GAAP (Generally Accepted Accounting Principles)

Updated on January 3, 2024
Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

GAAP Definition

GAAP (Generally Accepted Accounting Principles) are standardized guidelines for accounting and financial reporting. These principles should be followed when preparing a company’s financial statement.

It is mandated by the US Securities and Exchange Commission (SEC) for reporting publicly traded companiesPublicly Traded CompaniesPublicly Traded Companies, also called Publicly Listed Companies, are the Companies which list their shares on the public stock exchange allowing the trading of shares to the common public. It means that anybody can sell or buy these companies’ shares from the open market.read more. GAAP establishes a proper classification and measurement criteria for financial reporting. These principles assist investors in comparing the financial performance of different businesses. It is a legal procedure that ensures transparency and accuracy.

Key Takeaways

  • Generally Accepted Accounting Principles (GAAP) is a framework that chalks down rules, procedures, guidelines and best practices for financial accounting and reporting of business transactions.
  • Generally Accepted Accounting Principles ensure consistency, transparency, objectivity, materiality, and full disclosure.
  • These principles are set forth and reviewed by the Financial Accounting Standards Board (FASB).
  • The Securities Exchange Board (SEC) obligates publicly traded companies to prepare and record their business operations using these principles.

GAAP Explained

GAAP, or the US GAAP, is a framework that shows the right way of accounting to the organizations. Although it isn’t compulsory for every business entity, the Securities and Exchange Commission (SEC) has made it mandatory for publicly listed companies. The Generally Accepted Accounting Principles are issued by the Financial Accounting Standards Board (FASB). FASB follows the Financial Accounting Standards Board Advisory Council’s (FASAC) directives for improving these principles. One hundred ten countries in the world follow International Financial Reporting Standards (IFRS). The IFRS specifies, prepares, and discloses financial statementsFinancial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more of companies globally.

Generally Accepted Accounting Principles (GAAP)

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In simple words, Generally Accepted Accounting Principles are a collection of commonly used rules and procedures. These are the principles to be followed when preparing a financial statement of a company or a Firm. They set a foundation for preparing income statementsIncome StatementsThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements.read more, balance sheetsBalance SheetsA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more, and cash flow statementsCash Flow StatementsA Statement of Cash Flow is an accounting document that tracks the incoming and outgoing cash and cash equivalents from a business.read more. By doing so, they aid the taxation process. Further, these principles initiate proper classification and measurement criteria for financial reportingFinancial ReportingFinancial reporting is a systematic process of recording and representing a company’s financial data. The reports reflect a firm’s financial health and performance in a given period. Management, investors, shareholders, financiers, government, and regulatory agencies rely on financial reports for decision-making.read more. Ultimately, investors get a better picture of various firms and their financial performances.

Without these principles, there would be fraudulent accounting, which could potentially hinder an organization’s market credibility. In addition, in the absence of principles, companies would be free to decide what financial informationFinancial InformationFinancial Information refers to the summarized data of monetary transactions that is helpful to investors in understanding company’s profitability, their assets, and growth prospects. Financial Data about individuals like past Months Bank Statement, Tax return receipts helps banks to understand customer’s credit quality, repayment capacity etc.read more to report and how to report it. An absence of protocol would make it very difficult for investors and creditors who have a stake in a firm. In simple words, these principles are all about uniformity. When followed, auditing is easy, and as a result, a firm’s performance and policies are transparent.

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GAAP Principles in Accounting

Given below are 10 GAAP principles that frame the base of this accounting standard:

#1 – Principle of Regularity: This is the foremost principle that assures that the accountant has adhered to Generally Accepted Accounting Principles norms.

#2 – Principle of Consistency: The company should adopt a single accounting standard like Generally Accepted Accounting Principles or IFRSIFRSIFRS or International Financial Reporting Standards refers to a globally-accepted set of accounting and financial reporting guidelines for preparing and presenting financial statements. It ensures uniformity in accounting practice that makes financial records comparable across different reporting entities worldwide. Over the years, it has emerged as the new world standard in accounting.read more for reporting the financial position. This prevents confusion. Also, these principles make the comparison of financial statements from different periods easier, which is why, whenever an organization switches to a different accounting standard, they are required to state the reason clearly. This is mentioned as a footnote in the financial statement.

#3 – Principle of Sincerity: After interpreting all the data, the accountant should represent the company’s financial position accurately.

#4 – Principle of Permanence of Methods: The accountant should use the same accounting method every time. Standardization is crucial as these reports are often used for comparative studies.

#5 – Principle of Non-Compensation: The only purpose of financial reporting should be transparency in accounting. Irrespective of positive or negative information, transparency has to be upheld.

#6 – Principle of Prudence: Financial accountingFinancial AccountingFinancial accounting refers to bookkeeping, i.e., identifying, classifying, summarizing and recording all the financial transactions in the Income Statement, Balance Sheet and Cash Flow Statement. It even includes the analysis of these financial statements.read more has no space for speculation and should always be pillared upon actual data.

#7 – Principle of Continuity: It relates to concern, which presumes that the business will keep operating forever.

#8 – Principle of Periodicity: The financial statements pertain to a specific period, i.e., end time and start time. Business transactionsBusiness TransactionsA business transaction is the exchange of goods or services for cash with third parties (such as customers, vendors, etc.). The goods involved have monetary and tangible economic value, which may be recorded and presented in the company's financial statements.read more should be recorded on time. For instance, the balance sheet is to be reported annually.

