Generally Accepted Accounting Principles (GAAP): A Guide

Generally Accepted Accounting Principles (GAAP) are a set of rules, guidelines, and principles that U.S. companies of all sizes and across industries adhere to. In the U.S., these accounting standards have been established by the Financial Accounting Standards Board (FASB) and the Governmental Accounting Standards Board (GASB).

For companies that follow GAAP accounting principles, they are at the core of all of their accounting transactions. Businesses use these guidelines to organize and summarize financial information into accounting records.

In the following article, we’ll explore what the generally accepted accounting principles are, who uses them, and why GAAP is important.

Key Takeaways 

• GAAP is an important set of accounting standards in the U.S., used to standardize the financial statements of companies that are publicly traded.
• There are 10 main principles a GAAP-compliant accountant must adhere to, to ensure the company’s financial statements remain clear, standardized, and consistent.
• Four additional constraints are applied to ensure the integrity of GAAP-compliant accounting: recognition, measurement, presentation, and disclosure.
• As a rule, GAAP accounting uses accrual accounting methods, depreciation, historical cost, and bad debt reporting.
• GAAP is a U.S.-based standard, but internationally, the most commonly used accounting regulations are the International Financial Reporting Standards (IFRS).

Table of Contents

• What Is GAAP?
• Who Uses GAAP?
• GAAP Compliance
• 10 Core GAAP Principles
• Additional 4 GAAP Principles
• GAAP Rules
• GAAP vs. IFRS
• Why Is GAAP Important?
• Simplifying Accounting with FreshBooks
• Frequently Asked Questions

What Is GAAP?

GAAP is a set of accounting standards used in the United States to help publicly traded companies create their financial statements. These standards form the groundwork on which more comprehensive, complex, and legalistic accounting rules are based.

GAAP accounting practices cover a wide array of topics such as financial statement presentation, liabilities, assets, equities, revenue and expenses, business combinations, foreign currency, derivatives and hedging, and non-monetary transactions.

Financial accounting information is based on historical data. To facilitate comparisons, the information must follow generally accepted accounting principles.

Who Uses GAAP?

Publicly traded companies in the U.S. are required by the Securities and Exchange Commission (SEC) to follow GAAP, whereas private companies, state and local governments, and nonprofit organizations may choose to use GAAP standards or be required to follow its accounting principles by funders, lenders, investors, or regulators. Its relevance varies among private companies depending on their financial goals, like preparing for an initial public offering (IPO).

Many small businesses issue financial statements that don’t adhere to GAAP guidelines when reporting financial information. These alternatives are known as “other comprehensive basis of accounting” (OCBOA) methods, and they include cash basis accounting, modified cash basis, income tax basis, and regulatory basis.

In the European Union and other areas outside of the U.S., most public companies follow International Financial Reporting Standards (IFRS) rather than U.S. GAAP.

GAAP Compliance

Compliance is what it’s called when publicly traded companies in the U.S. use the same standards and principles set out by the Financial Accounting Standards Board (FASB). GAAP rules are useful for investors because they require all companies to present their financial information using the same standard metrics across the board, making it easier to make direct comparisons and financial decisions. 

These rules also help businesses successfully pass external audits with ease, as they ensure consistency, and help the auditor to compare numbers between similar entities. GAAP makes it easy for them to see that the financial records are complete and consistent. 

If a company is required to follow GAAP and is non-compliant with its standards, it may face serious fines and will lose credibility in the domestic and international business world. They might also face internal financial issues, in the case of incomplete or erroneous bookkeeping. 

10 Core GAAP Principles

The following are ten principles used to keep a company’s financial reporting consistent, clear, and standardized. These principles must be followed, otherwise, the company will face serious consequences like a loss of market credibility, and steep fines.

1. Principle of Regularity

The principle states that the accountant has to follow all GAAP rules and regulations in the accounting process. In other words, you can’t pick and choose which GAAP rules to follow.

2. Principle of Consistency

The accountants should enter all transactions and prepare all financial reports with a consistent presentation throughout the financial reporting process. By using consistent procedures and applying similar standards in the reporting process, accountants can avoid errors or discrepancies.

If a company changes the way it records or presents financial documents, the accountants are expected to disclose and explain the reasons behind the changes.

3. Principle of Sincerity

As per this principle, the accountant should provide an accurate and honest depiction of the business’s current financial situation in all financial reporting.

4. Principle of Permanence of Method

The focus of this principle is that there should be consistency in the procedures used in financial reporting.

5. Principle of Non-Compensation

The full financial information details should be disclosed, including negatives and positives. In other words, the financial report shouldn’t compensate (offset) a debt with the company’s assets or expenses with revenues.

6. Principle of Prudence

The financial data representation should be done “as it is” and not based on any speculation.

7. Principle of Continuity

The principle assumes that the business will continue its operations in the future.

8. Principle of Periodicity

The accounting entries are distributed across suitable reporting periods, such as quarterly or annually.

9. Principle of Materiality

While creating financial reports, accounting professionals must strive to disclose all situations, circumstances, events, and other commitments that are relevant to financial statement users.

10. Principle of Utmost Good Faith

This principle states that all parties involved in reporting financial data are expected to act honestly and in good faith.

While large companies primarily use the GAAP principles, if you want to eventually take your company public, you should follow these GAAP accounting guidelines early on.

