Generally Accepted Accounting Principles: Understanding GAAP

GENERALLY ACCEPTED ACCOUNTING PRINCIPLES
GAAP specifications include definitions of concepts and principles, as well as industry-specific

rules. The purpose of GAAP is to ensure that financial reporting is transparent and consistent from one
organization to another.
There is no universal GAAP standard and the specifics vary from one geographic location or
industry to another. In the United States, the Securities and Exchange Commission (SEC) mandates that
financial reports adhere to GAAP requirements. The Financial Accounting Standards Board (FASB)
stipulates GAAP overall and the Governmental Accounting Standards Board (GASB) stipulates GAAP for
state and local government. Publicly traded companies must comply with both SEC and GAAP
requirements.
Many countries around the world have adopted the International Financial Reporting Standards
(IFRS). IFRS is designed to provide a global framework for how public companies prepare and disclose
their financial statements. Adopting a single set of world-wide standards simplifies accounting
procedures for international countries and provides investors and auditors with a cohesive view of
finances. IFRS provides general guidance for the preparation of financial statements, rather than rules
for industry-specific reporting.
What Does Generally Accepted Accounting Principles Mean?
Generally accepted accounting principles (GAAP) refer to a common set of accepted accounting
principles, standards, and procedures that companies and their accountants must follow when they
compile their financial statements. GAAP is a combination of authoritative standards (set by policy
boards) and the commonly accepted ways of recording and reporting accounting information. GAAP
improves the clarity of the communication of financial information.
GAAP may be contrasted with pro forma accounting and with the IFRS standards, which are
both considered to be non-GAAP.
Understanding GAAP
GAAP is meant to ensure a minimum level of consistency in a company's financial statements,
which makes it easier for investors to analyze and extract useful information. GAAP also facilitates the
cross-comparison of financial information across different companies.
These 10 general principles can help you remember the main mission and direction of the
GAAP system.
1.) Principle of Regularity
The accountant has adhered to GAAP rules and regulations as a standard.
2.) Principle of Consistency
Professionals commit to applying the same standards throughout the reporting process
to prevent errors or discrepancies. Accountants are expected to fully disclose and explain the
reasons behind any changed or updated standards.
3.) Principle of Sincerity
The accountant strives to provide an accurate depiction of a company’s financial situation.
4.) Principle of Permanence of Methods
The procedures used in financial reporting should be consistent.
5.) Principle of Non-Compensation
Both negatives and positives should be fully reported with transparency and without the
expectation of debt compensation.
6.) Principle of Prudence
Emphasizing fact-based financial data representation that is not clouded by speculation.
7.) Principle of Continuity
While valuing assets, it should be assumed the business will continue to operate.
8.) Principle of Periodicity
Entries should be distributed across the appropriate periods of time. For example, revenue
should be divided by its relevant periods.
9.) Principle of Materiality / Good Faith
Accountants must strive for full disclosure in financial reports.
10.) Principle of Utmost Good Faith
Derived from the Latin phrase “uberrimae fidei” used within the insurance industry. It
presupposes that parties remain honest in transactions.
Compliance
GAAP must be followed when a company distributes its financial statements outside of the
company. If a corporation's stock is publicly traded, the financial statements must also adhere to rules
established by the U.S. Securities and Exchange Commission (SEC).
GAAP covers such things as revenue recognition, balance sheet item classification and
outstanding share measurements. If a financial statement is not prepared using GAAP, investors should
be cautious. Also, some companies may use both GAAP and non-GAAP compliant measures when
reporting financial results. GAAP regulations require that non-GAAP measures are identified in financial
statements and other public disclosures, such as press releases.
The hierarchy of GAAP is designed to improve financial reporting. It consists of a framework for
selecting the principles that public accountants should use in preparing financial statements in
line with U.S. GAAP. At the top of the GAAP hierarchy are statements by the Financial
Accounting Standards Board (FASB) and opinions by American Institute of Certified Public
Accountants (AICPA). The next level consists of FASB Technical Bulletins and AICPA Industry
Audit and Accounting Guides and Statements of Position. On the third level are AICPA
Accounting Standards Executive Committee Practice Bulletins and positions of the FASB
Emerging Issues Task Force (EITF). Also included are Topics discussed in Appendix D of EITF
Abstracts. On the lowest level are FASB implementation guides, AICPA Accounting
Interpretations, AICPA Industry Audit and Accounting Guides and Statements of Position not
cleared by the FASB. Also included are practices that are widely recognized.
Accountants are directed to first consult sources at the top of the hierarchy and then proceed to
lower levels only if there is no relevant pronouncement at a higher level. The FASB's Statement
of Accounting Standards No. 162 provides a detailed explanation of the hierarchy.
GAAP vs. IFRS

