Generally accepted accounting principles (GAAP) comprise a set of accounting rules and procedures used in standardized financial reporting practices. By following GAAP guidelines, compliant organizations ensure the accuracy, consistency, and transparency of their financial disclosures.
Publicly traded companies, businesses operating in regulated industries, registered nonprofit groups, government agencies, and organizations that receive federal funding awards from the U.S. government are required to follow GAAP. Other businesses may also adopt the standards on a voluntary basis.
Many reputable accounting degree programs teach generally accepted accounting principles as part of their curricula. This guide for accounting students explores GAAP standards and how they continue to evolve in a changing economy.
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What Are the Basic Principles of Accounting?
These 10 guidelines separate an organization's transactions from the personal transactions of its owners, standardize currency units used in reports, and explicitly disclose the time periods covered by specific reports. They also draw on established best practices governing cost, disclosure, matching, revenue recognition, professional judgment, and conservatism.
- Principle of Regularity: GAAP-compliant accountants strictly adhere to established rules and regulations.
- Principle of Consistency: Consistent standards are applied throughout the financial reporting process.
- Principle of Sincerity: GAAP-compliant accountants are committed to accuracy and impartiality.
- Principle of Permanence of Methods: Consistent procedures are used in the preparation of all financial reports.
- Principle of Non-Compensation: All aspects of an organization's performance, whether positive or negative, are fully reported with no prospect of debt compensation.
- Principle of Prudence: Speculation does not influence the reporting of financial data.
- Principle of Continuity: Asset valuations assume the organization's operations will continue.
- Principle of Periodicity: Reporting of revenues is divided by standard accounting periods, such as fiscal quarters or fiscal years.
- Principle of Materiality: Financial reports fully disclose the organization's monetary situation.
- Principle of Utmost Good Faith: All involved parties are assumed to be acting honestly.
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History of GAAP
Without regulatory standards, companies would be free to present financial information in whichever format best suits their needs. With the ability to portray a company's fiscal standing in a favorable light, investors could be easily misled.
The Great Depression in 1929, a financial catastrophe that caused years of hardship for millions of Americans, was primarily attributed to faulty and manipulative reporting practices among businesses. In response, the federal government, along with professional accounting groups, set out to create standards for the ethical and accurate reporting of financial information.
According to accounting historian Stephen Zeff in The CPA Journal, GAAP terminology was first used in 1936 by the American Institute of Accountants. Federal endorsem*nt of GAAP began with legislation like the Securities Act of 1933 and the Securities Exchange Act of 1934, laws enforced by the U.S. Securities and Exchange Commission (SEC) that target public companies. Today, the Financial Accounting Standards Board (FASB), an independent authority, continually monitors and updates GAAP.
All 50 state governments prepare their financial reports according to GAAP. The Governmental Accounting Standards Board (GASB) estimates that about half of the states officially require local and county governments to adhere to GAAP.
Who Develops GAAP?
Government institutions, including federal legislative and judicial branches, enforce compliance with GAAP guidelines. However, the government itself plays no role in developing or updating the associated accounting practices. Instead, that is left to private organizations and independent boards.
The following subsections introduce and explain the roles that various boards and organizations play in the ongoing development of generally accepted accounting principles.
Financial Accounting Foundation
The Financial Accounting Foundation (FAF) was formed in 1972 as the administrative corporation that oversees the FASB and the GASB.
The FAF is responsible for appointing board members and ensuring that these boards operate fairly and transparently. Members of the public can attend FAF organization meetings in person or through live webcasts.
Financial Accounting Standards Board
On the recommendation of the American Institute of CPAs (AICPA), the FASB was formed as an independent board in 1973 to take over GAAP determinations and updates. The board comprises seven full-time, impartial members, ensuring that it works for the public's best interest.
The 35-member Financial Accounting Standards Advisory Council monitors the FASB. FASB is responsible for the Accounting Standards Codification (ASC), a centralized resource where accountants can find all current GAAP.
The FASB Standards-Setting Process
- Identify current investor issues
- Draft issue agenda and hold public meetings
- Publish exposure draft for investor commentary
- Invite stakeholder feedback and host public hearings
- Weigh all public responses and revise accordingly
- Announce final revisions to the ASC
Recent Major Projects
- Defining a Reporting Entity: Adopted in June 2023, these FASB changes introduced a standardized definition of a "reporting entity." Prior to the change, the FASB's governing Conceptual Framework referenced the notion of a "reporting entity" without actually explaining the term with the necessary precision.
