What Is GAAP & How Does It Work?

By Lauren Ward · May 24, 2024 · 7 minute read

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What Is GAAP & How Does It Work?

An acronym for generally accepted accounting principles, GAAP 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 whether a business is performing well or poorly.

Read on to learn more on what GAAP is and how it works, pros and cons of GAAP, the differences between GAAP and non-GAAP, and more.

GAAP Defined

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.

How GAAP Works

Three nonprofit organizations — the Financial Accounting Foundation (FAF), Financial Accounting Standards Board (FASB), and Governmental Accounting Standards Board (GASB) — play a role in setting GAAP standards as follows:

•  FAF oversees the FASB and GASB organizations

•  FASB issues GAAP rules for businesses and nonprofits

•  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 needs to 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 accounting principles

•  Rules and standards issued by the FASB or GASB

•  Generally accepted industry practices

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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 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 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 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 in their reporting of a company’s financial performance as possible. 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. By doing so, 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 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 only include expenses and provisions for spending that have or will certainly take place.

7. Principle of Continuity

While 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

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.

The Takeaway

GAAP is the set of accounting rules and principles that 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 are not 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.

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FAQ

How many principles does GAAP have?

The generally accepted accounting principles, or GAAP, has ten principles. They are:

1.   Principle of regularity

2.   Principle of consistency

3.   Principle of sincerity

4.   Principle of permanence of methods

5.   Principle of non-compensation

6.   Principle of prudence

7.   Principle of continuity

8.   Principle of periodicity

9.   Principle of materiality

10.   Principle of utmost good faith

Is GAAP the same in every country?

No, only U.S. publicly traded companies must use GAAP (generally accepted accounting principles). IFRS (the International Financial Reporting Standards) is 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 could also provide opportunities for fraud.

What does GAAP stand for?

GAAP is the acronym for generally accepted accounting principles, 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) — 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.


Photo credit: iStock/AndreyPopov

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