Generally Accepted Accounting Principles (GAAP)

Generally Accepted Accounting Principles (GAAP) are a framework of accounting standards designed to ensure transparency, consistency, and integrity in financial reporting. Established in response to unethical financial practices observed during the Great Depression, GAAP comprises ten fundamental principles that govern how financial statements should be prepared and presented. These principles include regularity, consistency, sincerity, and materiality, among others, which collectively aim to provide a clear and truthful representation of a company’s financial health.

GAAP is primarily utilized by non-governmental accountants in the United States, while government entities adhere to similar guidelines set by the Governmental Accounting Standards Board (GASB). The Financial Accounting Standards Board (FASB) is the main organization responsible for developing and updating GAAP, ensuring the standards remain relevant to current business practices.

While all publicly traded companies must comply with GAAP, smaller entities may not be mandated to do so unless seeking investment or loans. The principles of GAAP are essential for protecting investors and maintaining trust in the financial markets. In contrast, international accounting practices are guided by the International Financial Reporting Standards (IFRS), which differ in structure and application, highlighting the importance of understanding the nuances between these two standards when analyzing financial information.

Published in: 2021

By: McBroom, Mandy M., MPH

Subject Terms

Generally Accepted Accounting Principles (GAAP)

Abstract

There are many opportunities for companies to mask or falsely report earnings or losses in the absence of regulations. During the Great Depression, many companies abused financial reporting, which was largely unregulated, even though some standards for transparency existed. In response to this dishonest reporting, a set of standards were devised to help guide responsible and transparent accounting practices and reporting. These standards are known collectively as Generally Accepted Accounting Principles (GAAP). GAAP is composed of ten tenets which govern responsible reporting. All non-governmental accountants use GAAP, while governmental agencies use a comparable set of principles.

Overview

To protect financial transactions and business, regulatory standards must be set in place to direct the conduct of financial reporting. Without these standards, companies would be able to dishonestly report their earnings, giving them an unfair advantage and enabling the deception of investors. A prime example of this deception was found during the Great Depression in 1929. Financial reporting practices were not regulated at the time and many businesses manipulated and deceived investors to protect themselves from further loss. This triggered the development of a set of standards for fair, transparent, and ethical financial reporting, termed Generally Accepted Accounting Principles (GAAP). Progenitor standards for GAAP first appeared in 1936, used by the American Institute of Accountants (AIA). Endorsement at the federal level for GAAP was found in the Securities Act of 1933, as well as the Securities Exchange Commission (SEC). As of 2018, GAAP regulation is within the auspices of the Financial Accounting Standards Board (FASB). The FASB is an independent entity that oversees and updates all non-governmental GAAP and independent authority. GAAP guidelines follow key principles of regularity, consistency, sincerity, permanence of methods, non-compensation, prudence, continuity, periodicity, materiality, and utmost good faith. Government entities adhere to a different set of GAAP standards as regulated by the Government Accounting Standards Board.

Governance of GAAP has changed hands several times since the stock market crash of 1929. Initially, the American Institute of Certified Public Accountants (AICPA) created the Committee on Accounting Procedure (CAP). In 1959, the AICPA found CAP to be insufficient to deal with a number of issues and appointed the Accounting Principles Board (APB). Operational issues in 1972 forced the AICPA to replace the APB with a group of three boards that had different responsibilities, all overseeing GAAP. These three boards were the Financial Accounting Foundation (FAF), FASB, and the Financial Accounting Standards Advisory Council (FASAC). The FASB has been the primary organization to regulate GAAP standards since 1973.

There is a hierarchy of GAAP an accountant needs to consult when solving a problem. At the top of the GAAP hierarchy resides statements by the FASB, shared by the AICPA. Next, there are FASB Technical Bulletins as well as the AICPA Industry Audit and Accounting Guides and Statements of Position. After that level, are AICPA Accounting Standards Executive Committee Practice Bulletins and FASB abstracts. The final and lowest level are the FASB implementation guidelines, AICPA accounting interpretations, and AICPA Industry Audit and Accounting Guides and Statement of position, an unofficial stance by AICPA. There are also unofficial guidelines that are included and deemed helpful.

GAAP guidelines were matured over the course of many iterations to include the following key principles: regularity, consistency, sincerity, permanence of methods, non-compensation, prudence, continuity, periodicity, materiality, and of utmost good faith. With regularity, this ensures that GAAP-compliant accountants always observe the established rules and regulations. Consistency enforces consistent standards that are applied across financial reporting. Sincerity guides GAAP-compliant accountants to be accurate and impartial. Permanence of methods ensures that consistency is applied in the preparation of financial reports. Non-compensation guards against compensation for financial reporting. Prudence guards against speculation (bias) in financial reporting. Continuity helps to protect asset valuations and helps to ensure an organization’s operations are maintained. Periodicity guides GAAP-compliant accountants to report at designated time points, usually quarterly or yearly. Materiality ensures that GAAP-compliant accountants are fully transparent about a company’s financial circumstances. Finally, the principle of utmost good faith assumes that all financial parties are honestly reporting.