- Recognition and Derecognition: In August 2023, the FASB issued new guidance on when specific line items should be included in or excluded from financial statements. Inclusionary standards are known as "recognition," and exclusionary standards are known as "derecognition."
- Accounting Standards Update No. 2023-06: The FASB updated its guidelines to include 14 new SEC disclosure rules in its accounting standards. These highly technical changes mainly function to facilitate easier and more direct comparisons of the financial statements issued by organizations subject to varying SEC disclosure requirements.
- Accounting for and Disclosing Cryptocurrency Assets: Cryptocurrencies have been a disrupting force since their emergence in the financial mainstream during the 2010s. These standards, adopted by the FASB in December 2023, established guidelines for compliant organizations to use in disclosing their cryptocurrency-based assets to investors.
Governmental Accounting Standards Board
The GASB was established in 1984 as a policy board charged with creating GAAP for state and local government organizations. Many groups rely on government financial statements, including constituents and lawmakers. GASB prioritizes fairness and transparency. The board's processes and communications are available for public review.
The GASB Standards-Setting Process
- Create an independent task force
- Conduct research on the subject of the new standard
- Engage the public through published commentary
- Create an exposure draft of the planned standard
- Host a public hearing before the standard is finalized
Recent Major Projects
- Omnibus 2022: Enacted in April 2022, this package of reforms implemented technical changes to an extensive set of accounting issues. It was developed in response to gaps and shortcomings encountered by accounting practitioners.
- Disclosure Framework: This June 2022 change to the GASB's Conceptual Framework focused on financial reporting practices used by government agencies. It established criteria for assessing note disclosure requirements for both current and future activities covered in government financial reports.
- Risks and Uncertainties Disclosures: In December 2023, the GASB approved a project intended to lead to the potential development of new disclosure standards for the risks and uncertainties faced by state and local government agencies.
- Financial Reporting Model: This April 2024 project reexamined multiple GASB financial reporting model standards, implementing a set of changes to improve the model's overall accuracy and functionality. The new standards apply to various public institutions, including local governments, state governments, and publicly funded colleges.
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Non-GAAP Reporting
Also known as "pro forma" reporting, non-GAAP reporting describes financial statements, reporting standards, and disclosures that were not prepared using GAAP guidelines. They may be used by U.S. businesses and organizations not subject to GAAP requirements, or by certain international entities operating in U.S. capital markets.
Non-GAAP reporting is the subject of much debate among accountants and financial regulators in the United States. Proponents of non-GAAP reporting standards contend that many associated practices offer useful financial insights that cannot be generated solely by following GAAP guidelines. They also contend that as a matter of standard practice, organizations clearly label all documented financial information generated by non-GAAP measures.
The opposing viewpoint holds that GAAP practices create a transparent standard that facilitates direct comparisons and accurate analysis. Non-GAAP accounting techniques deviate from these standards by definition, leading some professionals and stakeholders to dispute or reject their use.
The SEC receives a large number of comments and complaints about the issue. In December 2022, the SEC updated the standards it uses when evaluating financial disclosures that contain pro forma reporting. However, as of June 2024, the underlying debate remains without a definitive resolution.
Limitations of GAAP
While GAAP accounting strives to alleviate incidents of inaccurate reporting, it is by no means comprehensive. Companies can still suffer from issues beyond the scope of GAAP depending on their size, business categorization, location, and global presence.
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Diverse Types of Companies
GAAP may seem to take a "one-size-fits-all" approach to financial reporting that does not adequately address issues faced by distinct industries. For example, state and local governments may struggle with implementing GAAP due to their unique environments. New GAAP hierarchy proposals may better accommodate these government entities.
Small businesses may also struggle with implementing GAAP. These standards may be too complex for their accounting needs, and hiring personnel to create GAAP-compliant reports can be expensive. As a result, the FASB works with the Private Company Council to update GAAP with private company exceptions and alternatives.