#9 – Principle of Materiality: This Principle makes the adjustment of minute errors possible. That is, while maintaining accounting reports, there could be some minor errors like a $5 not matching. This principle can be used to adjust such errors.  

#10 – Principle of Utmost Good Faith: This principle is a belief that all the parties involved in the business transaction have been honest and trustworthy.

Advantages and Disadvantages

The application of Generally Accepted Accounting Principles in the accounting process mirrors the absolute financial position of the company. The standardization helps shareholders, investors, and creditorsCreditorsA creditor refers to a party involving an individual, institution, or the government that extends credit or lends goods, property, services, or money to another party known as a debtor. The credit made through a legal contract guarantees repayment within a specified period as mutually agreed upon by both parties. read more by maintaining a level of transparency. Thus, these principles help retain the trust of the investors and shareholdersShareholdersA shareholder is an individual or an institution that owns one or more shares of stock in a public or a private corporation and, therefore, are the legal owners of the company. The ownership percentage depends on the number of shares they hold against the company's total shares.read more. The principles also help creditors decide whether to extend credit to an organization or not. Such transparency, though, can hurt struggling firms.

It brings consistency and accuracy to a firm’s accounting procedureAccounting ProcedureThe accounting procedure is the process of standardized nature that performs a specific accounting function designed to incorporate better risk management policies to complete these functions efficiently. It includes billings, invoices to suppliers, bank reconciliation, requiring comprehensive and streamlined procedures.read more. It also facilitates the comparative study of different business entities based on their financial statements. Moreover, the internal analysis and identification of key improvement areas become easier with Generally Accepted Accounting Principles. Because, thanks to these principles, management now has a complete report of the company’s losses, expenses, investment, income, and revenuesRevenuesRevenue is the amount of money that a business can earn in its normal course of business by selling its goods and services. In the case of the federal government, it refers to the total amount of income generated from taxes, which remains unfiltered from any deductions.read more.

However, there are certain GAAP disadvantages that cannot be overlooked. Preparing a financial report is not effortless. For small businesses, following all the stated principles becomes a challenging task. Moreover, as the companies go global, they need to switch from Generally Accepted Accounting Principles to International Financial Reporting Standards (IFRS) since the former is applicable only in the US.

GAAP vs. IFRS vs. Non-GAAP

In accounting, there are different standards used for financial reporting; their uses and acceptability vary depending on the country, industry, and scale of operations. Generally Accepted Accounting Principles are guidelines for the preparation and reporting of a company’s transactions. In the US, the SEC requires publicly listed companies to follow these standards. But these principles are not accepted globally.

On the contrary, the International Financial Reporting Standards (IFRS) are accounting guidelines recognized worldwide. They facilitate corporate accounting for international companies. Therefore, when domestic organizations become international, they have to resort to the IFRS.  

The Non-GAAP measure contrasts both GAAP and the IFRS. It is Pro-forma accounting which is not standardized. Instead, it is a method of adjusted earnings and calls for reconciliation with GAAP-based earnings. At times though, this standard does produce accurate figures for revenues. The measures used under “Non-GAAP” include EBITDAEBITDAEBITDA refers to earnings of the business before deducting interest expense, tax expense, depreciation and amortization expenses, and is used to see the actual business earnings and performance-based only from the core operations of the business, as well as to compare the business's performance with that of its competitors.read more, EBITEBITEarnings before interest and tax (EBIT) refers to the company's operating profit that is acquired after deducting all the expenses except the interest and tax expenses from the revenue. It denotes the organization's profit from business operations while excluding all taxes and costs of capital.read more, free cash flowFree Cash FlowThe cash flow to the firm or equity after paying off all debts and commitments is referred to as free cash flow (FCF). It measures how much cash a firm makes after deducting its needed working capital and capital expenditures (CAPEX).read more, and operating incomeOperating IncomeOperating Income, also known as EBIT or Recurring Profit, is an important yardstick of profit measurement and reflects the operating performance of the business. It doesn’t take into consideration non-operating gains or losses suffered by businesses, the impact of financial leverage, and tax factors. It is calculated as the difference between Gross Profit and Operating Expenses of the business.read more.  

Frequently Asked Questions (FAQs)

What is GAAP?

Generally Accepted Accounting Principles (GAAP) are the Financial Accounting Standards Board’s (FASB) prescribed guidelines for accounting and financial reporting. The primary principles of accounting are as follows:

1. Consistency
2. Objectivity
3. Prudence
4. Materiality

Why is GAAP important?

GAAP standardizes the process of accounting and thus helps the company in self-analysis. These principles instruct the firms to disclose their financial statements to the shareholders. The uniformity further enables investors to interpret the organization’s financial health. Due to transparency, investors and stakeholders can easily compare the stats of competing firms. Ultimately these principles help investors make an informed decision.

Is GAAP legally binding?

The law doesn’t abide all organizations to follow GAAP; only the companies registered under the Securities and Exchange Commission (SEC) need to record their financial statements based on these standards. Basically, the SEC obligates publicly listed companies to follow Generally Accepted Accounting Principles.

This has been a guide to GAAP (Generally Accepted Accounting Principles) and its definition. Here we discuss GAAP basics, top 10 principles in accounting, advantages, and disadvantages. You can learn more about Accounting from the following articles –

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