In addition to the ten principles of GAAP, there are ten guidelines that organizations must follow in regard to standardization of reports, including the currency units, time periods, best practices for cost, professional judgement, conservatism in reporting, matching, and revenue recognition.

Since its takeover of GAAP regulatory responsibilities, the FASB has issued the Accounting Standards Codification, which is regularly updated. These standards include those originally issued by the APB that encompassed best practices. Some of the practices have roots going back further than the Great Depression. Even though there is a codification of standards for GAAP, there is no universal model observed by all businesses. It is more helpful for businesses to follow those best practices that reflect the nature of the appropriate industry (e.g., retail). However, in the United States, the SEC requires that all financial reports adhere to GAAP standards.

GAAP compliance is measured as: not GAAP-compliant, somewhat GAAP compliant, mostly GAAP compliant, and Fully GAAP compliant. Smaller companies are not required to use GAAP but when seeking credit or investors, GAAP protocols must be followed when preparing financial statements. All publicly traded companies must observe both SEC and GAAP requirements.

GAAP has evolved from more than authoritative entities. Foundational practices of transparency existed before an actual structure for GAAP existed. Some examples of these principles are straight-line and declining balance (depreciation methods). There were some disclosure principles originally required by the SEC during the Great Depression period. In fact, many of the statements of financial position and income evolved over time without being reflected in GAAP. Other unofficial sources of accounting principles can be found in FASB concept statements, AICPA issue papers, commentary from professional associations, AICPA practice aids, handbooks, and accounting textbooks.

While the FASB regulates GAAP overall, the Governmental Accounting Standards Board (GASB) sets requirements for state and local governments. The GASB has a set of processes that relay financial information for public consumption, and all stakeholders (lawmakers and constituents) depend on accuracy and transparency in government reporting. Nevertheless, fewer than half of U.S. states mandate local governments and school districts to use GAAP, though GASB reports that about 70 percent of county and local government offices use GAAP, even where it is not a requirement. At the state level, all fifty states prepare their financial reports using GAAP.

Further Insights

Each country has its own financial reporting standards. Outside of the United States, which is governed by the FASB, the International Financial Reporting Standards (IFRS) has emerged as the dominant set of standards. More than one hundred countries have adopted IFRS, which seeks harmonization of financial practices. The SEC has motioned to switch from GAAP to IFRS, but the suggestion remains controversial among governing bodies. Nevertheless, the FASB has been moving toward merging the IFRS and GAAP since 2002.

The IFRS was constructed to introduce harmonization of financial disclosures. This design includes a set of guidelines that sets accounting procedures, like GAAP, and helps investors and auditors understand international finances and make better decisions. The guidelines for financial reporting are general in nature and do not instruct specific aspects of industry. The main differences between GAAP and IFRS is that GAAP is rules-based and IFRS is principles-based. This means that the IFRS guidelines are less detailed than GAAP. This is good for harmonization purposes but allows more room for interpretation. Disclosures of financial statements are often lengthier than those mandated by GAAP. Some feel that IFRS is more intuitive and consistent, which makes these guidelines more logically sound. Another difference is in how inventory is reported. GAAP guidelines allow the last-in, first-out accounting method whereas IFRS does not. Both GAAP and IFRS permit first-in, first-out methods. Also, GAAP does not permit inventory reversals whereas IFRS does under specific conditions. Yet another difference between GAAP and IFRS is in the statement of comprehensive income. IFRS does not recognize comprehensive income as a performance indicator. This allows for blending owner and non-owner items on financial reports. As globalization expands the need for a completely harmonized guideline will become increasingly important. It is already evident in GAAP reporting metrics, where North American earnings reports dropped more than 50 percent in the twelve years between 2004 to 2016.

GAAP does not cover all operations of business. Operations or costs that do not fall under GAAP are considered non-GAAP, and are not regulated per se, but are expected to be reported along with GAAP standard reports. These costs typically include irregular or noncash expenses, restructuring, litigation costs, or one-time balance sheet adjustments. These costs are referred to as pro forma expenses. Without reporting these non-GAAP items, it leaves an incomplete financial picture. These items can help provide a view of future business health. These reports can be constructed in a way that hides these important outlooks and can mislead investors. The justification for reporting non-GAAP earnings is that one-time purchases or expenses can distort the true performance of a company. Often companies will exclude these items because they are not likely to occur again in the next fiscal year. To address these expenses it is common for companies to report adjusted earnings, which includes earnings before interest, taxes, depreciation, free cash flows, adjusted earnings, and amortization. When non-GAAP earnings are honestly and accurately reported, it provides a better picture of a company’s performance and overall value.

Issues

It is important for investors to identify when it is appropriate to consider non-GAAP versus GAAP figures. Because these financial reports can be misleading and demonstrate an incomplete financial picture of a company’s performance, more credence should be given to GAAP measurements. The more a non-GAAP report diverges from GAAP, the more suspect it should become. This is because combined GAAP and non-GAAP reports are more likely to hide the losses over gains. This is evidenced in the discrepancy between GAAP net income and non-GAAP profits shared by Dow Jones Industrial Average companies, where indicated growth increased from 11.8 percent in 2014 to 30.7 percent in 2015. This deceptive reporting was mainly due to the volatility of currency and commodity markets across many industries.