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Timeframe
Due to the thorough standards-setting process of the GAAP policy boards, it can take months or even years to finalize a new standard. These wait times may not benefit companies complying with GAAP, as pending decisions can affect their reports.
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Global vs. Domestic
GAAP is not the international accounting standard, which is a developing challenge as businesses become more globalized. The International Financial Reporting Standards (IFRS) is the most common set of principles outside the United States.
What Is the IFRS?
The IFRS system is widely used outside the United States. IFRS principles are issued and updated by the International Accounting Standards Board (IASB), an independent and private organization based in London. As of June 2024, IFRS guidelines are used in more than 100 countries, including most major economies in Europe, South America, and Asia.
Formal collaboration between the FASB and the IASB dates back to 2002, when the two entities formed a partnership known as the Norwalk Agreement. Under the agreement's terms, the FASB and the IASB established the joint objective of developing accounting standards with international cross-jurisdictional compatibility.
Despite some progress under the Norwalk Agreement, the FASB and the IASB continue to battle friction resulting from fundamental disagreements at the governance level. As of June 2024, the United States has not fully adopted IFRS principles, and domestic U.S. companies remain bound to GAAP reporting guidelines. However, the FASB and the IASB remain active collaborative partners and continue to work toward the formation of uniform international accounting standards.
Notably, IFRS standards do apply to some business entities operating in the United States. Foreign-based companies registered with the SEC use IFRS reporting guidelines in their U.S. disclosure filings. Some U.S. small and mid-size enterprises (SMEs) voluntarily use IFRS accounting procedures, which are neither expressly permitted nor prohibited under applicable U.S. laws.
IFRS vs. GAAP
The major difference between the GAAP and IFRS systems relates to the concept of "rules" versus "principles." Despite the presence of the word "principles" in its name, the GAAP system is rules-based and largely inflexible in its requirements. Meanwhile, IFRS standards are principles-based, offering more latitude and subjectivity when interpreting guidelines.
While both systems intend to protect the integrity and accuracy of financial disclosures, they also diverge in significant ways. The following table offers a high-level summary of some of the major differences between them:
| Key Difference | GAAP | IFRS |
|---|---|---|
| Conceptual Framework | Non-authoritative and not typically referenced by accountants when preparing financial statements | Conceptual Framework guidance is authoritative |
| Basic Preparation of Financial Statements | Specific disclosures are required if an entity faces the imminent need to liquidate | No specific disclosure standards apply with regard to potentially imminent liquidation |
| Forms and Components of Financial Statements | Comparative data is encouraged but not requiredBusinesses with multiple subsidiaries must issue consolidated financial statements | Comparative data is required when it applies to material disclosuresExemptions are available to some businesses with multiple subsidiaries that wish to consolidate their financial statements |
| Statement of Financial Position | SEC registrants must conform to regulations regarding the format and presentation of a minimum number of line items | Certain line items are required to be presented, but there is no prescribed format |
Frequently Asked Questions About GAAP
What is GAAP in simple terms?
GAAP is a set of accounting rules and procedures that domestic, publicly traded U.S. companies must use in their financial disclosures. The guidelines also include industry-specific guidance and standards to be followed by government agencies and nonprofit groups.
What are the basic principles of accounting?
Basic GAAP standards include the going concern, accrual, consistency, historical cost, materiality, and conservatism principles. These six essential standards form a fundamental accounting framework for businesses that use generally accepted accounting principles, either on a voluntary or mandatory basis.
What is an example of GAAP?
The "last-in first-out" (LIFO) principle is a good example of GAAP: LIFO reporting applies to inventory valuation and is only used in the United States. Under the LIFO method, the most recent inventory assets produced or purchased are the first to be tracked in expense reporting.
Who must abide by GAAP?
Domestic U.S. companies whose securities trade on public exchanges must use GAAP guidelines, as do businesses operating in regulated industries. GAAP standards also apply to nonprofit organizations and government agencies. Other for-profit entities may also use the guidelines on a voluntary basis.
Which GAAP principle is most important?
The principle of regularity is often cited as the most important GAAP standard. It compels accountants to honor and use all active reporting standards and regulations when preparing financial statements. Experts sometimes describe the principle of regularity as the bedrock upon which all other GAAP standards rest.
Page last reviewed June 12, 2024
