Generally accepted accounting principles (GAAP) form a combination of standards set by the Financial Accounting Standards Board that govern, among other things, the recording and reporting of information. Using GAAP ensures that you can easily compare your financial information with information from previous tax periods and with other companies that use the same standards.
GAAP, by standardizing and regulating definitions, assumptions and methods, ensures that a company’s financial statements can be analyzed in a way that guarantees that investors are comparing apples to apples when they look at financial information across different companies.
The mission of GAAP is to enforce these principles:
- Principle of Regularity — Accountants should use standardized accounting rules and regulations.
- Principle of Consistency — Accountants are expected to disclose and explain reasons behind any changed or updated standards in footnotes to financial statements.
- Principle of Sincerity — Accountants strive to provide accurate and impartial depictions of firms’ financial situations.
- Principle of Permanence of Method — Procedures used in financial reporting should be consistent.
- Principle of Non-Compensation — Both negatives and positives should be reported with full transparency and without the expectation of debt compensation.
- Principle of Prudence — Fact-based financial data representation should not be clouded by speculation.
- Principle of Periodicity — Revenue should be reported in its relevant accounting period.
- Principle of Utmost Good Faith — This presupposes that parties remain honest in all transactions.
GAAP is required protocol for publicly traded companies in the U.S., pursuant to a rule by the Securities and Exchange Commission (SEC). An auditor must certify GAAP compliance after an audit by an independent certified public accounting firm.
GAAP is viewed favorably by lenders and creditors when issuing business loans, which is why most companies in the U.S. follow GAAP even if they are not publicly traded and do not have to abide by SEC rules. The FASB, an independent nonprofit organization, is responsible for establishing accounting and financial reporting standards. The international alternative to GAAP is the International Financial Reporting Standards (IFRS), set by the International Accounting Standards Board.
The IASB and FASB have been working on convergence of their standards since 2002. The SEC in 2007 removed the requirement for non-U.S. companies registered in the U.S. to reconcile their financial reports with GAAP if their accounts already complied with IFRS. As corporations navigate global markets and conduct more and more operations worldwide, international standards are becoming increasingly popular at the expense of GAAP, even in the U.S.
Using standards such as GAAP doesn’t provide a guarantee that financial statements are free from errors or omissions intended to mislead investors. Therefore, would-be investors should closely scrutinize financial statements.