Everything You Need to Know About GAAP

Everything You Need to Know About GAAP

Your comprehensive guide to the Generally Accepted Accounting Principles.

In 1936, the American Institute of Accountants drafted its “Examinations of Financial Statements,” which established the Generally Accepted Accounting Principles (GAAP). Since then, GAAP has become the most widely accepted accounting standard for companies and organizations in the United States.

But the evolution of GAAP wasn’t complete, and the Financial Accounting Standards Board (FASB) was established in 1973. FASB provides the accounting principles and frameworks used to prepare and report financial statements.

As you navigate the fundamentals of GAAP, its history and its frameworks, you will begin to understand why GAAP has become the gold standard in accounting policies.

What is GAAP and why is it important?

GAAP is the set of standards and guidelines used by a public accountant in preparing, presenting and analyzing financial statements. It improves financial reporting and helps ensure that companies consistently report their finances.

Public companies, private companies and nonprofit organizations must comply with financial reporting standards when providing financial statements to the general public. Businesses also use financial statements to communicate their financial performance and position to investors and other stakeholders. Therefore, GAAP ensures that the information is reliable and transparent.

For internal auditing purposes, GAAP provides the framework and criteria to create consistency within reports and help identify fraudulent activities. Compared to external auditing, it can provide more in-depth results.

There are three critical GAAP elements, each providing unique insight into a business’s finances. These components include accounting principles, rules and standards, and generally accepted industry practices.

The importance of GAAP lies in its ability to provide high-quality financial information that is both reliable and consistent. This helps foster trust among users of financial statements and enables investors to make confident decisions.

The key principles of GAAP

GAAP comprises 10 core principles that must be followed when preparing financial statements:

  1. Principle of Regularity. Companies must follow GAAP consistently.
  2. Principle of Prudence. Financial information should be conservatively estimated and recorded.
  3. Principle of Continuity. Businesses should assume they will continue to exist for the foreseeable future.
  4. Principle of Consistency. Companies should use the same accounting methods from one period to another.
  5. Principle of Regularity. Companies should recognize expenses as soon as possible.
  6. Permanence of Methods. Companies should use the same method of accounting from one period to another.
  7. Principle of Sincerity. The financial statements should be presented truthfully and accurately.
  8. Principle of Non-Compensation. Companies should not attempt to offset losses with gains.
  9. Principle of Periodicity. Financial statements should be reported within the appropriate accounting period.
  10. Principle of Materiality. Material information must be disclosed to the best of the company’s knowledge and understanding.

Key GAAP guidelines

Beyond the 10 core GAAP accounting principles, you must follow additional accounting guidelines when preparing financial statements. These guidelines ensure accuracy and completeness in the financial reporting process.

Revenue recognition of financial statements

GAAP follows a specific set of accounting rules for recognizing revenue. This guideline states that companies should only recognize revenue when they have earned it, not when they have received the cash. This helps ensure that a business is only recording income that it actually earned and not simply inflating its results.

Correct measurements that meet GAAP standards

GAAP requires that businesses use the appropriate measurement method for each financial transaction. Financial instruments must be consistent with their market value, and any changes in the financial statements due to inflation must be adjusted for.

For example, a business should not measure inventory at cost but instead must use the lower of cost or market value. Standardizing measurements help ensure there is consistency in the financial reporting process.

Thorough reports with proper documents

A paper trail must be established to comply with GAAP. Companies must provide enough evidence and documentation to show that their financial statements are accurate. Financial reports should contain all relevant information, such as income statements, balance sheets, cash flow statements and notes to the financial statements. Direct expenses, such as sales commissions and advertising costs, must also be included in the GAAP accounting reports.

All information must be disclosed

Transparency is the number one goal of GAAP, and all information must be disclosed to investors. To discourage manipulating financial statements, companies must report any significant information that could affect an investor’s decision. This includes bad debts, off-balance sheet transactions and potential risks associated with investment decisions.

What are the limitations of GAAP financial reporting?

No accounting standard is perfect, and GAAP has its limitations. The major downside of GAAP is that it does not account for intangible assets, such as brand loyalty or customer relationships.

Additionally, since the rules are largely based on historical data, they may not be suited to rapidly changing markets or conditions. Finally, companies have some discretion in how they apply certain GAAP rules, which can lead to inconsistencies in financial reporting.

Non-GAAP measures, such as Economic Value Added (EVA) and Cash Flow Return on Investment (CFROI), have been created to address the limitations of GAAP. These measures focus on factors not considered in GAAP financial reporting and can provide a more comprehensive view of a business’s performance. However, they are not recognized by GAAP, and companies must disclose their use of any non-GAAP measures.

Streamline and maintain your accounting standards with the right support

GAAP principles provide a reliable way to standardize financial reporting and ensure accuracy. However, it can be difficult to implement and maintain complex rules and regulations.

Caseware’s Audit & ASsurance solution helps accounting firms streamline their compliance with GAAP by providing all engagement documents and support materials in a single location. With a comprehensive audit trail, you’ll never have to worry about losing track of important documentation. Plus, you eliminate the need for manual data entry, allowing you to focus on the analysis and insights that will help you make informed decisions.

Effective collaboration is the cornerstone of Caseware’s Audit & Assurance solution. The software allows team members to work together in real time, regardless of location. When team members can access the same information, accuracy and efficiency are maximized.Discover how to simplify and improve your compliance with GAAP. Learn more about Caseware’s Audit & Assurance solution.