What Are Generally Accepted Accounting Principles?
Generally Accepted Accounting Principles (GAAP) are standards created by the Financial Accounting Standards Board (FASB) and adopted by the United States Securities and Exchange Commission (SEC). GAAP is different from the International Financial Reporting Standards (IFRS). In the past, the two sets of standards were allowed to coexist in the United States, but today, the SEC requires domestic companies to use GAAP, making it an important aspect of financial reporting.
Historically, financial auditors were behind the creation of most accounting standards. The American Institute of Certified Public Accountants (AICPA) is one of the top organizations working to standardize procedures. In 1939, the AICPA created the Committee on Accounting Principles, replaced in 1959 by the Financial Accounting Standards Board (FASB). In 2008, the SEC first issued preliminary guidelines using GAAP.
In the US, accountants at all public companies must learn the rules of GAAP to properly prepare financial statements and related documents. Financial statements must be prepared correctly so they can be analyzed by investors. They are also important when filing taxes and securing corporate loans. GAAP is designed to show long-term trends in financial data, which may indicate a company’s growth or decline in multiple areas.
GAAP is based on general assumptions about each reporting company. The company must be separate from other companies or the company owners, meaning other revenue and expenses cannot be included in financial reporting. GAAP also assumes companies will report all records using the US dollar, and it must not be adjusted for inflation. This makes each report easily comparable to other internal reports and other companies across the market.
To further maintain regularity, 10 main concepts govern GAAP. One of these principles is consistency, which states that accountants must use the same standards across all financial periods. This consistency is important in determining long-term trends over multiple years or accounting periods in a single year. Accountants who need to update or change a standard from one period to another must write footnotes stating the exact change and the reason.
Another principle is non-compensation, which states that both negative and positive amounts should be properly displayed in statements without the expectation of debt compensation. GAAP also expects accountants to report only fact-based numbers with no speculation of gains or losses that can falsely manipulate records.
The SEC makes sure that all publicly traded companies in the United States remain compliant with GAAP. Corporations must regularly file statements to prove compliance and remain on stock exchanges. Independent certified public accounting (CPA) firms perform regular audits on public companies to ensure compliance.
Audits of large corporations can be difficult because they often have multiple operating sites and massive numbers of documents. Auditing teams usually divide tasks by area of expertise and audit only a sample of reports. Auditing teams may have a more manageable job looking at the records of small companies, which makes GAAP compliance important to all public companies regardless of size or annual revenue.
Many companies that are not publicly traded still use GAAP because lenders and creditors prefer it. Many corporate loan documents state that GAAP compliance is a stipulation for issuing loans.
Investors should be cautious if a private company does not use GAAP in its reporting because determining the company’s financial stability and yearly trends may be difficult. Lack of GAAP reporting also makes comparing similar companies difficult.
