What are Generally Accepted Accounting Principles (GAAP)

The Generally Applied Accounting Principles (GAAP) are a set of 10 standards, meant to maintain a certain consistency across companies’ financial statements. When accounting methods are standardized across industries, financial reports are much easier to analyze within a single business or to compare between businesses. As a result, investors and banks have a much easier, more reliable way of assessing the health of a company and extracting the information they need.

US GAAP rules are a little bit like other standards in the United States. Inches, feet, miles, pounds, and ounces. They all add up in the 50 states, but elsewhere, these concepts don’t make much sense.

As you know, the US uses a different system of measurement from most of the world. Americans use the Imperial system, rather than the Metric system. (Don’t ask us why!)

What you might *not *know is that the same goes for accounting standards. GAAP applies throughout the fifty United States, but are different from widely-used international rules.

The principles aren’t hard-and-fast laws written in difficult legal jargon. Actually there’s not a lot of accounting or finance jargon either! GAAP is written in everyday language, with clear concepts that outline the idea of integrity in accounting. The 10 principles are like the medical world’s edict, “First, do no harm” — but for accounting: a combination of ethics, legal expectations, and proven best practices.

If you’re doing business in the US, or you’re hoping for investments or loans from American sources, then you should absolutely follow these standards. This article will explain what each principle means, who develops and regulates them, and how to comply.

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Who determines the GAAP?

Good question! It’s not who you might think. While the federal government requires public companies to comply with the set of principles, they don’t create or maintain it. Instead, a few independent boards and organizations are responsible for developing, distributing, and continuously updating the accounting principles.

The main authority is the Financial Accounting Standards Board (FASB), who releases regular statements, keeps meticulous archives, and offers helpful resources for businesses and accountants looking to adapt to GAAP. The board is private and non-governmental, but works for the public’s best interest. It has seven full-time members, who are in turn monitored by a 30-person Financial Accounting Standards Advisory Council (FASAC).

Why is GAAP important?

GAAP is essential because it creates a standardized framework for financial reporting, ensuring consistency, accuracy, and transparency across all businesses. This uniformity allows investors, regulators, and other stakeholders to compare financial statements confidently, making informed decisions based on reliable data. By reducing the risk of misleading or inconsistent reporting, GAAP plays a critical role in maintaining trust and stability in the financial markets.

The 10 GAAP principles

1. Principle of Regularity The accountant adheres to these rules and regulations as a standard, on a regular basis.
2. Principle of Consistency This is one of the main points. Accountants and business professionals commit to using the same standards throughout all reporting, from period to period. This maintains consistency and prevents errors. If accountants use other standards at any point in the reporting process, they’re expected to fully disclose the change and explain the reasons why.
3. Principle of Sincerity Here’s a commitment to do a sincere, objective job. The accountant strives to provide an accurate depiction of a company’s financial situation.
4. Principle of Permanence of Methods Another one about consistency! The procedures used in financial reporting should be consistent, should provide a coherent picture of the business, and allow for comparison to other businesses.
5. Principle of Non-Compensation The accountant shows full accounting details, both negatives and positives, without trying to compensate one with the other. Debts are left separate from assets, expenses separate from revenue.
6. Principle of Prudence “Prudence” means wisdom, good judgment, and common sense. In this context, GAAP expects fact-based financial data representation that is cautious and grounded, not speculative. Basically, don’t try to make it look more impressive.
7. Principle of Continuity While valuing assets, it should be assumed the business will continue to operate (and not be sold on the spot, for example). Assets are considered at their historical value, rather than a disposable value.
8. Principle of Periodicity Each financial entry should accord to one single time period. If the entry covers several time periods in one (like an upfront annual payment of a subscription), then the revenue should be split and recorded across the appropriate periods of time. This practice is called revenue recognition.
9. Principle of Materiality or Full Disclosure There must be full disclosure in financial reports. No hiding or holding anything back.
10. Principle of Utmost Good Faith Honesty is the best policy, and GAAP presumes that businesses and accountants are all being honest in their reporting. This principle is similar to the Latin phrase uberrimae fidei, “utmost good faith,” used in the insurance industry.

Compliance with GAAP

GAAP ensures that a company's financial statements are consistent, transparent, and comparable across periods and with other businesses. Failing to comply can result in inaccurate reporting, legal issues, and loss of stakeholder trust.

Public companies in the US are required to comply. Private companies can use the reporting methods of their choice. But, since private companies also seek investments or loans at times, it’s highly recommended to use GAAP as that’s what investors and banks prefer.

Any time a company releases financial statements outside of the business, these accounting principles must be followed.

