Following GAAP rules is not a requirement for most small businesses. That shouldn’t prevent you from understanding GAAP accounting because these principles affect reporting for the entire business sector. They will improve your financial procedures, and make your business more appealing to investors.
In this article:
- What is GAAP in accounting?
- Why were accounting regulations created?
- The 10 generally accepted accounting principles (GAAP)
- GAAP vs IFRS
- What is Non-GAAP accounting?
What Is GAAP In Accounting?
To begin GAAP stands for Generally Accepted Accounting Principles. So then GAAP accounting is adhering to principles, issued by the Financial Accounting Standards Board (FASB), for financial accounting. The main idea is to record transactions and prepare statements and taxes in a clear uniform manner. GAAP accounting principles normalizes the United States financial field so public companies can be compared like apples to apples.
Who Came Up With Generally Accepted Accounting Principles (GAAP)?
After the Great Depression the U.S. government sided with business reporting regulations. It was determined that the economy imploded due to manipulative reporting or “cooking the books.” In 1936, there was federal endorsement of GAAP principles initiated by the American Institute of Accountants (AIA). These new reporting laws were enforced by the Securities and Exchange Committee (SEC).
To remain unbiased the United States Government is no longer involved in the maintenance of these principles. Now independent boards are responsible for creating, maintaining, and updating GAAP. These boards meet to discuss potential changes and additional standards as business and corporate affairs evolve.
Financial Accounting Standards Board (FASB)
The Financial Accounting Standards Board (FASB) was formed as an independent board in 1973 to modify and manage GAAP. The board serves as impartial members, ensuring they represent the interest of the public. FASB is responsible for the Accounting Standards Codification (ASC), a centralized platform where accountants keep pulse on GAAP principles.
FASB Standards Due Process:
- Identify current investor pain points with reporting standards
- Draft issues for revisions and hold public meetings for feedback
- Publish draft standards for investor feedback
- Propose new business standards and invite feedback
- Address all feedback in revisions
- Announce final revised standards to the ASC
Financial Accounting Foundation (FAF)
The Financial Accounting Foundation (FAF) is the board that oversees the FASB. Through an arm of the foundation, called the Financial Accounting Standards Advisory Council (FASAC), they ensure due process when setting standards for GAAP accounting rules. FASAC is a 35-member board comprised of CEOs, CFOs, partners of public accounting firms, executives of professional organizations, and members of academic and analyst communities. It is the utmost concern of these board members that GAAP accounting rules are created with transparency fairness.
Why Were Accounting Regulations Created?
Accounting regulations were created to govern the world of accounting. GAAP principles are something that all industries can use to standardize and regulate the definitions, assumptions, and methods of accounting. These regulations guide things like revenue recognition, balance sheet classification, and materiality for publicly traded companies.
The ultimate goal of GAAP accounting regulations is that reporting is complete, consistent, and comparable. Making it easier for investors and lenders to analyze company financial information through an even lens. Without regulatory standards, companies would be free to report as they please, potentially misleading investors and the public.
10 Generally Accepted Accounting Principles
What are the generally accepted accounting principles? They are 10 principles of accounting that serve as bylaws for accountants and businesses reporting under GAAP. Here is a list of rules and what each rule means:
|1. Principle of Regularity||GAAP accounting rules are followed.|
|2. Principle of Consistency||Accountants report financials consistently to reduce errors and for comparison between periods. If there are errors, corrections are explained with detailed notes.|
|3. Principle of Sincerity||Accountants strive for accuracy and impartiality in reporting.|
|4. Principle of Permanence of Methods||Accounting procedures should be consistent, allowing a comparison over time.|
|5. Principle of Non-Compensation||Company performance, negative or positive, is transparently reported, without expectation of debt compensation.|
|6. Principle of Prudence||Factually-based financial data presentation, rather than speculative.|
|7. Principle of Continuity||Valuing assets in reports like the business will continue to operate.|
|8. Principle of Periodicity||Reporting is standardized into appropriate accounting periods: quarterly, annually.|
|9. Principle of Materiality||Accountants strive to fully disclose all financial data in financial reports.|
|10. Principle of Utmost Good Faith||All parties report transactions honestly.|
Publicly traded companies must abide by rules established by the U.S. Securities and Exchange Commission (SEC). The SEC requires that these companies regularly file GAAP-compliant financial statements to remain open for public investment on U.S. stock exchanges. A CPA will confirm GAAP compliance through an external audit.
GAAP vs IFRS
GAAP is focused on U.S. accounting and financial reporting. The international community uses its own standards called the International Financial Reporting Standards (IFRS), set by the International Accounting Standards Board (IASB). IFRS accounting is followed in over 120 countries, including the European Union (EU).
To facilitate the global economy, the FASB and the IASB have been working on the unification of GAAP and IFRS. In 2007, the SEC updated reporting rules for companies using IFRS. They removed the requirement for non-U.S. companies registered in America to reconcile their financial reports with IFRS. Before this, non-U.S. companies trading on U.S. exchanges had to be GAAP-compliant.
Differences Between GAAP vs IFRS Accounting Rules:
A major difference between GAAP vs IFRS is that GAAP has rules laid out per industry. IFRS assesses each business with principles situationally. Here are the common differences in reporting between the two:
- LIFO Inventory: GAAP allows companies to use the Last In First Out (LIFO) as an inventory cost method. IFRS does not because it can produce a net income that appears lower.
- Reversing Write-Downs: GAAP specifies that the original amount of write-down of an inventory cannot be changed if the market value of the asset increases. IFRS allows write-down reversals and some argue that creates large fluctuations in inventory valuation.
- Revaluation of Assets: GAAP only allows a revaluation of marketable securities, not assets. IFRS states that certain assets can be revalued depending on fair market value.
- Intangible Assets: Charged as an expense as they are incurred under GAAP. Under IFRS, they are capitalized and amortized over multiple periods in certain scenarios.
What Is Non-GAAP Accounting?
Some companies report both GAAP and non-GAAP financial data. In some instances, it can be argued, that these accounting regulations do not allow for an accurate depiction of company success. Reporting non-GAAP figures are permitted according to the GAAP accounting principle of non-compensation. However, all reporting needs to be clearly identified as non-GAAP in any financial statement.
Pro forma accounting is the typical method used for non-GAAP reporting. Companies will lean on this style of accounting when they believe GAAP accounting rules are not flexible enough. For instance, Pro forma reporting does not include one-off transactions. So these reports may show more accurate accounting data by excluding a random event. This is usually done to show a better overall cash position.
Note: Buyer beware when looking at pro forma non-GAAP reporting. Some companies will treat repeated earnings as one-time events to exclude figures and fluff financial statements.
Why GAAP Accounting Matters For Your Business
Even if you don’t do GAAP accounting, it has an affect on your business. GAAP principles of accounting help maintain trust in U.S. financial markets. Trust from investors, who would be hesitant to invest in companies based on shaky financial information; trust from creditors, who would be less likely to process business loans; trust from the public to purchase goods/services and participate in the economy.