuscation that could harm both parties.

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GAAP may be a mandatory practice, but it’s one every business should want to to join – public or private. And, even in a situation without GAAP standardization, this framework provides the basis for best practices in financial reporting. In short: GAAP levels the playing field and ensures that everyone plays by the same rules.