Inches, feet, miles, pounds, and ounces. They all add up in the US, but elsewhere, these concepts don’t make much sense.
As you know, the United States 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, the Generally Accepted Accounting Principles, apply throughout the fifty United States, but are different from widely-used international rules.
The GAAP 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 ten GAAP 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 GAAP standards. This article will explain what each principle means, who develops and regulates them, and how to comply.
What are the GAAP?
The Generally Applied Accounting Principles are a set of ten 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.
Who determines the GAAP?
Good question! It’s not who you might think. While the federal government requires public companies to comply with GAAP, 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’s comprised of seven full-time members, who are in turn monitored by a 30-person Financial Accounting Standards Advisory Council (FASAC).
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The ten GAAP principles
- Principle of Regularity
The accountant adheres to GAAP rules and regulations as a standard, on a regular basis.
- 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 prevent 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.
- 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.
- 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.
- 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.
- Principle of Prudence
“Prudence” means wisdom, good judgment, 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.
- 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.
- 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.
- Principle of Materiality or Full Disclosure
There must be full disclosure in financial reports. No hiding or holding anything back.
- 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.
Actual GAAP accounting standards
The ten GAAP 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
If you really want to get into the nitty-gritty of which accounting standards businesses must follow, you need to access the Accounting Standards Codification, an online resource with all the precise rules (and legal jargon!). You can create an account and request access to the Basic version, all for free.
Otherwise, FASB provides some helpful guides if you need to implement certain GAAP accounting practices for the first time, or if you’re transitioning to GAAP from another system. Check out their guides on implementing new GAAP standards.
Tips for GAAP compliance
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, GAAP must be followed.
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 International Financial Reporting Standards (IFRS), make a note on the document that it’s non-GAAP.
Read on for a quick overview of the differences between GAAP and IFRS and other accounting concepts.
How does GAAP evolve?
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, GAAP 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.