GAAP Explained: Understanding Generally Accepted Accounting Principles

GAAP, or Generally Accepted Accounting Principles, is a commonly recognized set of rules and procedures designed to govern corporate accounting and financial reportingSEC FilingsSEC filings are financial statements, periodic reports, and other formal documents that public companies, broker-dealers, and insiders are required to submit to the U.S. Securities and Exchange Commission (SEC). The SEC was created in the 1930s with an aim to curb stock manipulation and fraud in the United States (US). The US GAAP is a comprehensive set of accounting practices that were developed jointly by the Financial Accounting Standards Board (FASB) and the Governmental Accounting Standards Board (GASB), so they are applied to governmental and non-profit accounting as well.

US securities law requires all publicly-traded companiesPrivate vs Public CompanyThe main difference between a private vs public company is that the shares of a public company are traded on a stock exchange, while a private company's shares are not., as well as any company that publicly releases financial statements, to follow the GAAP principles and procedures.

In addition, or as an alternative, are the International Financial Reporting Standards (IFRS)IFRS StandardsIFRS standards are International Financial Reporting Standards (IFRS) that consist of a set of accounting rules that determine how transactions and other accounting events are required to be reported in financial statements. They are designed to maintain credibility and transparency in the financial world established by the International Accounting Standards Board (IASB). The IFRS rules govern accounting standards in the European Union, as well as in a number of countries in South America and Asia.

The Core GAAP Principles

GAAP is set forth in 10 primary principles, as follows:

1. Principle of consistency: This principle ensures that consistent standards are followed in financial reporting from period to period.
2. Principle of permanent methods: Closely related to the previous principle is that of consistent procedures and practices being applied in accounting and financial reporting to allow comparison.
3. Principle of non-compensation: This principle states that all aspects of an organization’s performance, whether positive or negative, are to be reported. In other words, it should not compensate (offset) a debt with an asset.
4. Principle of prudence: All reporting of financial data is to be factual, reasonable, and not speculative.
5. Principle of regularity: This principle means that all accountants are to consistently abide by the GAAP.
6. Principle of sincerity: Accountants should perform and report with basic honesty and accuracy.
7. Principle of good faith: Similar to the previous principle, this principle asserts that anyone involved in financial reporting is expected to be acting honestly and in good faith.
8. Principle of materiality: All financial reporting should clearly disclose the organization’s genuine financial position.
9. Principle of continuity: This principle states that all asset valuations in financial reporting are based on the assumption that the business or other entity will continue to operate going forward.
10. Principle of periodicity: This principle refers to entities abiding by commonly accepted financial reporting periods, such as quarterly or annually.

The Generally Accepted Accounting Principles further set out specific rules and principles governing such things as standardized currency units, cost and revenue recognitionRevenue Recognition PrincipleThe revenue recognition principle dictates the process and timing by which revenue is recorded and recognized as an item in a company's, financial statement format and presentation, and required disclosures. For example, it requires precise matching of expenses with revenues for the same accounting period (the matching principleMatching PrincipleThe matching principle is an accounting concept that dictates that companies report expenses at the same time as the revenues they are related).

History of GAAP

Generally Accepted Accounting Principles were eventually established primarily as a response to the Stock Market Crash of 1929 and the subsequent Great Depression, which were believed to be at least partially caused by less than forthright financial reporting practices by some publicly-traded companies. The federal government began working with professional accounting groups to establish standards and practices for consistent and accurate financial reporting.

Generally Accepted Accounting Principles began to be established with legislation such as the Securities Act of 1933The 1933 Securities ActThe 1933 Securities Act was the first major federal securities law passed following the stock market crash of 1929. The law is also referred to as the Truth in Securities Act, the Federal Securities Act, or the 1933 Act. It was enacted on May 27, 1933 during the Great Depression. ...the law was aimed at correcting some of the wrongdoings and the Securities Exchange Act of 1934.

The GAAP has gradually evolved, based on established concepts and standards, as well as on best practices that have come to be commonly accepted across different industries.

Why is GAAP Important?

Generally Accepted Accounting Principles make financial reporting standardized and transparent, using commonly accepted terms, practices, and procedures. The consistency of presentation of financial reports that results from GAAP makes it easy for investors and other interested parties (such as a board of directors) to more easily comprehend financial statements and compare the financial statements of one company with those of another company.

GAAP also seeks to make non-profit and governmental entities more accountable by requiring them to clearly and honestly report their finances.

In short, GAAP is designed to ensure a consistent presentation of financial statementsThree Financial StatementsThe three financial statements are the income statement, the balance sheet, and the statement of cash flows. These three core statements are, making it easier for people to read and comprehend the information contained in the statements.

Applications in Financial Analysis

For financial analysts performing valuation work and financial modelingWhat is Financial ModelingFinancial modeling is performed in Excel to forecast a company's financial performance. Overview of what is financial modeling, how & why to build a model., it’s important to have a solid understanding of accounting principles. While this is important, financial models focus more on cash flow and economic value, which is not significantly impacted by accounting principles (other than for the calculation of cash taxes).

Alternatives to GAAP

GAAP is the set of standards and practices that are followed in the United States, but what about other countries? Outside the US, the alternative in most countries is the International Financial Reporting Standards (IFRS), which is regulated by the International Accounting Standards Board (IASB). While the two systems have different principles, rules, and guidelines, IFRS and GAAP have been working towards merging the two systems.

Additional Resources

Learn more about Generally Accepted Accounting Principles at FASB’s website.

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• Accounting EthicsAccounting EthicsAccounting ethics is an important topic because, as accountants, we are the key personnel who access the financial information of individuals
• Audited Financial StatementsAudited Financial StatementsPublic companies are obligated by law to ensure that their financial statements are audited by a registered CPA. The purpose of the
• Internal ControlsInternal ControlsInternal controls are policies and procedures put in place by management to ensure that, among other things, the company's financial
• Types of SEC FilingsTypes of SEC FilingsThe US SEC makes it mandatory for publicly traded companies to submit different types of SEC filings, forms include 10-K, 10-Q, S-1, S-4, see examples. If you are a serious investor or finance professional, knowing and being able to interpret the various types of SEC filings will help you in making informed investment decisions.