Additional 4 GAAP Principles

These four principles can be seen as additional constraints placed upon accountants using GAAP when preparing financial statements. They are in place to ensure the consistency and integrity of the documents and are different from the ten principles already mentioned. 

1. Recognition

The financial statements must be thorough, and accurately show all of the assets, liabilities, expenses, revenue, and financial commitments the company holds. There must not be any modifications or omissions, whether deliberate or accidental.

2. Measurement

The financial statements must be created following all of the ten principles so they meet GAAP standards. They should always measure the organization’s performance and financial results by GAAP.

3. Presentation

Each financial statement provided by a company should be presented in the same way, with a balance sheet, an income statement, a statement of shareholder equity or statement of Net Assets, a statement of ownership, and a cash flow statement.

4. Disclosure

All GAAP financial statements should include a section disclosing any additional, relevant information required to understand the financial reports. This could be presented as an addendum, in footnotes, or otherwise included notes. 

GAAP Rules

The Financial Accounts Standards Board (FASB) has established the rules required for a business to be by GAAP standards of practice. Some of the biggest rules set out by the board are as follows:

• Accrual Accounting

GAAP accounting is accrual accounting, meaning revenue is recorded the moment a good or service is sold, not when money changes hands. Direct expenses are noted at the time of sale, while indirect expenses are recorded once the expense is paid. Accrual-based accounting gives an accurate snapshot of a company’s current financial condition, giving investors a good look at the actual state of the business’ health.

• Depreciation

Calculating the total cost of an asset, the length of time an asset will last before it needs replacing, and how much it can be sold for at the end of its useful life will help an accountant depreciate the asset under GAAP. Calculating asset valuations in this way provides an accurate representation of its current value, allowing investors to make better-informed decisions.

• Historical Cost

The company must account for, and record assets at their original purchase price on the balance sheet, without adjustments for inflation or market changes as time goes on. This prevents overstating the asset’s value in the future, especially when its appreciation is due to a volatile market. 

• Bad Debts

Companies that have a large amount of money owed to them by customers, and are unable to collect, must report an expense to offset the revenue reported at the time of sale. A high level of bad debt may cause potential investors to shy away, as the company may look to be taking too many financial risks.

GAAP vs. IFRS

While GAAP standards are necessary for public companies in the U.S., and internationally, the International Financial Reporting Standards (IFRS) are the most commonly used accounting regulations and can be found in use in over 100 countries worldwide. 

IFRS rules are maintained, overseen, and updated regularly by the International Financial Reporting Standards Foundation. Both methods are designed to maintain transparency, clarity, and organization, with some key differences. For example, IFRS does not allow last-in first-out (LIFO) inventory accounting, but GAAP does. 

While public U.S. businesses must adhere to the GAAP rules, private businesses may choose to follow IFRS or other non-GAAP standards. Companies with international operations can benefit from incorporating IFRS methods, as it’s used in most of the world. 

Why Is GAAP Important?

The biggest reason GAAP accounting is important is to maintain investor trust within the financial market. GAAP-compliant financial statements are standardized, easy to understand, and make it simpler for investors to analyze companies’ financial dealings with side-by-side analysis. 

GAAP keeps corporate accounting and reporting consistent, and ensures that all entities remain accountable by requiring them to openly report all financial gains and losses accurately. Because all terms, practices, and procedures are standardized, investors will be more likely to make transactions, effectively lowering transaction costs and strengthening the country’s economy. 

Simplifying Accounting with FreshBooks

Generally accepted accounting principles are put in place to keep accounting processes consistent for public companies. These standards and practices ensure transparency and accuracy across various industries throughout the United States, guiding the preparation, presentation, and reporting of financial statements. 

If you’re running your own business, FreshBooks accounting software can help you with accurate financial reporting, automate your revenue and expense tracking, and simplify your accounting process to make it easier than ever to meet the requirements set out by GAAP. 

Want to learn more about how FreshBooks can help? Try FreshBooks free today. 

FAQs About GAAP

The following frequently asked questions will further explore some GAAP examples, common GAAP violations, and more about generally accepted accounting principles in the U.S. 

What is an example of GAAP?

An example of GAAP would be when an accountant working in a publicly owned company only 

reported revenue at the time it was earned, which will likely be before the cash is received. They would also report the expense or product of activity at the time of sale, not when the cash is paid out on the invoice.

Which GAAP principle is most important?

The most important generally accepted accounting principle is likely the objectivity principle, as it states that all financial statements must be based upon objective evidence. This keeps financial records accurate and transparent, with full documentation, and does not allow for accountants to insert their own biases or judgments. 

What are three common GAAP violations?

3 GAAP violations to avoid include using the accelerated depreciation methods allowed in the tax code, escalating or varied rent payments, and the capitalization of overhead costs, like applying overhead costs incorrectly to the value of inventory, and not accounting for the actual capacity versus production for cost allocation. 

What are the four financial statements required by GAAP?

The four financial statements required by GAAP are balance sheets, statements of shareholder and owner’s equity (or statement of net assets for nonprofits), statements of cash flows, and income statements. These four items give an excellent overall view of the company’s financial health and growth potential.  

What companies are bound to the generally accepted accounting principles?

Publicly traded domestic U.S. companies are required by law to follow GAAP procedures. This includes for-profit companies, not-for-profits, and government entities. Private businesses may also choose to follow GAAP procedures as they keep financial information consistent and organized, but they are not required to do so.

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