What Are Accounting Principles Generally Accepted in the USA?

Generally Accepted Accounting Principles, or GAAP, is the established framework of rules and guidelines for financial accounting in the United States. Its purpose is to create a common financial language, ensuring that financial information is consistent, comparable, and reliable for users like investors, creditors, and regulatory bodies. By providing this uniform structure, GAAP allows stakeholders to analyze a company’s financial health and make informed economic decisions.

The principles govern a wide array of topics, from revenue recognition to balance sheet classifications. While mandatory for publicly traded companies, many private businesses also adopt GAAP, particularly if they seek external financing or plan to go public.

The Standard-Setting Framework

The authority to regulate financial reporting for public companies in the United States rests with the U.S. Securities and Exchange Commission (SEC). This authority was granted by Congress through legislation like the Securities Act of 1933 and the Securities Exchange Act of 1934. The SEC’s mission is to protect investors and maintain fair markets by ensuring companies provide accurate and complete financial information.

While the SEC has this authority, it has largely delegated the responsibility of setting accounting standards to the private sector. Since 1973, the SEC has recognized the Financial Accounting Standards Board (FASB) as the designated independent organization for establishing and improving GAAP. This arrangement allows a dedicated body to focus on the technical aspects of standard-setting, and the Sarbanes-Oxley Act of 2002 reaffirmed the FASB’s role.

The FASB is overseen by the Financial Accounting Foundation (FAF), which helps ensure the independence and integrity of the standard-setting process. The FAF also oversees the Governmental Accounting Standards Board (GASB), which is responsible for setting accounting standards for state and local governments.

To organize the vast collection of standards, the FASB developed the Accounting Standards Codification (ASC). Launched in 2009, the ASC is the single, authoritative source for all nongovernmental U.S. GAAP. Before the Codification, GAAP was a complex hierarchy of various documents; the ASC reorganizes these pronouncements into a logical structure of about 90 topics. Any accounting literature not included in the Codification is considered nonauthoritative, which simplifies compliance.

Foundational Concepts and Principles

U.S. GAAP is built on underlying assumptions and principles that provide the foundation for financial reporting, ensuring information is recorded and presented logically.

The economic entity assumption requires that a company’s transactions be accounted for separately from its owners’ transactions. For example, an owner’s personal vacation paid for with company funds must be recorded as a withdrawal, not a business expense. This separation ensures financial statements reflect only the business’s activities, providing a clear picture of its performance.

The going concern principle assumes a business will continue to operate for the foreseeable future, meeting its obligations. This assumption justifies recording assets at their original cost rather than their immediate liquidation value. For instance, a delivery truck is recorded as an asset to be used over several years, not at its current sale price.

The monetary unit assumption dictates that economic activity is measured in a stable currency, the U.S. dollar. This principle allows for a common denominator in reporting and assumes the dollar’s purchasing power is relatively stable, ignoring the effects of inflation in the financial statements.

The periodicity assumption allows a company’s ongoing activities to be divided into distinct time periods, such as months, quarters, or years. This allows for the regular preparation of financial statements, providing timely information to decision-makers. An annual income statement is an application of this assumption.

The measurement principle, or historical cost principle, requires that assets be recorded at their original cash-equivalent cost at the time of acquisition. If a company buys land for $200,000, it is recorded at that price, even if its market value later increases. This principle is valued for its objectivity.

The revenue recognition principle dictates when and how revenue is recorded. Revenue is recognized when a company satisfies its obligation to a customer by providing a good or service, regardless of when cash is received. A software company selling a one-year subscription for $1,200 would recognize $100 of revenue each month.

The matching principle requires that expenses be recorded in the same accounting period as the revenues they helped generate. For instance, the commission paid to a salesperson for a sale should be recorded as an expense in the same period that the revenue from that sale is recognized. This provides a more accurate depiction of a company’s profitability.

The full disclosure principle requires that financial statements and their notes include all information necessary for a user to understand the company’s financial position. This includes narrative disclosures about accounting policies or pending lawsuits. For example, a company must disclose the details of a significant loan agreement in the notes to its financial statements.

Core Financial Statements under US GAAP

The application of U.S. GAAP culminates in a set of financial statements that provide a comprehensive view of a company’s financial health and performance. These reports are the primary means of communicating financial information to external stakeholders. There are four main financial statements required by GAAP.

• The Balance Sheet, also known as the statement of financial position, presents a snapshot of a company’s assets, liabilities, and stockholders’ equity at a single point in time. It is based on the accounting equation: Assets = Liabilities + Equity, and provides insight into a company’s resources, its obligations, and the ownership interest in the company.
• The Income Statement, sometimes called the profit and loss (P&L) statement, shows a company’s financial performance over a specific period, such as a quarter or a year. It applies the revenue recognition and matching principles to calculate the company’s net income or net loss, indicating its profitability.
• The Statement of Cash Flows provides information about the cash inflows and outflows of a company over a period. It categorizes cash activities into three main sections: operating, investing, and financing. This report helps users understand how a company generates and uses cash, providing insights into its liquidity and solvency.
• The Statement of Stockholders’ Equity details the changes in the equity section of the balance sheet during an accounting period. It reconciles the beginning and ending equity balances, showing the impact of transactions such as net income, dividend payments, and the issuance of new stock.

Key Differences Between US GAAP and IFRS

While U.S. GAAP is the standard in the United States, many other countries use International Financial Reporting Standards (IFRS). The primary distinction is their approach: U.S. GAAP is considered more “rules-based,” with detailed guidance, while IFRS is more “principles-based,” offering broader guidelines that require more professional judgment.

One technical difference relates to inventory valuation. U.S. GAAP allows companies to use the Last-In, First-Out (LIFO) method, where the most recently acquired inventory is assumed to be sold first. IFRS prohibits the use of LIFO, arguing that it can distort earnings and comparability. Both frameworks permit the First-In, First-Out (FIFO) and weighted-average cost methods.

Another area of divergence is accounting for research and development (R&D) costs. Under U.S. GAAP, R&D costs are generally expensed as incurred. IFRS also requires research costs to be expensed, but it requires companies to capitalize development costs if certain criteria are met, such as technical feasibility and the intent to complete and sell the asset. This can lead to different impacts on the income statement and balance sheet.