What is GAAP?
These generally accepted accounting principles dictate the transparent and uniform way to present a company’s financial reports. Without this standard, there’s potential for discrepancies and potential fraud. Its principles help investors and other stakeholders understand a company’s financial statement, so they can make better decisions.
It states what periods to include, how cash is reported and even how the statements are filed. It’s mostly geared toward publicly traded companies that are subject to regulation by the Securities and Exchange Commission (SEC). They can enlist the help of a certified public accounting (CPA) firm to ensure compliance. Failure to provide compliant financial statements could result in the company being delisted.
Private companies aren’t required to follow GAAP, but those who need credit lines or loans find that lenders and creditors favor the standard. As a result, many private companies adhere to it.
Three components of GAAP
While it is seen as a single entity, GAAP is composed of three parts:
- Principles and guidelines. This component covers the framework. It’s based on integrating fundamental tenets of business accounting, including separating personal and organizational transactions. It dictates standardized time periods and currency units in financial reports. There are also best practices around accounting conservatism. This means that financial reports have a high degree of verification, where losses are immediately reported, while gains are held until they are received.
- Rules and standards. These are the concise, detailed collection of codes. The Financial Accounting Standards Board (FASB) has a list of principles known as the Accounting Standards Codification. This is the backbone of the GAAP.
- Accepted industry practices. Each industry has its own complexities and their financial reporting should reflect those nuances while maintaining standard methods, even if they aren’t required to adhere to GAAP.
10 principles of GAAP
To keep financial statements uniform, these are the 10 concepts behind GAAP:
1. Principle of Regularity
It states that accountants must use a widely accepted reporting system. This helps other accountants understand the report.
2. Principle of Consistency
Once you’ve adopted a certain accounting method, keep using it for all periods going forward. The consistency principle makes it easier to compare one period to another, or even one company’s financials to another.
3. Principle of Sincerity
A company’s financial information must be fair and accurate. The report must not intentionally mislead anyone, and the data should be easily replicated by another accounting professional.
4. Principle of Permanence of Methods
Report preparation procedures must be coherent and consistent. This makes it easy to compare and contrast any company’s financial data.
5. Principle of Non-Compensation
Regardless of whether the statement shows a profit or a loss, there should be no attempt to compensate for either. The report must show full details.
6. Principle of Prudence
Show the details as they are, without trying to make them look more favorable. In other words, make sure revenue is reported when received and expenses are entered when they’re incurred.
7. Principle of Continuity
Business goes on while assets are being valued.
8. Principle of Periodicity
Revenue reporting is distributed over its relevant standard accounting period. For example, revenue is typically reported over a fiscal time period.
9. Principle of Materiality
There must be full disclosure of all financial accounting data in the reports. This is how investors and stakeholders understand the business’s position.
10. Principle of Utmost Good Faith
The Latin phrase uberrimae fidei means utmost good faith. In accounting, this means all parties must be honest in all transactions and presentations.
The GAAP hierarchy
The four levels of GAAP hierarchy are about reinforcing the principle of consistency and comparability. It provides accountants with a framework for researching and preparing financial data for nongovernmental agencies (NGOs).
In addition to the FASB and the SEC providing their accounting guidance, there is also the AICPA, a nonprofit organization that provides CPAs with guidance about how to audit private organizations. In an effort to find the best guidance, the hierarchy tells accountants which authoritative body to look at and in what order. They start from the top level and go to the next level if the topic isn’t covered.
- Top-level. Accounting Research Bulletins and opinions from AICPA are considered, as long as they don’t conflict with official statements from the FASB. In cases of conflict, the FASB takes precedence.
- Second level. It includes Technical Bulletins by the FASB and AICPA Industry Audit and Accounting Guides and Statements of Position. While the FASB is the governing authority, the AICPA statements are used to clarify guidance and are usually incorporated into FASB standards.
- Third level. It’s about the AICPA’s Accounting Standards Executive Committee Practice Bulletins, and the FASB Emerging Issues Task Force (EITF) are the governing documents.
- Fourth and lowest level. It includes FASB Implementation Guides, as well as both the Account Interpretations and Industry Audit and Accounting Guides and Statements of Position from the AICPA. Any other generally recognized accounting practices fall into this level of the hierarchy.
GAAP’s role in inventory accounting
When it comes to inventory accounting, GAAP allows three methods of measurement:
- Average cost. Also known as the weighted-average method, this tabulates the total cost of inventory items, purchased or produced, within a certain period and is divided by the total number of items.
- First in, first out (FIFO). Items that are first acquired or produced are used or sold first, and it’s assumed that the remaining items were purchased last. It’s popular because it provides good cost flow management.
- Last in, first out (LIFO). The item that was bought last is sold first. In this case, LIFO lowers net income, which can be a tax advantage under certain conditions.
As of 2017, the FASB recommends using FIFO net asset value, which is the total asset value minus liabilities, instead of replacement cost.
GAAP’s limitations
While GAAP is the standard for accounting accuracy in reporting, it does have its limitations, which can affect the companies who are trying to do the right thing.
- Standard-setting time. Because it requires a high level of standards, the process to get those standards approved by the GAAP policy board can take years. This means companies trying to comply can have their reports in limbo because of pending decisions.
- Not customizable. GAAP is a one-size-fits-all approach and has no means to readily accommodate special entities. Small businesses may find it too complex and expensive for their needs.
- Not globalized. GAAP is the standard for the U.S. only and is not accepted globally. Because businesses are becoming more globalized, this is a problem. GAAP is seen as too complicated to be adopted internationally.
GAAP accounting FAQs
What is IFRS and how does it differ from GAAP?
International Financial Reporting Standards (IFRS) states how certain types of transactions should be represented according to international standards. This standard has been adopted by more than 140 countries and is popular because it’s considered more transparent than GAAP.
The main difference is that while GAAP is a rules-based standard, IFRS is principles-based. IFRS doesn’t require lengthy disclosure and is seen as more logically sound and consistent in the eyes of many. Another favorite feature is that IFRS doesn’t use the FIFO method for inventory accounting.
What is the accountant’s letter?
The accountant’s letter is a cover letter from an independent auditor that precedes and is about the company’s financial report. It summarizes the auditor’s opinion on the reports. The opinion is classified as either “qualified,” which means there were irregularities, or “unqualified,” which means there were no issues found.
What organizations influence GAAP?
Three organizations influence GAAP:
- Securities and Exchange Commission (SEC). It has the power to regulate financial markets and accounting standards.
- Financial Accounting Standards Board (FASB). A seven-member board that sets GAAP standards.
- International Accounting Standards Board (IASB). A 16-member body that sets the global standards for international accounting.
What is CAP?
CAP, the Committee on Accounting Procedure, was a 21-person American Institute of Accountants (AIA) subcommittee that put together the first GAAP standards. In 1973, it was replaced by Financial Accounting Standards Board (FASB).
