Generally Accepted Accounting Principles (GAAP): Definition and Limitations
Updated July 21, 2022
GAAP, or the generally accepted accounting principles, is an important part of the accounting world and is the standard by which businesses are required to report their financial statements in the United States. Understanding and utilizing GAAP can help your company's financial status be better understood by investors and lenders and ensure that you are practicing the most acceptable and accurate accounting principles possible.
In this article, we will explore what GAAP is, the principles of GAAP and tips for incorporating these principles into your business.
What is GAAP?
GAAP, which stands for generally accepted accounting principles, is a set of agreed-upon rules that most public businesses and corporations follow when reporting their finances. These principles are used by the Financial Accounting Standards Board to outline its approved methods of accounting and how and what should be included in an organization's financial reports. While several U.S. businesses use GAAP, it is required by law for publicly traded companies and businesses that release their reports to the public to use the GAAP guidelines when submitting financial reports.
Organizations may use GAAP to organize their financial information into accounting records, create public financial statements and outline supporting information that may be important to these statements. GAAP allows the easy analysis and comparison of one company's financial statements to other organizations and is an important component when a company is being evaluated by investors, potential donors and lenders. These principles are also used by taxpayers and citizens to ensure that the government is held accountable.
The following are the topics that GAAP incorporates into a company's financial statements:
Hedging and derivatives
Industry-specific accounting factors
Specific industries may have more strict rules to follow under GAAP and each industry may vary significantly.
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Principles of GAAP
The following are the key concepts, or principles, that are outlined by GAAP and that companies are expected to follow when submitting public financial statements:
Principle of regularity: This principle states that companies and organizations using GAAP must adhere to its regulations.
Principle of consistency: This principle entails that a business will use consistent standards throughout its financial reporting and if standards are updated or changed, this is clearly explained.
Principle of sincerity: The principle of sincerity states that accountants and other individuals using GAAP are committed to impartial and honest preparation of financial records.
Principle of permanence of methods: This principle refers to a company's commitment to preparing all financial reports using the same methods and procedures.
Principle of non-compensation: The principle of non-compensation states that companies will report both positive and negative financial performance with no prospect of debt compensation.
Principle of prudence: The prudence principle entails that financial reports will be based on fact-based findings rather than speculation.
Principle of continuity: This principle denotes that financial reports will be prepared under the assumption that an organization's operations will continue and the company will continue to be a going interest.
Principle of periodicity: The principle of periodicity implies that companies will perform and base their financial reports on standard accounting time periods such as fiscal quarters and years.
Principle of materiality: This principle states that organizations are to clearly and honestly report their financial situation.
Principle of utmost good faith: This principle entails that all parties involved in the preparation of financial records are to act in good faith.
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Limitations of using GAAP
While the generally accepted accounting principles strive to reduce inaccurate financial reporting and guide companies in preparing accurate and clear financial data, these principles come with limitations that should be taken into consideration when using them. The following are the most common limitations that may arise when using GAAP:
GAAP is not global
The generally accepted accounting principles are not globally recognized as the standard for preparing financial reports. This can make using GAAP challenging for organizations that are international or are becoming more globalized. Outside of the U.S., the International Financial Reporting Standards is the set of principles most commonly used by organizations. Currently, the U.S.-based Financial Accounting Standards Board and the International Accounting Standards Board are working to develop globally uniformed standards.
GAAP tends to take a "one-size-fits-all" approach rather than accounting for the immense diversity that is often seen between companies. As a result, using these principles can be difficult for companies in certain industries as well as for smaller businesses. For example, a small business using the generally accepted accounting principles may find GAAP too complex and struggle to incorporate all the principles into its basic financial records.
Long wait times for new standards
GAAP policy boards go through rigorous deliberation and an extensive process to set new standards for the generally accepted accounting principles. As a result, companies who use these principles may be negatively affected when new standards are being put into place because they would have to wait for the standards to be approved before being able to implement them.
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International Financial Reporting Standards vs. GAAP
The International Financial Reporting Standards (IFRS) is an alternative to the GAAP. While public organizations in the United States are required to use GAAP, other companies have the option as to how to prepare their financial statements and the principles and methods they use. The IFRS is one method of preparing financial records that an organization may choose to use if the company is not public.
The following are the primary differences between GAAP and IFRS:
GAAP has more concrete guidelines and principles compared to IFRS.
IFRS requires assets and liabilities to be separated whereas GAAP only recommends this method of financial reporting.
GAAP considers intangible assets to be fair value, whereas IFRS only considers intangible assets if they will have a future benefit.
GAAP requires companies to provide a Statement of Comprehensive Income whereas IFRS does not.
GAAP requires organizations to list extraordinary items under a separate new income column whereas IFRS allows extraordinary items to be listed with other items on the income statement.
GAAP does not permit inventory write down reversals, whereas IFRS allows inventory write down reversals in some cases.
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