GAAP is focused on the practices of U.S. companies. The Financial Accounting Standards
Board (FASB) issues GAAP. The international alternative to GAAP is the International
Financial Reporting Standards (IFRS) set by the International Accounting Standards
Board (IASB). The IASB and the FASB have been working on the convergence of IFRS and
GAAP since 2002. Due to the progress achieved in this partnership, the SEC, in 2007, removed
the requirement for non-U.S. companies registered in America to reconcile their financial reports
with GAAP if their accounts already complied with IFRS. This was a big achievement, because
prior to the ruling, non-U.S. companies trading on U.S. exchanges had to provide GAAP-
compliant financial statements.
Some differences that still exist between both accounting rules include:
 LIFO Inventory - While GAAP allows companies to use the Last In First Out (LIFO) as
an inventory cost method, it is prohibited under IFRS.
 Costs of Development - These costs are to be charged to expense as they are incurred
under GAAP. Under IFRS, the costs can be capitalized and amortized over multiple
periods.
 Write-Downs - GAAP specifies that the amount of write-down of an inventory or fixed
asset cannot be reversed if the market value of the asset subsequently increases. The
write-down can be reversed under IFRS.
As corporations increasingly need to navigate global markets and conduct operations worldwide,
international standards are becoming increasingly popular at the expense of GAAP, even in the
U.S. As the chart below shows, in 2004, almost all North American companies reported their
earnings using GAAP metrics. By 2016 that number had fallen to less than half.
Notes
GAAP is only a set of standards. Although these principles work to improve the transparency in
financial statements, they do not provide any guarantee that a company's financial statements are
free from errors or omissions that are intended to mislead investors. There is plenty of room
within GAAP for unscrupulous accountants to distort figures. So, even when a company uses
GAAP, you still need to scrutinize its financial statements.
GAAP is short for Generally Accepted Accounting Principles. GAAP is a cluster of accounting
standards and common industry usage that have been developed over many years. It is used by
organizations to:
 Properly organize their financial information into accounting records;

 Summarize the accounting records into financial statements; and
 Disclose certain supporting information.
One of the reasons for using GAAP is so that anyone reading the financial statements of
multiple companies has a reasonable basis for comparison, since all companies using GAAP
have created their financial statements using the same set of rules. GAAP covers a broad array
of topics, including:
 Financial statement presentation

 Assets
 Liabilities
 Equity
 Revenue
 Expenses
 Business combinations
 Derivatives and hedging
 Fair value
 Foreign currency
 Leases
 Nonmonetary transactions
 Subsequent events
 Industry-specific accounting, such as airlines, extractive activities, and health care
The industry-specific accounting that is allowed or required under GAAP may vary
substantially from the more generic standards for certain accounting transactions.
GAAP is derived from the pronouncements of a series of government-sponsored accounting

entities, of which the Financial Accounting Standards Board (FASB) is the latest. The Securities
and Exchange Commission also issues accounting pronouncements through its Accounting Staff
Bulletins and other announcements that are applicable only to publicly-held companies, and
which are considered to be part of GAAP. GAAP is codified into the Accounting Standards
Codification (ASC), which is available online and (more legibly) in printed form.
GAAP is used primarily by businesses reporting their financial results in the United States.
International Financial Reporting Standards, or IFRS, is the accounting framework used in most
other countries. GAAP is much more rules-based than IFRS. IFRS focuses more on general
principles than GAAP, which makes the IFRS body of work much smaller, cleaner, and easier
to understand than GAAP. Since IFRS is still being constructed, GAAP is considered to be the
more comprehensive accounting framework.
There are several working groups that are gradually reducing the differences between the GAAP
and IFRS accounting frameworks, so eventually there should be minor differences in the
reported results of a business if it switches between the two frameworks. The re is a stated intent
to eventually merge GAAP into IFRS, but this has not yet occurred. Given recent differences of
opinion arising during several joint projects, it is possible that the frameworks will never be
merged.
Definition of GAAP
GAAP is the acronym for generally accepted accounting principles. In the U.S., GAAP consists of
the following:
 The basic underlying accounting principles, assumptions, and concepts such as the cost
principle, matching principle, full disclosure principles, etc.
 The detailed reporting standards and other rules issued by the Financial Accounting Standards
Board (FASB) and its predecessor the Accounting Principles Board which are now organized into
the FASB Accounting Standards Codification (FASB ASC)
 generally accepted industry practices

GAAP must be adhered to when a company distributes its financial statements to anyone outside of
the company. If a corporation's stock is publicly traded, the financial statements must also comply
with the rules of the U.S. Securities and Exchange Commission (SEC). This includes having its
financial statements audited by an independent, registered CPA firm.

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GENERALLY ACCEPTED ACCOUNTING PRINCIPLES

GAAP specifications include definitions of concepts and principles, as well as industry-specific

1.) Principle of Regularity

The accountant has adhered to GAAP rules and regulations as a standard.

2.) Principle of Consistency

The accountant strives to provide an accurate depiction of a company’s financial situation.

4.) Principle of Permanence of Methods

The procedures used in financial reporting should be consistent.

5.) Principle of Non-Compensation

6.) Principle of Prudence

Emphasizing fact-based financial data representation that is not clouded by speculation.

7.) Principle of Continuity

8.) Principle of Periodicity

9.) Principle of Materiality / Good Faith

Accountants must strive for full disclosure in financial reports.

10.) Principle of Utmost Good Faith

GAAP vs. IFRS

 Properly organize their financial information into accounting records;

 Financial statement presentation

GAAP is derived from the pronouncements of a series of government-sponsored accounting

 generally accepted industry practices

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