Generally Accepted Accounting Principles (GAAP) refer to the standard framework of guidelines for financial accounting used in any given jurisdiction; generally known as Accounting Standards. GAAP includes the standards, conventions, and rules accountants follow in recording and summarizing , and in the preparation of financial statements.
US GAAP
The term "GAAP" is an abbreviation for Generally Accepted Accounting Principles (GAAP). GAAP is a codification of how CPA firms and corporations prepare and present their business income and expense, assets and liabilities on their financial statements. GAAP is not a single accounting rule, but rather the aggregate of many rules on how to account for various transactions. The basic principles underlying GAAP accounting are set forth below.
When preparing financial statements using GAAP, most American corporations and other business entities use the many rules of how to report business transactions based upon the various GAAP rules. This provides for consistency in the reporting of companies and businesses so that financial analysts, Banks, Shareholders and the SEC can have all reporting companies preparing their financial statements using the same rules and reporting procedures. This allows for an "Apple to Apple" comparison of any corporation or business entity with another. Thus, if Company A reports $1,000,000 of net income, using GAAP, then the public and other users of financial statements can compare that net income to another company that is reporting $500,000 of net income, using GAAP.
The rules and procedures for reporting under GAAP are complex and have developed over a long period of time. Currently there are more than 150 "pronouncements" as to how to account for different types of transactions, ranging from how to report regular income from the sale of goods, and its related inventory values, to accounting for incentive stock option distributions. By using consistent principles, all companies reporting under GAAP report these transactions on their financial statements in a consistent manner.
The various rules and pronouncements come from the Financial Accounting Standards Board (FASB) which is a non-profit organization that the accounting profession has created to promulgate the rules of GAAP reporting and to amend the rules of GAAP reporting as occasion requires. The more recent pronouncements come as Statements of the Financial Accounting Standards (SFAS). Changes in the GAAP rules can carry tremendous impact upon American business. For example, when FASB stopped requiring banks to mark their assets (loans) to the lower of cost or market (i.e. value of a foreclosed home loan), the effect on a bank’s "net worth" as defined by GAAP can change dramatically. While generally neutral, there is some pressure on the FASB to yield to industry or political pressure when it makes its rules.
Nonetheless, since all companies report using the same set of rules, knowing the rules of GAAP reporting can tell the user of financial statements a great deal. The study of accounting, in large part, entails learning the many rules and promulgations set forth by FASB and how to apply those rules to actual business events.
GAAP is slowly being phased out in favor of the International Accounting Standards as the global business becomes more pervasive. GAAP applies only to United States financial reporting and thus an American company reporting under GAAP might show different results if it was compared to a British company that uses the International Standards. While there is tremendous similarity between GAAP and the International Rules, the differences can lead a financial statement user to incorrectly believe that company A made more money than company B simply because they report using different rules. The move towards International Standards seeks to eliminate this kind of disparity.
Financial Accounting is information that must be assembled and reported objectively. Third-parties who must rely on such information have a right to be assured that the data are free from bias and inconsistency, whether deliberate or not. For this reason, financial accounting relies on certain standards or guides that are called "Generally Accepted Accounting Principles" (GAAP).
Principles derive from tradition, such as the concept of matching. In any report of financial statements (audit, compilation, review, etc.), the preparer/auditor must indicate to the reader whether or not the information contained within the statements complies with GAAP.
- Principle of regularity: Regularity can be defined as conformity to enforced rules and laws.
- Principle of consistency: This principle states that when a business has once fixed a method for the accounting treatment of an item, it will enter all similar items that follow in exactly the same way.
- Principle of sincerity: According to this principle, the accounting unit should reflect in good faith the reality of the company’s financial status.
- Principle of the permanence of methods: This principle aims at allowing the coherence and comparison of the financial information published by the company.
- Principle of non-compensation: One should show the full details of the financial information and not seek to compensate a debt with an asset, revenue with an expense, etc. (see convention of conservatism)
- Principle of prudence: This principle aims at showing the reality "as is": one should not try to make things look prettier than they are. Typically, revenue should be recorded only when it is certain and a provision should be entered for an expense which is probable.
- Principle of continuity: When stating financial information, one should assume that the business will not be interrupted. This principle mitigates the principle of prudence: assets do not have to be accounted at their disposable value, but it is accepted that they are at their historical value (see depreciation and going concern).
- Principle of periodicity: Each accounting entry should be allocated to a given period, and split accordingly if it covers several periods. If a client pre-pays a subscription (or lease, etc.), the given revenue should be split to the entire time-span and not counted for entirely on the date of the transaction.
- Principle of Full Disclosure/Materiality: All information and values pertaining to the financial position of a business must be disclosed in the records.
- Principle of Utmost Good Faith: All the information regarding to the firm should be disclosed to the insurer before the insurance policy is taken.
International Accounting Standards and Rules
Many countries use or are converging on the International Financial Reporting Standards (IFRS), established and maintained by the International Accounting Standards Board. In some countries, local accounting principles are applied for regular companies but listed or large companies must conform to IFRS, so statutory reporting is comparable internationally, across jurisdictions.