Generally Accepted Accounting Principles (GAAP)
Generally accepted accounting principles (GAAP) are uniform accounting principles for private companies and nonprofits in the U.S. These principles are largely set by the Financial Accounting Standards Board (FASB), an independent nonprofit organization whose members are chosen by the Financial Accounting Foundation
What are Accounting Principles?
Accounting principles are the rules and guidelines that companies and other bodies must follow when reporting financial data. These rules make it easier to examine financial data by standardizing the terms and methods that accountants must use.
The International Financial Reporting Standards (IFRS) is the most widely used set of accounting principles, with adoption in 167 jurisdictions. The United States uses a separate set of accounting principles, known as generally accepted accounting principles (GAAP).
Accounting Principles
The Purpose of Accounting Principles.
The ultimate goal of any set of accounting principles is to ensure that a company’s financial statements are complete, consistent, and comparable.
This makes it easier for investors to analyze and extract useful information from the company’s financial statements, including trend data over a period of time. It also facilitates the comparison of financial information across different companies. Accounting principles also help mitigate accounting fraud by increasing transparency and allowing red flags to be identified.
The ultimate goal of standardized accounting principles is to allow financial statement users to view a company’s financials with certainty that the information disclosed in the report is complete, consistent, and comparable.
Comparability
Comparability is the ability for financial statement users to review multiple companies’ financials side by side with the guarantee that accounting principles have been followed to the same set of standards.
Accounting information is not absolute or concrete, and standards are developed to minimize the negative effects of inconsistent data.
When accounting principles allow a choice among multiple methods, a company should apply the same accounting method over time or disclose its change in accounting method in the footnotes to the financial statements.
1. Generally Accepted Accounting Principles (GAAP)
Generally accepted accounting principles (GAAP) are uniform accounting principles for private companies and nonprofits in the U.S. These principles are largely set by the Financial Accounting Standards Board (FASB), an independent nonprofit organization whose members are chosen by the Financial Accounting Foundation.
A similar organization, the Governmental Accounting Standards Board (GASB), is responsible for setting the GAAP standards for local and state governments.
And a third body, the Federal Accounting Standards Advisory Board (FASAB), publishes the accounting principles for federal agencies.
Although privately held companies are not required to abide by GAAP, publicly traded companies must file GAAP-compliant financial statements to be listed on a stock exchange. Chief officers of publicly traded companies and their independent auditors must certify that the financial statements and related notes were prepared in accordance with GAAP.
Privately held companies and nonprofit organizations also may be required by lenders or investors to file GAAP-compliant financial statements. For example, annual audited GAAP financial statements are a common loan covenant required by most banking institutions. Therefore, most companies and organizations in the U.S. comply with GAAP, even though it is not a legal requirement.
2.
International Financial Reporting Standards (IFRS)
The International Accounting Standards Board (IASB) issues International Financial Reporting Standards (IFRS). These standards are used in more than 120 countries, including those in the European Union (EU)
The Securities and Exchange Commission (SEC), the U.S. government agency responsible for protecting investors and maintaining order in the securities markets, has expressed interest in transitioning to IFRS. However, because of the differences between the two standards, the U.S. is unlikely to switch in the foreseeable future.
However, the FASB and the IASB continue to work together to issue similar regulations on certain topics as accounting issues arise.
For example, in 2014, the FASB and the IASB jointly announced new revenue recognition standards.
Since accounting principles differ around the world, investors should take caution when comparing the financial statements of companies from different countries. The issue of differing accounting principles is less of a concern in more mature markets. Still, caution should be used, as there is still leeway for number distortion under many sets of accounting principles.
Various bodies are responsible for setting accounting standards. In the United States, generally accepted accounting principles (GAAP) are regulated by the Financial Accounting Standards Board (FASB). In Europe and elsewhere, International Financial Reporting Standards (IFRS) are established by the International Accounting Standards Board (IASB).
5 GAAP Principles
1. Principle of Regularity: GAAP-compliant accountants strictly adhere to established rules and regulations.
Principle of Consistency: Consistent standards are applied throughout the financial reporting process.
2. Principle of Sincerity: GAAP-compliant accountants are committed to accuracy and impartiality.
3. Principle of Permanence of Methods: Consistent procedures are used in the preparation of all financial reports.
4. Principle of Non-Compensation: All aspects of an organization's performance, whether positive or negative, are fully reported with no prospect of debt compensation.
5. Principle of Prudence: Speculation does not influence the reporting of financial data.
10 key differences between IFRS and GAAP accounting
1. Adoption
IFRS is a globally adopted method for accounting, while GAAP is exclusively used within the United States.
2. Methodology
GAAP focuses on research and is rule-based, whereas IFRS looks at the overall patterns and is based on principle.
3. Developed by
The principles of IFRS are issued by the International Accounting Standard Board (IASB), while GAAP are issued by Financial Accounting Standard Board (FASB)
4. Inventory Methods
GAAP uses the Last In, First Out (LIFO) method for inventory estimates. However, in IFRS, the LIFO method for inventory is not allowed.
5. Inventory Reversal
IFRS and GAAP accounting also differ when it comes to inventory write-down reversals. In GAAP, the amount of the write-down cannot be reversed. However, under IFRS, the amount of the write-down can be reversed.
6. Income Statements
Extraordinary or unusual items are included in the income statement and not segregated under IFRS. While, under GAAP, they are separated and shown below the net income portion of the income statement.
7. Intangible Assets
When it comes to intangible assets, IFRS takes into account whether an asset will have a future economic benefit as a way of assessing the value. Intangible assets measured under GAAP are recognized at the fair market value and nothing more.
8. Fixed Assets
In fixed assets, companies using GAAP accounting must value these assets using the cost model. IFRS uses a different model for fixed assets called the revaluation model.
9. Development Costs
Development costs can be capitalized under IFRS, as long as certain criteria are met. With GAAP, development costs are not allowed to be capitalized.
10. Quality Characteristics
Finally, the qualitative characteristics of how the accounting methods function. GAAP uses a hierarchy of characteristics, such as relevance, reliability, comparability and understandability, to make informed decisions based on user-specific circumstances. IFRS also works with the same characteristics, except that decisions cannot be made based on an individual’s specific circumstances.