Key areas to focus on for GAAP compliance:

1. Accurate Revenue Recognition Under the ASC 606 standard, revenue must be recognized when it is earned and realizable—not just when cash is received. This ensures financial statements reflect the actual economic activity of the business.
   • Action step: Use an accounting system that supports deferred revenue tracking and recognizes income only when performance obligations are met.
2. Proper Expense Matching Match expenses to the revenues they helped generate within the same period. This provides a more accurate picture of profitability.
   • Action step: Maintain detailed records of all expenses and link them directly to their associated revenue streams.
3. Consistent Financial Statements GAAP requires standardized formats for financial statements: income statement, balance sheet, and cash flow statement. Consistency helps ensure stakeholders can read and compare reports easily.
   • Action step: Use accounting software that generates GAAP-compliant financial statements automatically, and review them monthly to ensure consistency and accuracy.
4. Use of Accrual Accounting GAAP mandates the use of accrual accounting, not cash accounting. This means you record income and expenses when they’re earned or incurred—not when cash changes hands.
   • Action step: Ensure your accounting practices reflect the accrual method, and consult a professional if transitioning from cash-based accounting.
5. Documentation and Audit Trails Maintain clear documentation for all transactions. This includes invoices, receipts, contracts, and subscription agreements. A complete audit trail ensures that financial reports can be verified if audited.
   • Action step: Implement a document management system or cloud-based storage solution where all financial records are organized and easily accessible.
6. Internal Controls and Separation of Duties Internal controls help prevent errors and fraud by separating financial responsibilities across different individuals or departments.
   • Action step: Assign different team members to handle billing, bank reconciliations, approvals, etc. If you’re a solopreneur, work with an external accountant for oversight.
7. Regular Financial Reviews and Audits Routine checks help identify issues early and ensure ongoing GAAP compliance.
   • Action step: Conduct monthly financial reviews, reconcile accounts, and schedule annual audits to verify that reporting standards are being met.

GAAP vs. IFRS

While GAAP is the standard accounting framework in the United States, its global counterpart is the International Financial Reporting Standards (IFRS), developed by the International Accounting Standards Board (IASB) and used in over 140 countries, including most of Europe, Canada, Australia, parts of Asia and South America. While both frameworks aim to present accurate financial information, they differ in structure, methodology, and global reach. GAAP takes a more rules-based approach, offering detailed guidance for specific scenarios, whereas IFRS is more principles-based, allowing greater flexibility and interpretation based on general concepts.

Key differences between GAAP and IFRS:

• Revenue Recognition: While both have adopted similar models recently (GAAP’s ASC 606 and IFRS 15), differences still exist in implementation and detail.

• Inventory Accounting: GAAP allows Last-In, First-Out (LIFO) inventory accounting; IFRS prohibits it.

• Development Costs: IFRS allows capitalization of certain development costs, while GAAP typically requires expensing them.

• Revaluation of Assets: IFRS permits revaluation of fixed assets; GAAP generally does not.

GAAP and IFRS usage trends and adoption

The U.S. continues to adhere to GAAP, especially due to regulatory requirements by the Securities and Exchange Commission (SEC). However, there's been ongoing dialogue about aligning more closely with IFRS to ease reporting for global entities. Meanwhile, IFRS continues to gain traction worldwide as countries modernize and unify their accounting standards for global comparability.

Who uses GAAP and IFRS?

• GAAP Users: Major U.S.-based companies such as Apple, Amazon, and JPMorgan Chase report under GAAP.

• IFRS Users: Global giants like Nestlé, Toyota, Siemens, and Unilever follow IFRS, allowing their financials to be more easily compared across international markets.

In summary, the choice between GAAP and IFRS depends largely on geographic location, regulatory environment, and the scale of international operations. Understanding the differences is crucial for businesses, investors, and financial professionals working in or with multinational firms.

Note: If you ever use non-GAAP measurements in financial statements or other public documents (e.g. a press release), you must identify them. So if you follow a pro forma financial statement or an accounting practice from the IFRS, make a note on the document that it’s non-GAAP.

Here at Quaderno we've also written a quick overview of the differences between GAAP and IFRS and other accounting concepts.

How do the GAAP principles evolve?

The 10 principles provide the foundation for countless concrete standards and processes. These standards are managed by the FASB and cover such things as:

• Revenue recognition
• Balance sheet item classification
• Outstanding share measurements
• Accrual-based accounting
• Hedge accounting
• Non-profit financial reporting
• Credit losses

Perhaps the keywords here are “Generally Accepted.” The principles are generally accepted by the boards who monitor, the businesses who comply, and the investors who review. This leaves room for flexibility and evolution, based on the consensus of these three groups.

The principles are under constant review and alignment, evolving to solve the needs of business owners and investors alike. For instance, in the last few years, the board has suggested some approved alternatives for private companies, to ease the burden of compliance. This shows that GAAP is not a rigid set of rules stuck in the past, but a living agreement.

There’s room for improvement, though. As economies become more globalized and businesses reach across continents, the division between GAAP and IFRS causes more problems and confusion. Some American officials stress the importance of aligning US accounting principles with the rest of the world. In recent years, the Securities and Exchange Commission is considering how to do just that, undertaking a prioritized but huge, slow-moving project.

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Resources

• Financial Accounting Standards Board
• How to Implement New GAAP Standards, FASB
• American Institute of Certified Public Accountants
• Accounting Standards Codification
• Guides on implementing new GAAP standards.