In accounting speak, GAAP is an acronym you will hear often. It stands for generally accepted accounting principles. For accountants, it is referring to the best practices and commonly-followed guidelines in doing business accounting, but it is also primarily American and varies regionally within the nation.
Accounting often requires judgement calls as to whether incidentals are claimable and how. So in practice, applying GAAP principles indicates there will be a similar process and readability that others will be able to understand when reading public reports of corporate financials.
TL;DR (Too Long; Didn't Read)
GAAP was created over decades of evolving governance and legal theory from the bodies monitoring accounting practices in the United States.
Basics of GAAP
GAAP is a general set of rules including nuances, best practices and legal regulations of business and corporate accounting. GAAP can apply more broadly but is generally intended for companies that are publicly traded on stock exchanges and issue reports for stakeholders and the public.
There are 10 key principles or concepts featured under GAAP, and they include:
- Principle of regularity: All the reporting follows GAAP rules and regulations.
- Principle of consistency: Consistent standards are applied throughout the financial reporting process.
- Principle of permanence of methods: All financial reports will be made with consistent procedures throughout their preparation.
- Principle of sincerity: The accountant has allegiance to GAAP rather than the client, in order to maintain accurate, impartial reporting.
- Principle of non-compensation: An organization’s performance will be reported factually, whether negative or positive, without expectation of compensation for debts.
- Principle of prudence: The financial data reported is based on fact and not speculation.
- Principle of continuity: Any values assigned to assets are done so under the presumption that the company will continue operations.
- Principle of periodicity: Revenue reporting will be done in accordance with its appropriate time period, such as fiscal quarters or fiscal years.
- Principle of materiality: Financial reports will fully disclose the company’s monetary status.
- Principle of utmost good faith: This is the presupposing that all parties are acting fairly and honestly.
Who Founded GAAP?
GAAP is not a finite document that was mulled over and then introduced overnight like the American Constitution. It is similar to the Constitution in one way, though: It is a document that continues to evolve and modernize with the times.
The introduction of GAAP came by way of seeds planted in the dark days after the stock market crash of 1929. In the decade that followed, corporate accounting practices were under the purview of the Securities and Exchange Commission (SEC).
A decade later, that responsibility was handed to the private sector, and the Committee on Accounting Procedure (CAP) was born under the American Institute of Certified Public Accountants. After two decades, the CAP gave way to the Accounting Principles Board (APB), and things began to evolve under them.
The ASB (Auditing Standards Board) adopted the habit of issuing opinions on the accounting practices used in business and public disclosure. Since 1973, these responsibilities have been shouldered by the Financial Accounting Standards Board (FASB).
Since then, the FASB has issued opinions and rendered judgment on accounting scenarios. It is all those opinions and judgments from both the FASB and the APB that now form what is known as GAAP.
Who Uses GAAP?
While GAAP was created to set ethical reporting boundaries for companies that are publicly traded on stock exchanges, it does not mean things end there. The transparency and readability of GAAP-compliant reports makes them attractive to private companies too. Clarity, consistency, impartiality and all the other qualities that are the cornerstones of GAAP are simply sound accounting practices.
There are some decisions and pronouncements from the SEC and other bodies that weave their way into GAAP, but the one thing they all have in common is that they are American. GAAP varies from state to state, but it is an American set of values in the world of corporate financials reporting.
That does not mean the world lacks principles in reporting corporate details. They just have their own methods: If you have ever seen IFRS mentioned anywhere, it is how the world does its reporting. It is not just popular beyond America either, since the SEC has expressed a desire to switch America’s standards to the IFRS.
What Is the IFRS?
IFRS is short for International Financial Reporting System, and it is used by over 140 countries to ensure transparency and consistency in how companies report their financial details. The IFRS was not such an ambitious project in its early days but instead was begun when accounting associations of Australia, Canada, France, Germany, Japan, Mexico, Netherlands, U.K./Ireland and the United States all adopted international accounting standards.
It took time, but by 1998, the G7 was hounding the International Accounting Standards Committee (IASC) to create a proposal for a full range of standards and practices that could bolster the international financial system through consistency and transparency.
After that, things progressed quickly, and in 2002, the European Union passed a law dictating that all publicly-traded companies and even insurance firms and banks adopt the IASC’s standards for financial reporting. By 2007, over 100 countries would get on board for IFRS reporting methods, and even the SEC would decree that American companies could adopt IFRS for their reports.
GAAP vs. IFRS: Primary Differences
GAAP is written with principles, but it is actually backstopped by rules and regulations, whereas IFRS actually is principles and not rules. This means the IFRS is more of a suggestion on what passes as transparency, concision and so on. The result is that IFRS requires less detail, which also means accountants have a little more leeway in their attributions. A consequence of this looser, leaner version of reporting is that lengthier disclosures are often required, but the framework, consistency and intuitive nature of IFRS reports often depict the economic transactions more astutely.
Another difference is that GAAP demands reports to include comprehensive income. IFRS, however, thinks comprehensive income is not an indicator of a company’s performance, and it is not included in the report. In its simplest terms, comprehensive income is revenue or loss that is from occurrences outside the company’s regular business operations. Think derivative instruments, foreign currencies transactions, pension losses and gains and debt securities — things that do not really register on the regular profit-and-loss sheet.
Most notably different, though, is the LIFO accounting process, which can be used in GAAP but not IFRS reporting. The last in, first out method is not widely used, but is attractive to businesses like car dealers with large and expensive inventories. It allows them to take advantage of rising prices and lower taxes so it can make the report look good. However, if they use it in that scenario, GAAP stipulates they must use it to report financial results to shareholders too.
Times May Change
With even the SEC preferring IFRS, the odds are pretty good that GAAP is heading for the pastures in coming years. Given the traded nature of firms involved with such reporting and the ever-increasing globalized world of business, adopting international accounting standards can mean companies have more consistent reporting over the long haul as their operations expand beyond borders.