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GAAP, an acronym for generally accepted accounting principles, is a set of rules and principles that public companies in the U.S. must follow when preparing their annual financial statements.
Without GAAP, it would be much more difficult for lenders, investors, and other interested parties to know how a business is performing.
Read on to learn more about what GAAP is, how it works, pros and cons of GAAP, the differences between GAAP and non-GAAP, and more.
Key Points
• GAAP’s meaning is “generally accepted accounting principles.”
• It provides a common set of accounting standards, helping to ensure consistency in financial reporting.
• GAAP enhances the clarity and transparency of financial statements for investors and stakeholders.
• It helps ensure that financial data is reported accurately, reducing the risk of errors or fraudulent reporting.
• GAAP has 10 fundamental principles that complying companies must follow.
What Is GAAP?
GAAP, or generally accepted accounting principles, is a commonly recognized set of rules and procedures designed to govern corporate accounting and financial reporting in the U.S.
GAAP was established to provide consistency in how financial statements are created, eliminate the potential for fraudulent or misleading financial reports, and make it easier for investors and creditors to evaluate companies and compare them apples-to-apples.
All publicly traded businesses in the U.S. must use GAAP in their financial statements. While small businesses that don’t get audited aren’t required to use GAAP, doing so can still be helpful, particularly if your business may be interested in attracting an investor or exploring small business loans at some point.
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How GAAP Works
Three nonprofit organizations — the Financial Accounting Foundation (FAF), the Financial Accounting Standards Board (FASB), and the Governmental Accounting Standards Board (GASB) — play a role in setting GAAP standards as follows:
• The FAF oversees the FASB and GASB organizations
• The FASB issues GAAP rules for businesses and nonprofits
• The GASB issues GAAP standards for state and local governments
For businesses filing periodic reports with the U.S. Securities and Exchange Commission (SEC), GAAP dictates how a company can recognize revenue and expenses and how information must be presented to shareholders in an audited report. It also standardizes the financial reporting process so that third parties can easily compare and contrast two GAAP-compliant companies or entities.
GAAP incorporates three components to help eliminate misleading accounting and financial reporting practices:
• 10 GAAP accounting principles
• Rules and standards issued by the FASB or GASB
• Generally accepted industry practices
Why Is GAAP Important?
GAAP is crucial because it provides a standardized framework for financial reporting, ensuring consistency, accuracy, and transparency across businesses. This allows investors, regulators, and stakeholders to compare financial statements and make informed decisions. GAAP also helps maintain trust in the financial system by reducing the risk of fraud and misrepresentation.
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Who Must Follow GAAP?
The SEC requires that publicly traded companies in the U.S. follow GAAP in the financial statements they file. While businesses that are not publicly traded aren’t subject to this rule, most financial institutions require annual GAAP-compliant statements as part of their debt covenants, which results in many businesses following GAAP even if the SEC requirement doesn’t apply to them. However, GAAP is not always used for small-business accounting.
In addition, many government entities also use GAAP. That includes all 50 states and many smaller jurisdictions, like counties and municipalities. Many federal agencies follow the guidance of the Federal Accounting Standards Advisory Board (FASAB), but some do use GAAP. such as the U.S. Postal Service, federal government corporations, and some entities of the Department of the Treasury, among others.
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Pros and Cons of GAAP
GAAP offers a number of benefits. It guides companies in preparing accurate and clear financial data, reduces fraudulent financial reporting, and provides consistency in the financial statements of one GAAP-compliant company compared to another.
However, GAAP also has some limitations. Its “one-size-fits-all” approach to financial reporting, for example, doesn’t always address issues faced by specific industries. GAAP can also be overly complex, as well as costly to implement, for smaller businesses. And, it’s not a globally used standard, which can make it challenging for international organizations and for investors who want to compare companies operating in different countries.
Pros of GAAP
Here are some of the pros of GAAP:
• Fosters honesty and transparency in financial reporting
• Makes it easy to compare one GAAP-compliant company to another GAAP-compliant company
• Ensures that compliant businesses follow the same accounting principles for all reporting periods
• Enables businesses to compare their performance with that of their competitors
Cons of GAAP
Here are some of the cons of GAAP:
• Strict accounting model does not address many industry-specific situations
• Can be costly for smaller companies to become GAAP-compliant
• Overshadows non-U.S. GAAP financial performance metrics, such as adjusted EBITDA
• Not a global standard
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10 Important GAAP Principles
GAAP has 10 fundamental principles that companies must follow:
1. Principle of Regularity
Accountants must adhere to the rules and regulations of GAAP accounting. This principle keeps accountants from making up their own methods. With GAAP, any accountant can understand the work of another accountant. This is extremely important when comparing businesses and analyzing their worth.
2. Principle of Consistency
Accountants must apply the same standards and techniques for all accounting periods. This ensures financial comparability between periods. Any changes or updated standards must be explained in the footnotes to the financial statements.
3. Principle of Sincerity
Accountants must be as honest, impartial, and accurate as possible in their reporting of a company’s financial performance. They cannot lie or fudge numbers to make a company seem more profitable.
4. Principle of Permanence of Methods
All GAAP-compliant companies must be consistent with their methods and procedures. This way, all GAAP-compliant companies can be compared regardless of their industry.
