Generally Accepted Accounting Principles (GAAP) - Explained
What is GAAP?
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Table of ContentsWhat are Generally Accepted Accounting Principles?How are Generally Accepted Accounting Principles Used?GAAP vs. IFRSAcademic Research on GAAP
What are Generally Accepted Accounting Principles?
Generally accepted accounting principles (GAAP) is an embodiment of rules and standards that are acceptable and practiced in the accounting industry. GAAP contains a set of accounting standards, principles, c and procedures that accountants and accounting companies must follow. The United States Securities and Exchange Commission (SEC) adopts these standards and accountants are mandated to follow these principles when arranging or collating financial statements. GAAP is a standard framework that was developed by professionals in the accounting industry. Commonly accepted accounting practices were also included in the framework. Financial reporting must be tailored to reflect GAAP, otherwise, it might be unacceptable. IFRS standards and pro forma accounting are non-GAAP.
Back to: ACCOUNTING, TAX, & REPORTING
How are Generally Accepted Accounting Principles Used?
GAAP was designed to improve accounting practices especially when accountants compile financial statements. GAAP ensure consistency in financial reports which makes it easier for investors to access useful and reliable financial information as compiled by accountants with ethical practices. There are 10 general principles states in GAAP, they are the principles of;
- Time Specificity
This is also called principle of periodicity, it entails that financial entries should be distributed at the specific time assigned to them. Also, the release of financial statements should align with the start and end date pertaining to them.
This principle binds accountants to adhere to the regulations and standards of GAAP and also desist from irregularities in financial reporting.
Professionals must consistently practice the standards and procedures outlined in GAAP.
When an accountant values an asset in a financial report, it must assume the continuity of the business. This means the accountant must assume the business will have no end date.
- Good Faith or Full Disclosure
This entails that accountants make full disclosure of every aspect of a company while compiling financial reports.
This means that an accountant must be accurate while depicting the financial status of a company in a financial report. Businesses that conduct some of their operation in foreign currencies need to convert the amount to the accepted currency and disclose this.
- Permanence of Methods to Matching Principle
This entails that the accounting procedures used in financial reporting (either debit or credit) should be consistent.
This is also a GAAP principle that states that an accountant must present fact-based data at all times and not present speculated data.
- Principle of Non-compensation
This means financial reporting should be made without any expectation for compensation.
- Honesty/Utmost Good faith
All parties involved in financial transactions must exhibited the good trait of honesty. Accounting companies and professionals are expected to comply with the principles and standards states in GAAP. Financial statements and reports, when issued, must also comply with these principles. Aside from the standards outlined in GAAP, there are also some regulations of the United States Securities and Exchange Commission (SEC) that professionals and corporations with adhere to. GAAP was developed to improve the standards of accounting and financial reportings. Professionals and accounting corporations use the principles of GAAP when preparing financial statements. Non-GAAP measures can also be combined with GAAP when making financial reports. GAAP has aa hierarchy with financial statements by FASB and AICPA occupying the top position while reports from some other agencies occupy the remaining ranks.
GAAP vs. IFRS
IFRS standards are considered non-GAAP, this is because IFRS standards are set by IASB (International Accounting Standards Board ) while the Financial Accounting Standards Board (FASB), sets GAAP. as an international alternative to GAAP, IFRS is the accounting standard used in more than 110 countries while GAAP remains the benchmark for accounting practices in the United States. Diverse strategies have been put in place by both IASB and FASB to merge IFRS and GAAP, the partnership has yielded specific results. The achievement resulting from this partnership is the removal of certain requirements placed on non-US companies registered in the US by SEC. This enables these companies who already have financial statements with IFRS to also file reports with GAAP. Despite the convergence of IFRS and GAAP, there are still some differences that are noticeable in these two accounting concepts. IFRS gained popularity over GAAP in recent times. These differences are;
- Costs of development under GAAP are to be charged to expense as they are incurred, but these costs can be amortized under IFRS.
- LIFO (Last In First Out) which is a practice that allows goods that are produced last to be sold out first is prohibited under IFRS while it can be used under GAAP.
- Write downs: this is the reduction in the value of an asset. The amount of write-down of an inventory cannot be changed even if the market value increases under GAAP but write-downs amounts can be reversed under IFRS.
Although, GAAP are accepted standards and principles that are meant to be practiced in the accounting industry, GAAP is not a guarantee for human errors and exclusion of figures in financial statements. There are some lapses in some of the financials statements despite that the procedures of GAAP were adhered to. Errors in financial statement due to distortion of figures, misconducts of accountants among other behaviors often mislead investors. Even if the principles of GAAP are followed in preparing a company's financial statement, there is still need to thoroughly inspect the statement.
Academic Research on GAAP
- Earnings management under German GAAP versus IFRS, Van Tendeloo, B., & Vanstraelen, A. (2005). European Accounting Review, 14(1), 155-180.
- GAAP versus the street: An empirical assessment of two alternative definitions of earnings, Bradshaw, M. T., & Sloan, R. G. (2002). Journal of Accounting Research, 40(1), 41-66.
- Detecting GAAP violation: Implications for assessing earnings management among firms with extreme financial performance, Beneish, M. D. (1997). Journal of accounting and public policy, 16(3), 271-309.
- IAS versus US GAAP: information asymmetrybased evidence from Germany's new market, Leuz, C. (2003). Journal of accounting research, 41(3), 445-472.
- Incentives and penalties related to earnings overstatements that violate GAAP, Beneish, M. D. (1999). The Accounting Review, 74(4), 425-457.
- A comparison of the value-relevance of US versus non-US GAAP accounting measures using form 20-F reconciliations, Amir, E., Harris, T. S., & Venuti, E. K. (1993). Journal of Accounting Research, 31, 230-264.
- The circumstances and legal consequences of nonGAAP reporting: Evidence from restatements, Palmrose, Z. V., & Scholz, S. (2004). Contemporary Accounting Research, 21(1), 139-180.
- Economic benefits of adopting IFRS or USGAAP have the expected cost of equity capital really decreased?, Daske, H. (2006). Journal of Business Finance & Accounting, 33(34), 329-373.
- International GAAP differences: The impact on foreign analysts, Bae, K. H., Tan, H., & Welker, M. (2008). The Accounting Review, 83(3), 593-628.
- The market valuation of IAS versus US-GAAP accounting measures using Form 20-F reconciliations, Harris, M. S., & Muller III, K. A. (1999). Journal of Accounting and economics, 26(1-3), 285-312.