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 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 companies, 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) 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:
- Principle of consistency: This principle ensures that consistent standards are followed in financial reporting from period to period.
- 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.
- 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.
- Principle of prudence: All reporting of financial data is to be factual, reasonable, and not speculative.
- Principle of regularity: This principle means that all accountants are to consistently abide by the GAAP.
- Principle of sincerity: Accountants should perform and report with basic honesty and accuracy.
- 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.
- Principle of materiality: All financial reporting should clearly disclose the organization’s genuine financial position.
- 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.
- 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 recognition, 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 principle).
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 1933 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 statements, 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 modeling, 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.
Learn more about Generally Accepted Accounting Principles at FASB’s website.
In addition to this explanation of GAAP, CFI offers a wealth of information on accounting and business finance, including the global Financial Modeling & Valuation Analyst (FMVA)® certification program. To further your education, the following CFI resources will also be helpful: