GAAP is short for Generally Accepted Accounting Principles. GAAP finance rules are used to produce clear, consistent financial reports and to let investors analyze them easily.
What Are GAAP Finance Rules?
The Generally Accepted Accounting Principles are a set of commonly used procedures, standards, and principles that accounting professionals use when compiling various financial statements. GAAP combines authoritative standards and accepted methods to help companies record and report many types of accounting information. In short, GAAP serves to facilitate the clear communication of a company’s overall financial situation.
GAAP is often contrasted with IFRS standards and pro forma methods of accounting. You’ll often see these alternate modes referred to as ‘non-GAAP.’
GAAP Finance Rules and the 10 Principles that Drive Them
The purpose of GAAP finance rules is to make sure that a corporation’s financial statements meet a minimum standard of consistency. This consistency makes it easier for investors to interpret a company’s financial reports and pull relevant information from them. Because of the consistency that GAAP helps create, it is also much easier to compare the financial situation of various companies.
The following ten principles create common ground for the accounting methods of different companies and can help you remember what GAAP is supposed to accomplish:
1.The Principle of Regularity:
This means the accountant has followed GAAP finance rules and used them to standardize their company’s financial reporting.
2. The Principle of Consistency:
This means that accounting professionals are committed to applying the same standards throughout the entire reporting process. The purpose of adhering to identical standards is to prevent discrepancies, errors and to help their clients claim the . It’s expected that accountants fully disclose the reasons they have for updating or changing any of these standards.
3. The Principle of Sincerity:
An accountant will strive to give an accurate picture of the financial situation of a business.
4. The Principle of Permanence of Methods:
All financial reporting procedures should be consistent.
5. The Principle of Non-Compensation:
The entire portrayal of a company’s financial situation—both positives and negatives—should be presented transparently and with no expectation of any debt compensation.
6. The Principle of Prudence:
This principle emphasizes that any financial information the accountant presents should be based upon fact and not muddled by guesswork or speculation.
7. The Principle of Continuity:
Whenever assets are evaluated, there is an assumption that the company is going to remain in operation.
8. The Principle of Periodicity:
All entries must be distributed over the appropriate time periods. For instance, revenue reports need to be divided by the relevant timeframes.
9. The Principle of Good Faith or Materiality:
Accountants must seek full disclosure in all their financial reports.
10. The Principle of Utmost Good Faith:
This is derived from ‘uberrimae fidel,’ a Latin phrase which is commonly used in the insurance industry. It assumes that all parties will be honest when conducting transactions.
GAAP needs to be followed whenever a business is distributing its financial statements externally. As long as a company’s stock is publicly traded, the financial statements have to follow the various rules of the United States Securities and Exchange Commission or SEC.
GAAP covers outstanding share measurements, balance sheet item classification, and revenue recognition. If a financial statement isn’t up to GAAP standards, investors should be cautious. There are companies who use both GAAP standards and non-GAAP-compliant measures to report their finances. But GAAP regulations demand that any non-GAAP measures are disclosed within all financial and public statements. This transparency tells investors what they should be paying the closest attention to.
GAAP is intended to improve any and all financial reporting. It is a framework for the principles that public accountants use when preparing financial statements.
The top level of the GAAP hierarchy are opinions by the American Institute of Certified Public Accountants (AICPA) and statements by the Financial Accounting Standards Board (FASB). The second level is made up of technical bulletins from the FASB as well as position statements, accounting, and audit industry guides from the AICPA. The third level offers positions from the Emerging Issues Task Force (EITF) of FASB and practice bulletins from the Accounting Standards Executive Committee of AICPA. This level also has topics from Appendix D from EITF Abstracts. The lowest level includes implementation guides from FASB, and position statements, accounting guides, and accounting interpretations from AICPA that aren’t yet cleared by the FASB.
Accountants are directed to consult the top level of the hierarchy. They only move down the ladder when the higher levels aren’t relevant. A more thorough explanation of the hierarchy can be found in No. 162 of the Statement of Accounting Standards from the FASB.
The Reliability of GAAP Compliant Financial Reporting
Remember that GAAP finance rules are only standards that accounting professionals are expected to meet. While the guidelines of the GAAP are designed to increase the transparency of financial reporting, they do not guarantee that a given company will issue financial statements that are honest and accurate. Unfortunately, GAAP does leave a great deal of room for unscrupulous accounting practices otherwise called “Earnings Management“. Therefore, you must always examine a company’s financial statements carefully, even if they claim adherence to generally accepted principles.
About Esther Kim
Esther is a licensed Certified Public Accountant (CPA) and Certified Fraud Examiner (CFE). She obtained specialized designations in the accounting field as a Certified Financial Forensic (CFF), Chartered Global Management Accountant (CGMA), and Certified Information Technology Professional (CITP). She has worked in the capacity of an interim Chief Financial Officer, interim controller, and financial consultant for several small and medium sized companies for over 10 years. Esther specializes in high potential start-ups from the conceptual stages, such as formulating business plans and helping obtain seed funding, to scaling them in putting infrastructure and systems in place for rapid growth. She graduated with a Bachelor of Arts degree from the University of California, Los Angeles (UCLA) with a triple major in Economics, East Asian Studies and Sociology within four years and obtained a Master of Public Policy degree, and a Master of Arts in Humanities with distinction from California State University Northridge (CSUN).