GAAP, or generally accepted accounting principles, is a set of rules and standards that accounting professionals follow when preparing financial statements and the related disclosures. In the United States, the Financial Accounting Standards Board (FASB) implements GAAP through its Accounting Standards Codification (ASC), a more detailed set of standards that lists down all the accounting rules and principles. The Securities and Exchange Commission (SEC) requires publicly traded companies to strictly comply with GAAP in publishing financial statements.
The FASB released a GAAP alternative called the Financial Reporting Framework (FRF) for SMEs Small and Medium Enterprises . The FRF, designed to provide accounting guidance for the small business community in the US, simplifies the reporting requirements compared to the full GAAP.
Key Takeaways:
- GAAP aims to make financial statements relevant, reliable, consistent, and comparable. It also ensures fairness and uniformity in financial reporting across companies and periods.
- GAAP has 10 principles, which accountants must follow when preparing the financial statements of businesses required to comply with GAAP.
- Small businesses generally aren’t required to follow GAAP—unless requested by a bank or investor—but they may opt for voluntary compliance. Alternatively, the FRF for SMEs offers a simpler accounting standard than GAAP.
- Companies that trade debt (like bonds) and equity (such as common stock) instruments in the stock exchange are required to adhere strictly to GAAP.
- Private companies with bank loans may also be required to follow GAAP as part of the debt covenants.
The Purpose of GAAP
GAAP sets the rules for financial reporting, making all financial statements of publicly traded companies in the US relevant, reliable, consistent, and comparable. Accounting standards help external users, such as creditors, investors, and regulators, make informed decisions about the company’s financial performance and financial health.
Having accounting standards in place ensures uniformity and fairness in financial reporting. Standards prevent companies from using different kinds of accounting methods and practices that might inflate their income or net worth. However, deviation from GAAP is allowed—as long as companies can justify and explicitly mention the deviation during financial reporting.
Examples of GAAP in accounting are the standards that govern specific accounting areas like ASC 360 for property, plant, and equipment and ASC 310 for receivables.
GAAP financial statements prepared by CPAs must be accompanied by an opinion. The opinion and the level of assurance it provides regarding the accuracy of the statements depends on whether the CPA performed an Audit, Review or Compilation.
10 GAAP Principles
Though GAAP has extremely detailed rules and procedures, all accounting rules are created with the following principles in mind:
- Regularity: Companies must adhere to GAAP when processing and reporting financial information. This principle also implies the use of the accrual basis of accounting since it is the accounting method embedded in GAAP.
- Consistency: Accountants must follow the same standards for all accounting periods unless a newer standard supersedes an old standard. For example, the release of the new revenue recognition standard (ASC 606) required companies to retrospectively adjust all contracts based on the new standard.
- Sincerity: This principle refers to unbiased financial reporting which requires accountants to report bad financial information as is and ensure its full disclosure.
- Permanence of methods: Accountants must follow the same procedures and methods in financial reporting. This means that accountants can’t pick any method they like to use for the sake of trying something new.
- Noncompensation: This principle emphasizes that good information won’t compensate for bad information. For example, accountants must not offset gains with losses to report a net gain. If the standard requires explicit reporting of the loss, it should be shown as a separate line item.
- Prudence: Measurement methods should be grounded on facts, not guesswork-speculations are not considered in accounting. Besides that, accountants should make an effort in making decisions that will least likely overstate assets or understate liabilities.
- Continuity: This principle assumes that the business will continue to operate in the foreseeable future. Accountants should value assets and liabilities with the assumption that the business will operate indefinitely. That’s why fixed assets are recorded at cost, not at its liquidation value, because the continuity assumption states that the fixed asset will be used throughout its useful life.
- Periodicity: Financial statements should be divided into relevant accounting periods such as calendar or fiscal periods.
- Materiality: Accountants should disclose all material facts in financial statements. This allows for deviation from GAAP if the amounts are immaterial in amount. Though materiality is subjective, the best practice is that omissions resulting in a 5% change in total assets or net income should be separately disclosed and reported.
- Utmost good faith: Parties involved in the overall financial reporting process should exercise honesty and integrity in collecting, processing, and reporting financial information. This means that the accountant, accounting staff, and even the owner should embody this principle. The accountant and owner should not be in connivance in manipulating financial statements for tax evasion.
