Generally accepted accounting principles, typically shortened to GAAP, are a collection of rules and regulations that control how financial statements need to be created and shown. GAAP rarely affect individuals that do not have complex finances or taxes, but they are very important for businesses of all kinds. GAAP are not static: they change based on changing laws and may differ slightly from state to state or between business types. These principles have several very important functions.
First, GAAP help create a uniform tax code for states and the IRS. Without generally accepted accounting principles, these organizations would have difficulty asking for specific financial information from businesses and would not be able to institute widespread changes effectively. For instance, depreciation schedules are an aspect of accounting directly related to taxes and regulated by the IRS. Without these accounting principles, each business could choose a different type of depreciation schedule and taxation would become difficult if not impossible. Tax regulations often form the backbone of GAAP.
GAAP is also vital for investors researching potential companies to invest in, usually by buying stock and therefore ownership in that company. GAAP structures the major financial statements and allows investors to examine the same information between different companies, allowing for comparison. General accounting principles also require a certain amount of openness and displayed information from corporation to their investors, frequently mandated and updated by the federal government.
The United States is not the only country to use generally accepted accounting principles. In the international framework of business there are several different types of accepted accounting principles used by companies (German GAAP, for instance, is a separate set of principals). Together these accounting principles allow countries to understand the financial systems other nations use and successfully transact business with each other. GAAP also pave the way for an international set of principles that countries can use in common, which is being slowly created as a combination between the most popular GAAP systems.
One purpose of the U.S. GAAP is to allow for flexibility. Accounting principles are not designed to regulate every single accounting decision made. They try to leave room for companies to make different decisions, use different methods and move money around easily and quickly. GAAP attempt to straddle the line between improving honesty and preventing fraud while still allowing businesses to be creative and use funds as they need to.