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An acronym for Generally Accepted Accounting Principles, GAAP is a set of rules and principles that companies in the U.S. must follow when preparing their annual financial statements. Much like basketball has rules and regulations to keep games fair, so does the world of business. Without GAAP, it would be much more difficult for lenders, investors, and other interested parties to know whether a business is performing well or poorly. While you may use an accountant to prepare your business’s financial statements, it can still be a good idea to understand the basics of GAAP accounting, since it impacts when and how your business transactions are recorded. Understanding GAAP-compliant statements can also allow you to compare your company’s performance from one reporting period to another, as well as to other businesses in your industry. Here’s what every small business owner needs to know about GAAP.
GAAP Defined
GAAP, or Generally Accepted Accounting Principles, is a commonly recognized set of rules and procedures designed to govern corporate accounting and financial reporting in the U.S. GAAP was established to provide consistency in how financial statements are created, eliminate the potential for fraudulent or misleading financial reports, and make it easier for investors and creditors to evaluate companies and compare them apples-to-apples.All publicly traded businesses in the U.S. must use GAAP in their financial statements. While small businesses that don’t get audited aren’t required to use GAAP, doing so can still be helpful, particularly if your business may be interested in attracting an investor or exploring business loans at some point in the future.
How GAAP Works
Governed by the U.S. Securities and Exchange Commission (SEC) and administered by the Financial Accounting Standards Board (FASB), GAAP dictates how a company can recognize revenue and expenses and how information needs to be presented to shareholders in an audited report. It also standardizes the financial reporting process so that third parties can easily compare and contrast two GAAP-compliant companies or entities. GAAP incorporates three components to help eliminate misleading accounting and financial reporting practices:
10 accounting principles
FASB rules and standards
Generally accepted industry practices
Pros and Cons of GAAP
GAAP offers a number of benefits. It guides companies in preparing accurate and clear financial data, reduces fraudulent financial reporting, and provides consistency in the financial statements of one GAAP-compliant company to another. However, GAAP also has some limitations. Its "one-size-fits-all" approach to financial reporting, for example, doesn’t always address issues faced by specific industries. GAAP can also be overly complex, as well as costly to implement, for smaller businesses. And, it’s not a globally used standard, which can make it challenging for international organizations and for investors who want to compare companies operating in different countries.
Pros of GAAP
Cons of GAAP
Fosters honesty and transparency in financial reporting
Strict accounting model that does not address many industry-specific situations
Makes it easy to compare one GAAP-compliant company to another GAAP-compliant company
Can be costly for smaller companies to become GAAP-compliant
Ensures that businesses follow the same accounting principles for all reporting periods
Many companies feel it does reflect how well they are actually doing, and will use other models in addition to GAAP
Enables businesses to compare their performance with that of their competitors
Not a global standard
GAAP Principles
GAAP has 10 fundamental principles companies must follow.
1. Principle of Regularity
Accountants must adhere to the rules and regulations of GAAP accounting. This principle keeps accountants from making up their own methods. With GAAP, any accountant can understand the work of another accountant. This is extremely important when comparing businesses and analyzing their worth.
2. Principle of Consistency
Accountants must apply the same standards and techniques for all accounting periods. This ensures financial comparability between periods. Any changes or updated standards must be explained in the footnotes to the financial statements.
3. Principle of Sincerity
Accountants must be as honest, impartial, and accurate in their reporting of a company’s financial performance as possible. They cannot lie or fudge numbers to make a company seem more profitable.
4. Principle of Permanence of Methods
All GAAP-compliant companies must be consistent with their methods and procedures. By doing so, all GAAP-compliant companies can be compared regardless of their industry.
5. Principle of Non-Compensation
Businesses must report all aspects of their performance, both good and bad, and without the expectation of debt compensation.
6. Principle of Prudence
Accountants should never speculate or give their opinion in a financial report. All records must only include expenses and provisions for spending that have or will certainly take place.
7. Principle of Continuity
While valuing assets, accountants must assume the business will continue to operate in the foreseeable future. Any potential buyouts or foreclosures should not be considered.
8. Principle of Periodicity
Accountants must report all revenue and expenses in the appropriate accounting period, such as fiscal quarters or fiscal years.
9. Principle of Materiality
Accountants must strive to fully disclose all financial data and accounting information in financial reports.
10. Principle of Utmost Good Faith
All parties that contribute to a company’s financial report are assumed to be honest and reputable.
GAAP Assumptions
GAAP rules and regulations are based on four key assumptions:
Specific Time Period Assumption All financial statements have to indicate the date or time period for the activity being reported.
Business Entity Assumption The business exists apart from its owners, creditors, and anyone else. This assumption applies even if your business is a sole proprietorship, since, legally, your business can exist independently of you.
Going Concern Assumption The business will continue to operate for the foreseeable future. If an accountant is concerned the business might be forced to close and liquidate, they are required to disclose this concern under GAAP.
Monetary Unit Assumption All business activity must be recorded in the same currency. This is why you have to go through the extra effort to complete your bookkeeping for foreign transactions.
What Are the Basic Principles of Accounting?
Under GAAP, there are four basic principles of accounting that businesses must abide by in their financial reporting.
Revenue Recognition Principle:This is an accrual basis accounting principle which says that all revenue is recorded on an income statement when it’s earned, regardless of when payment for the product or service is actually received.
Historical Cost Principle:This means that the cost of an item doesn’t change in the financial reporting. Even if you’ve bought something that has dramatically increased in value since you purchased it, your accountant will still report the asset at the amount for which it was obtained, regardless of fair market value.
