Generally Accepted Accounting Principles (GAAP): Definition and Rules

What Are the Generally Accepted Accounting Principles (GAAP)?

The generally accepted accounting principles (GAAP) are a set of accounting rules, standards, and procedures issued and frequently revised by the Financial Accounting Standards Board (FASB) and the Governmental Accounting Standards Board (GASB). These principles ensure consistency, accuracy, and transparency in financial reporting across various industries in the United States. Public companies must follow GAAP when preparing their financial statements, which is also widely used in governmental accounting.

Understanding GAAP

GAAP combines authoritative standards set by policy boards and widely accepted methods for recording and reporting accounting information. It covers revenue recognition, balance sheet classification, and materiality.

The main objective of GAAP is to ensure that a company's financial statements are complete, consistent, and comparable, allowing investors to analyze and extract useful information from financial statements. It also facilitates the comparison of financial information across different companies.

Unlike pro forma accounting, a non-GAAP method, GAAP provides a standardized framework. Internationally, the equivalent standard is the international financial reporting standards (IFRS), used in 168 jurisdictions worldwide.

GAAP is also utilized by government entities. All 50 states follow GAAP, and many local entities, such as counties, cities, towns, and school districts, must adhere to these principles.

Compliance With GAAP

If a corporation's stock is publicly traded, its financial statements must follow rules set by the U.S. Securities and Exchange Commission (SEC). The SEC mandates that publicly traded companies in the U.S. file GAAP-compliant financial statements regularly to maintain their public listing on stock exchanges. GAAP compliance is verified through an appropriate auditor's opinion, resulting from an external audit by a certified public accounting (CPA) firm.

While non-publicly traded companies aren't required to follow GAAP, it is still highly regarded by lenders and creditors. Most financial institutions require annual GAAP-compliant financial statements as a part of their debt covenants when issuing business loans, leading many U.S. companies to adopt GAAP.

Investors should be cautious if a financial statement isn't prepared using GAAP. Comparing financial statements across different companies—even within the same industry—becomes challenging without GAAP. Some companies may use GAAP and non-GAAP measures to report their financial results. GAAP regulations require that non-GAAP measures be identified in financial statements and other public disclosures, such as press releases.

GAAP vs. IFRS

The international financial reporting standards (IFRS), set by the International Accounting Standards Board (IASB), is an alternative to GAAP that is widely used worldwide.

One key difference between GAAP and IFRS is the treatment of inventory. IFRS rules ban using last-in, first-out (LIFO) inventory accounting methods, whereas GAAP permits LIFO. Both systems accept the first-in, first-out (FIFO) and weighted average-cost methods.

Since 2002, the IASB and the FASB have worked to align IFRS and GAAP. A significant milestone was reached in 2007 when the SEC allowed non-U.S. companies registered in the U.S. to use IFRS without reconciling to GAAP. This was a big achievement because it eliminated the need for non-U.S. companies on U.S. exchanges to provide GAAP-compliant financial statements.

As global operations and markets expand, international standards like IFRS are gaining traction, even in the U.S. Nearly all S&P 500 companies report at least one non-GAAP measure in their financial statements. This trend is evident in the widespread use of several non-GAAP metrics, with 77% of S&P 500 companies reporting adjusted earnings, 77% using adjusted EPS (earnings per share), and 29% reporting EBITDA or adjusted EBITDA.

Since much of the world uses the IFRS standard, a convergence to IFRS could benefit international corporations and investors alike.

The Bottom Line

GAAP is meant to ensure consistency, accuracy, and transparency in financial reporting and aims to provide a reliable foundation for investors to make informed decisions. While the rules established under GAAP generally improve the transparency in financial statements, they don't guarantee that a company's financial statements are free from errors or omissions meant to mislead investors. Always scrutinize financial statements, as there can still be room for manipulation within the framework of GAAP.