What Are Generally Accepted Accounting Principles (GAAP)?

Generally Accepted Accounting Principles (GAAP) is the established framework of accounting rules and procedures used in the United States for preparing and presenting financial statements. The purpose of GAAP is to ensure financial reporting is consistent and comparable, allowing investors and lenders to make more informed decisions by providing a transparent and reliable analysis of a company’s financial health.

The Foundation of GAAP

In the United States, independent, private-sector bodies have the authority to set accounting standards to ensure objectivity. The Financial Accounting Standards Board (FASB) is the primary body for establishing GAAP for public and private companies and non-profit organizations. For government entities, the Governmental Accounting Standards Board (GASB) sets standards for state and local governments, while the Federal Accounting Standards Advisory Board (FASAB) does so for the federal government. The U.S. Securities and Exchange Commission (SEC) officially recognizes the FASB as the standard-setter for public companies.

This system arose after the 1929 stock market crash, which was partly blamed on inconsistent financial reporting. In response, Congress created the SEC to regulate markets and protect investors, highlighting the need for credible, standardized accounting to foster trust in financial markets.

Core Accounting Principles

GAAP is built on a set of core principles that guide accountants in recording and reporting financial information to ensure a faithful representation of a company’s economic activities.

Economic Entity Principle

The economic entity principle requires that a business’s transactions be kept separate from the personal financial activities of its owners and any other business. Even for a sole proprietorship, GAAP mandates separate accounting records. For example, if a business owner uses a company credit card for a personal vacation, that expense cannot be recorded as a business cost and must be accounted for as an owner withdrawal.

Revenue Recognition Principle

The revenue recognition principle dictates when and how revenue is recorded. Guided by Accounting Standards Codification 606, revenue is recognized when the control of goods or services is transferred to a customer. This means revenue is recorded when it is earned, not necessarily when cash is received. A software company that receives a $1,200 payment for a one-year subscription must recognize $100 of revenue each month as the service is provided.

Matching Principle

The matching principle requires that expenses be recorded in the same period as the revenues they helped generate. For example, if a company pays sales commissions to its employees in January for sales made in December, the commission expense must be recorded in December’s financial statements alongside the corresponding sales revenue.

Cost Principle

The cost principle, also known as the historical cost principle, requires that assets be recorded on the balance sheet at their original purchase price. This value is not adjusted for inflation or changes in market value over time. If a company buys a building for $500,000, it will remain on the books at that price, even if its market value increases years later.

Full Disclosure Principle

The full disclosure principle mandates that a company’s financial statements, including the footnotes, must include all information that would affect a reader’s understanding of those statements. For example, if a company is facing a significant lawsuit that could result in a large financial loss, the details of this contingent liability must be disclosed in the footnotes.

Going Concern Principle

The going concern principle is the assumption that a business will continue to operate for the foreseeable future, typically at least the next 12 months. This assumption is fundamental to many accounting practices, such as the depreciation of assets over their useful lives. If an auditor has substantial doubt about a company’s ability to continue as a going concern, that doubt must be disclosed in the financial statements.

Application of GAAP Standards

The requirement to use GAAP depends on whether a company is publicly or privately held. The SEC mandates that all companies with publicly traded securities must file periodic financial reports that adhere strictly to GAAP.

There is no federal requirement for private companies to follow GAAP. However, many choose to do so voluntarily for several strategic reasons. Having a history of clean, GAAP-compliant financials is a significant advantage for a company that wants to:

• Obtain loans or other forms of credit from financial institutions
• Attract outside investors
• Seek venture capital
• Be acquired or go public through an Initial Public Offering (IPO)

Some private companies may opt for other accounting methods, such as the cash basis or tax basis, which can be simpler but are less comprehensive.

GAAP and International Standards

While GAAP is the standard in the United States, most of the world uses a different framework known as International Financial Reporting Standards (IFRS). IFRS is used in over 140 jurisdictions, making it the predominant set of standards for global business.

The most significant difference between the two frameworks lies in their underlying philosophy. GAAP is considered “rules-based,” providing detailed and specific rules for how to account for transactions. In contrast, IFRS is “principles-based,” offering broader guidelines and requiring more professional judgment to determine how to apply the principles to a specific situation. For years, there were efforts to converge the two systems, but these initiatives have largely stalled, and significant differences remain.