Application of GAAP Principles
GAAP is applied in the four stages of financial reporting:
1. Recognition and derecognition: When are assets, liabilities, equity, revenues, and expenses recognized and derecognized in the financial statements?
- You should refer to specific ASCs that govern a particular element of the financial statement.
2. Measurement: How are assets, liabilities, equity, revenues, and expenses measured?
- GAAP has different measurement principles and approaches. Depending on the requirement of a particular ASC, measurement be based on historical cost, fair value, liquidation value, or present value.
3. Presentation: How are assets, liabilities, equity, revenues, and expenses presented in the face of the financial statements?
- The ASC often mentions if a particular item needs to be a line item in the face of the financial statement, a footnote, or just a note in the notes to financial statements.
4. Disclosure: What other information should be disclosed in the notes rather than in the face of the financial statements?
- Some financial information need not be presented in the face of the financial statements. Instead, the ASC would specifically mention how to disclose additional information to provide readers context on the figures presented in the face of the financial statements.
Should Small Businesses Follow GAAP?
Generally, small businesses aren’t required to follow GAAP except when:
- A debt covenant requires a small business to use GAAP in financial reporting
- Stockholders and board of directors of a small private corporation want to use GAAP for accounting purposes
Small businesses may voluntarily follow GAAP as long as they commit to full compliance to it. GAAP doesn’t allow partial compliance because that would defeat the regularity principle.
FRF for SMEs vs GAAP
Since GAAP compliance can be tedious because of the required disclosures and level of detailed reporting, the American Institute of Certified Public Accountants (AICPA) released a separate set of standards from the ASC called FRF for SMEs. For simplicity, let’s refer to the ASC as the full GAAP.
The FRF for SMEs was designed with SMEs in mind. The AICPA patterned the FRF for SMEs with full GAAP but omitted some complex disclosures that aren’t relevant for SMEs. Its aim is to help SMEs to produce financial statements without the complexities of full GAAP.
What makes the FRF for SMEs simpler than full GAAP is that the FRF for SMEs is principles-based, whereas full GAAP is rules-based. This means that the FRF for SMEs doesn’t enumerate specific rules to follow. Instead, it lays down all the principles and allows CPAs to interpret and apply these principles based on their competence, experience, and expertise.
In our expert opinion, following either full GAAP or FRF for SMEs is a matter of cost and benefit. Following standards means hiring or outsourcing the talent needed.
GAAP- or FRF-based financial information must produce meaningful information that outweighs its cost. If the information is costlier than the value it gives, then we recommend small businesses not to comply with GAAP or FRF. Instead, we urge you to follow good accounting practices and practice honesty, integrity, and transparency in financial reporting.
GAAP vs IFRS
Both GAAP and the International Financial Reporting Standard (IFRS) are accounting standards that govern financial accounting and reporting in a particular country. GAAP is unique to the US while 168 jurisdictions have adopted the IFRS. In general, GAAP is rules-based while IFRS is principles-based. Many accounting professionals argue that principles-based standards provide more leeway for interpretation than rules-based standards.
The most controversial difference is that the GAAP allows last-in, first-out (LIFO) inventory while IFRS doesn’t. It is controversial since LIFO can create potential distortions to the financial statements.
Since 2002, the FASB and the International Accounting Standards Board (IASB), the promulgator of the IFRS, have been working on a convergence between GAAP and IFRS to create a unified accounting standard. As of 2018, both GAAP and IFRS are aligned in terms of revenue recognition, with a focus on the five-step model.
Frequently Asked Questions (FAQs)
GAAP is only used and applicable in the US. Internationally, the popular accounting standard is the IFRS.
Yes, but only for publicly traded companies and private corporations required by debt covenants to use GAAP. Otherwise, GAAP compliance is voluntary.
The FASB is a private organization and the standard-setting body in charge of promulgating the GAAP while the SEC is the regulatory body of the US government in charge of regulating the securities market. The SEC, not FASB, requires publicly traded companies to follow the GAAP in financial reporting.
It is a corporation whose shares of stocks are traded on a stock exchange. Corporations like Apple, Tesla, and Google are examples of publicly traded companies.
Bottom Line
In a small business setup, GAAP compliance isn’t mandatory—it is up to the business owners if complying with the GAAP would produce better accounting information for the business’ stakeholders. However, for publicly traded companies, GAAP compliance is mandatory and these companies have no choice but to follow the GAAP.