Matching Principle:All sales and the expenses used to produce those sales (such as wages and overhead costs) are reported in the same accounting period. In other words, they are reported on an accrual basis vs a cash basis (in which revenue is reported when received and expenses are reported when cash is spent).
Full Disclosure Principle:A business must disclose all information that relates to the function of its financial statements in notes accompanying the statements. This ensures that investors or stockholders are not misled by anything on a company’s financial reports.
FASB Rules and Standards
The Financial Accounting Standards Board, or FASB, is an independent board, formed in 1973, that reviews, updates, and oversees GAAP. The board is made up of seven full-time, impartial members to ensure that it always works for the public's best interest. FASB is responsible for the Accounting Standards Codification (ASC), a centralized resource where accountants can find all current GAAP.
Generally Accepted Industry Practices
All businesses and organizations in the U.S. do not follow the GAAP model. Some businesses will instead follow industry-specific accounting guidelines that reflect the nuances and complexities specific to that industry. A bank, for example, will use different accounting and financial reporting methods than those used by retail businesses. For this reason, many businesses will publish both GAAP and non-GAAP financial reports (such as EBITDA (or earnings before interest, taxes, depreciation, and amortization).
Why GAAP Compliance is Important
GAAP compliance is crucial to today’s economy because it creates trust. Without GAAP, it would be hard for investors to trust information presented to them by companies. This could lead to less investment and an overall less robust economy. GAAP also fosters consistency in financial reporting, which makes it easier for investors and other interested parties to understand financial statements and compare the financial statements of one company with those of another company. When applying for a small business loan, lenders will often want to see GAAP-compliant financial statements.
History of GAAP
GAAP came into being primarily as a response to the Stock Market Crash of 1929 and the subsequent Great Depression, which were thought to be at least partially caused by dishonest financial reporting by some publicly-traded companies. GAAP first started to take shape with two pieces of legislation: the Securities Act of 1933 and the Securities Exchange Act of 1934.The Securities Act of 1933 had two objectives:
Prohibit deceit and fraud in the sale of securities
Require investors be able to receive any financial information revolving around the sale of securities.
The Securities Exchange Act of 1934 gave the Securities and Exchange Commission (SEC) the power to require regular reporting of financial information by companies with publicly traded securities. GAAP slowly evolved from these acts, and had a few different names prior to becoming GAAP. Several groups, including the American Institute of Certified Public Accountants, the Governmental Accounting Standards Board, and the SEC all had a hand in its creation. GAAP is currently moderated and updated by the FASB.
What Are Non-GAAP Measures
Businesses are allowed to present financial information without following GAAP, as long as they clearly identify those figures as not conforming to GAAP, or non-GAAP. Companies will often do this if they think that GAAP rules aren’t able to capture the nuances of their operations. In these cases, businesses may publish both GAAP and non-GAAP earnings.One of the biggest differences between GAAP vs. non-GAAP, for example, is that non-GAAP eliminates non-recurring expenses. By doing this, the net income of a company is sometimes increased dramatically. Many companies also believe that non-GAAP provides a more in-depth and accurate look at their overall financial performance.
Alternatives to GAAP
IFRS
The International Financial Reporting Standards, or IFRS, are another set of accounting standards, but these are used at the international level. IFRS is standard in the European Union and many countries in Asia and South America, but not in the United States. IFRS was established so that companies could be comparable from country to country.The main difference between GAAP vs. IFRS is that GAAP prioritizes rules and detailed guidelines, whereas IFRS only provides general principles to follow. Accountants have more leeway when following IFRS, but often need to include explanatory documents. On the other hand, businesses that use GAAP may feel confined by the lengthy rules.
Tax Basis
Tax basis accounting follows the accounting that a company is required to use for filing its federal tax return. If allowed by creditors, investors, and other financial statement users, tax basis accounting can make sense for a privately-held company, since it means less work when preparing the company’s tax return. When comparing tax basis vs. GAAP, tax basis accounting is less complex and often leads to less footnote disclosures in financial statements.
GAAS
Generally Accepted Auditing Standards, or GAAS, is the framework that guides auditors. GAAS standards help auditors prepare a transparent and reliable audit report on companies. Following these standards also ensures that auditors don’t miss any important information. When comparing GAAS vs GAAP, it’s important to remember that GAAP is used by accountants, whereas GAAS is used by auditors. Therefore, an auditor following GAAS may see how well a company is following GAAP. Recommended: Small Business Audits: How to Prepare
The Takeaway
GAAP is the set of accounting rules and principles that U.S. companies must follow when putting together financial statements. The goal of GAAP is to hold publicly traded companies accountable and ensure their financial statements are complete, consistent, and comparable. For small business accounting, you are not required to follow GAAP regulations. However, doing so can make it easier for outsiders to evaluate your business and compare it to other companies in your industry. Publishing GAAP-compliant financial statements could make it easier for your business to attract an investor or get approved for certain types of business loans.
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If you need to borrow money to cover seasonal cash flow fluctuations, a business line of credit, rather than a term loan, provides the flexibility you likely need.
SBA loans are guaranteed by the U.S. Small Business Administration and typically offer favorable terms. They can also have more complicated applications and requirements than non-SBA business loans.
Frequently Asked Questions
How many principles does GAAP have?
Is GAAP the same in every country?
Why is GAAP important?
Photo credit: iStock/SethCortright
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About the Author
Lauren Ward
Lauren Ward is a personal finance expert with nearly a decade of experience writing online content. Her work has appeared on websites such as MSN, Time, and Bankrate. Lauren writes on a variety of personal finance topics for SoFi, including credit and banking.