5. Principle of Non-Compensation
Businesses must report all aspects of their performance, both good and bad, and do so without the expectation of debt compensation.
6. Principle of Prudence
Accountants should never speculate or give their opinion in a financial report. All records must include only expenses and provisions for spending that have taken or will certainly take place.
7. Principle of Continuity
When valuing assets, accountants must assume the business will continue to operate in the foreseeable future. Any potential buyouts or foreclosures should not be considered.
8. Principle of Periodicity
Accountants must report all revenue and expenses in the appropriate accounting period, such as fiscal quarters or fiscal years.
9. Principle of Materiality
Accountants must strive to fully disclose all financial data and accounting information in financial reports.
10. Principle of Utmost Good Faith
All parties that contribute to a company’s financial report are assumed to be honest and reputable.
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Alternatives to GAAP
IFRS
The International Financial Reporting Standards, or IFRS, are another set of accounting standards, but these are used at the international level. IFRS is standard in the European Union and many countries in Asia and South America, but not in the United States. IFRS was established so that companies could be comparable from country to country.
The main difference between GAAP vs. IFRS is that GAAP prioritizes rules and detailed guidelines, whereas IFRS only provides general principles to follow. Accountants have more leeway when following IFRS, but often need to include explanatory documents. On the other hand, businesses that use GAAP may feel confined by the lengthy rules.
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Tax-Basis Accounting
Tax-basis accounting follows the accounting that a company is required to use for filing its federal tax return. If allowed by creditors, investors, and other financial statement users, tax-basis accounting can make sense for a privately held company, since it means less work when preparing the company’s tax return. When comparing tax-basis vs. GAAP accounting, tax-basis accounting is less complex and often leads to less footnote disclosures in financial statements.
GAAS
Generally accepted auditing standards, or GAAS, is the framework that guides auditors. GAAS standards help auditors prepare a transparent and reliable audit report on companies. Following these standards also ensures that auditors don’t miss any important information. When comparing them, it’s important to remember that GAAP is used by accountants, whereas GAAS is used by auditors. Therefore, an auditor following GAAS may see how well a company is following GAAP.
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OCBOA (Other Comprehensive Basis of Accounting)
Other comprehensive basis of accounting (OCBOA) refers to systems that are not GAAP or IFRS. These can include tax-basis accounting, but also cash-basis accounting. To understand that approach, imagine your company’s business checking account. You would only count revenue when you actually had gotten the cash deposited in the account and expenses only after you’d paid the cash out, so your statement would reflect exactly what was in the account, Cash-basis accounting extends this approach to all your company’s financials Accrual accounting, by way of contrast, counts revenue when it’s earned, even if it hasn’t been received yet, and expenses when they’re incurred, not when you actually pay them.
Other systems that fall under OCBOA include modified cash-basis accounting (a hybrid form of cash-basis and accrual accounting) and regulatory-basis accounting, in which you’re following rules set by a government or industry regulatory agency. Methods like these can make financial reporting easier and help keep results clear, but aren’t always useful for cross-industry comparisons, investors, or compliance purposes.
The Takeaway
GAAP accounting principles are what public U.S. companies must follow when putting together financial statements. The goal of GAAP is to hold publicly traded companies accountable and ensure their financial statements are complete, consistent, and comparable.
For small business accounting, you aren’t required to follow GAAP regulations. However, doing so can make it easier for outsiders to evaluate your business and compare it with other companies in your industry. Publishing GAAP-compliant financial statements could make it easier for your business to attract an investor or get approved for certain types of business loans.
If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.
FAQ
How many GAAP principles are there?
The generally accepted accounting principles, or GAAP, has 10 principles. They are the principle of regularity, the principle of consistency, the principle of sincerity, the principle of permanence of methods, the principle of non-compensation, the principle of prudence, the principle of continuity, the principle of periodicity, the principle of materiality, and the principle of utmost good faith.
Is GAAP the same in every country?
No, only publicly traded companies in the U.S. must use GAAP (generally accepted accounting principles). IFRS (International Financial Reporting Standards) is a framework used in the European Union and many countries in Asia and South America.
Why is GAAP important?
GAAP (generally accepted accounting principles) is important because it ensures honesty, transparency, and uniformity in financial reporting. Without GAAP standards, businesses could report their earnings differently, which could make it difficult for investors and creditors to evaluate and compare companies, and the absence of GAAP could also provide opportunities for fraud.
What does GAAP stand for?
As an acronym, GAAP’s meaning is “generally accepted accounting principles.” It’s a comprehensive framework of accounting rules. GAAP is primarily used in corporate accounting and financial reporting in the United States.
Who oversees GAAP?
Three nonprofit organizations — the Financial Accounting Foundation (FAF), Financial Accounting Standards Board (FASB), and Governmental Accounting Standards Board (GASB) — each play a role in setting GAAP standards. FAF oversees the FASB and GASB organizations, while FASB issues GAAP rules for businesses and nonprofits and GASB issues GAAP standards for state and local governments. The U.S. Securities and Exchange Commission (SEC) can establish GAAP via government regulations, but it typically allows the private sector to establish the standards.
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