What are Generally Accepted Accounting Principles (GAAP)?

U.S. GAAP regulations are meant to hold companies to a high reporting standard, ensure financial transparency, and make it easy to compare the financial results between different companies. GAAP compliance is a major consideration for finance and accounting professionals; understanding GAAP standards and properly implementing them is crucial for companies of all sizes.

The history of GAAP

The Stock Market Crash of 1929, which was followed by the Great Depression, was driven largely by elusive and inaccurate accounting practices of large corporations at the time. In an attempt to prevent similar incidents in the future, the government partnered with a variety of accounting groups to develop a set of accounting standards and reporting requirements for businesses.

The first official introduction of the GAAP principles was through the Securities Act of 1933 and the Securities Exchange Act of 1934. In the last 90 years, these basic accounting principles have changed and evolved as new best practices have come forward.

10 GAAP principles

1. Principle of Regularity: An organization’s accounting principles must be aligned with GAAP standards. All accountants must abide by the regulations set out by GAAP.
2. Principle of Consistency: Consistent application of the standards must be followed from period to period; the way they are applied cannot change from month to month or year to year.
3. Principle of Permanent Methods: In hand with the principle above, GAAP compliance dictates that accounting practices used for accrual accounting and financial reporting must remain uniform.
4. Principle of Sincerity: Accountants within an organization must be committed to maintaining the utmost integrity and accuracy when reporting financial outcomes.
5. Principle of Non-Compensation: No matter how an organization performs within a reporting period, all performance metrics must be reported. No prospect of debt compensation may be used.
6. Principle of Prudence: Accounting records should be free of speculation and reports should avoid overstating assets or income.
7. Principle of Continuity: When valuing assets or liabilities, it must be assumed that the business will remain operational unless there is evidence to suggest otherwise.
8. Principle of Periodicity: Accounting periods must be even and consistent. Most organizations use monthly, quarterly, and annual periods.
9. Principle of Materiality: Financial reports must clearly disclose the financial standing of the organization.
10. Principle of Utmost Good Faith: Professionals involved in accounting practices or reporting methods must be working in good faith.

GAAP’s Requirements & Stipulations

Legally, only publicly traded companies must abide by GAAP standards. Tied to the rules established by the U.S. Securities and Exchange Commission (SEC), corporations listed on stock exchanges in the U.S. must follow all GAAP principles above if they want to stay listed on stock exchanges. External auditors who work for a certified public accounting firm are responsible for verifying GAAP compliance. Regular external audits sift through financial statements, ensure basic accounting principles are respected, and verify GAAP principles within an organization

Although non-publicly traded companies are not legally required to follow GAAP accounting rules, lenders and investors often require their clients to follow these rules. Most loan agreements require businesses to submit GAAP-compliant documents before being approved for business loans. Because of this dynamic, most companies in the country use U.S. GAAP principles in all accounting practices.

GAAP vs. IFRS

Although U.S.-based companies are tied to accrual accounting and other GAAP principles, international companies aren’t required to follow the GAAP standards. Instead, the International Financial Reporting Standards (IFRS) are used on the international stage. IFRS is used in 168 countries around the world. This set of standards has a very similar set of goals as GAAP principles do; transparency, reliability, and comparability are the driving forces behind the development of these standards.

The International Financial Reporting Standards were developed by the International Accounting Standards Board (IASB) and they tend to be more principle-based instead of rule-based like GAAP principles. IFRS provides a broad set of guidelines that are up for more lenient interpretation, while GAAP standards are specific, rule-based practices. How the two sets of standards treat things like intangible assets, R&D costs, and financial statement presentations vary as well.

Why does GAAP matter?

GAAP accounting standards serve a very important purpose; they do more than ensure uniformity in accrual accounting, they protect consumers and the general public, too. U.S.-based companies have a major impact on the nation’s economy and overall financial stability, so if their accounting practices are unethical or lack transparency, they’re putting a lot of people and other businesses at risk. GAAP standards help prevent shady business practices, and in turn, protect the economy, U.S. residents, and even global financial health.

Summary

• A standard set of accounting rules for U.S. companies, GAAP, ensures financial reporting transparency, uniformity, and comparability.
• Created in response to the 1929 Stock Market Crash and the Great Depression, GAAP policies are meant to prevent future economic disasters by setting guardrails for business accounting practices. These guardrails serve U.S. citizens by preventing the financial collapse of large companies due to negligence in questionable accounting methods.
• The 10 GAAP principles are: Regularity, Consistency, Permanent Methods, Sincerity, Non-Compensation, Prudence, Continuity, Periodicity, Materiality, Utmost Good Faith.
• Publicly traded companies must comply with GAAP to maintain listing on stock exchanges, and that compliance must be verified by external auditors. Non-publicly traded firms often follow GAAP due to investor and lender demands.
• Although GAAP has a similar goal as IFRS, the two standards vary from one another. GAAP is used in the United States while IFRS exists on an international stage.