Studies performed by academic and professional organizations have shown that it is important to consider GAAP and non-GAAP reporting. When considering both types, investors are encouraged to look at particular exclusions of adjusted figures; personal economic outlooks are important, as well. The discrepancies that occurred in 2015 left many investors dubious about trusting the integrity of the reports, as accountants were clearly using loopholes to circumvent negative reporting. In this case, it is more likely that bullish investors should be heavily considering non-GAAP reports for an indication of company financial outlook. Companies that frequently purchase smaller firms are more likely to exclude acquisition-related costs because the ongoing costs would diminish the bottom line or cloud the predictive power of financial outlook forecasts. Therefore, those non-GAAP reports that are adjusted for items like equity compensation are less reliable for use. That being stated, there are responsible companies that use non-GAAP reporting to present an accurate financial picture, and these companies build trust with investors.

Because some companies, mainly technology companies, are frequent abusers of non-GAAP reporting, the SEC created a mandatory measure called Regulation G (Reg G), in 2017. This measure was enacted to ensure that GAAP financial statements are reported before non-GAAP earnings. Technological companies are notorious for abusing non-GAAP reporting because they acquire a large amount of asset impairments and R&D costs. Lastly, companies are also required to reconcile pro forma and GAAP numbers for transparency.

Terms & Concepts

Accounting Principles Board (APB): Regulatory board of the AICPA that was formed in the Great Depression Era. It was later replaced by the FASB. Principles of the board are still used in GAAP regulations today.

Accounting Standards Codification: A listing of GAAP principles and explanation of said principles, that are produced by the FASB and updated on a regular basis.

APB Opinion: Official issuance created by the APB, to assimilate and interpret stances on financial issues and policies. From 1962 to 1973, the APB issued thirty-one opinions, some of which are still codified in modern GAAP.

Financial Accounting Standards Board (FASB): Regulatory board that replaced the APB in overseeing GAAP regulations and principles. The board consists of seven independent and impartial members who are members of the accounting community. The FASB is the highest-ranking board for the oversight of GAAP.

Generally Accepted Accounting Principles (GAAP): A set of ten principles for accounting that govern responsible and transparent financial reporting. Large companies are required to follow GAAP reporting while smaller companies are not. Government entities are required to follow a similar set of accounting principles.

Pro Forma Earnings: Earnings that are typically considered non-GAAP, meaning any non-cash items (asset impairment), restructuring charges, litigation fees, or amortization costs. Before Regulation G, created in 2015 to protect investors against omissions and false reports of non-GAAP items, pro forma earnings were not regulated. This resulted in a loss of confidence from investors to utilize financial reports from technological companies.

Bibliography

Bently, J. W., Christensen, T. E., Gee, K. H., & Whipple B. C. (2018). Disentangling managers’ and analysts’ non-GAAP reporting. Journal of Accounting Research, 56(4), 1039–1081. Retrieved from EBSCO Online Database Business Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=131152809&site=ehost-live

Black, E., Christensen, T. E., Kiosse, P. V., & Steffen, T. D. (2017). Has the regulation of non-GAAP disclosures influenced managers’ use of aggressive earnings exclusions? Journal of Accounting, Auditing & Finance, 32(2), 209–240. Retrieved December 15, 2018 from EBSCO Online Database Business Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=121748212&site=ehost-live

Black, E., Christensen, T. E., Taylor, J. T., & Schmardebeck, R. (2017). The relation between earnings management and non-GAAP reporting. Contemporary Accounting Research, 34(2), 750–782. Retrieved December 9, 2018 from EBSCO Online Database Business Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=123411565&site=ehost-live

Burton, G. F., & Jermakowicz, E. K. (2015). International financial reporting standards: A framework-based perspective. New York: Routledge.

Cohn, M. (2018). SEC chief accountant warns against mischief in non-GAAP reporting. Accountingtoday.com, 1. Retrieved December 16, 2018 from ESBCO Online Database Business Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=129452250&site=ehost-live

FASB issues maintenance update for Accounting Standards Codification. (2017). Journal of Accountancy, 224(2), 1. Retrieved December 15, 2018 from EBSCO Online Database Business Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=124672087&site=ehost-live

Flood, J. M. (2018). Wiley GAAP 2018: Interpretation and application of generally accepted accounting principles. Hoboken, NJ: John Wiley & Sons.

Hogan, B. R., Krishnamoorthy, G., & Maroney, J. J. (2017). Pro forma earnings presentation effects and investment decisions. Behavioral Research in Accounting, 29 (2), 11–24. Retrieved December 9, 2018 from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=125222751&site=ehost-live

Leung, D., & Veenman, D. (2018). Non-GAAP earnings disclosure in loss firms. Journal of Accounting Research, 56(4), 1083–1137. Retrieved December 15, 2018 from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=131152812&site=ehost-live

Generally Accepted Accounting Principles (GAAP)

On this Page

Subject Terms

Generally Accepted Accounting Principles (GAAP)

Abstract

Overview

Further Insights

Issues

Terms & Concepts

Bibliography

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