A quick history of GAAP
With the stock market crash of 1929, questions on the ethics and accuracy of financial reporting made by publicly traded companies arose. Among legislation and regulatory boards created to combat the Great Depression, the need for standardized methods of reporting financial data was identified. As a result of the Securities Exchange Act of 1934, the General Accepted Accounting Principles (GAAP) became a set of principles and regulations established to standardize how companies reported on their finances. Knowing what GAAP is and why it is beneficial to your company as a reporting option will make a difference for company growth, investor speculation, and auditor review.
What is GAAP?
GAAP is a set of principles, standards, and procedures that are applied through the use of an accrual accounting process by an AP department. Some aspects it covers are: procedures on income, expenditures, financial statement presentation, liabilities and assets, and foreign currency. Using GAAP, accountants are then able to report the financial performance of a company over a period of time, typically a fiscal year. Publicly traded companies in the United States are required to submit financial information to a non-affiliated certified public accounting (CPA) firm to remain on the stock exchange.
GAAP principles and standards are applied to three main financial statements:
- Income statement (Profit and Loss statement)—The income statement focuses on the revenue and expenses of a company.
- Balance sheet—This report shows the capital structure of the company: owned assets, investments from shareholders, and liabilities.
- Cash flow statement—A statement of currency exchange over a period of time that can include: cash generated by operating activities, cash equity available after expenditures, modeling of cash availability where no debt (leverage) is present, and reporting of net cash from one time period to the next.
GAAP was created, and is regulated by, the Government Accounting Standards Board (GASB), the Financial Accounting Standards Board (FASB), The American Institute of Certified Public Accountants (AICPA), and the Securities and Exchange Commission (SEC). While it is used specifically in the United States, other countries have similar principal guidelines: The International Financial Reporting Standards (IFRS) which are regulated by the International Accounting Standards Board (IASB).
What is the role of GAAP?
Because the SEC requires larger businesses (25M+), or those that are publicly traded in the United States, to report their financial information, a more comprehensive and universal system is required to encourage accuracy, accountability, and transparency. GAAP compliance fulfills these necessities by providing guiding principles and standards that all publicly traded companies are required to implement, creating equitable and reliable data from which financial decisions are made. Financial information created using GAAP may be used in federal reporting, investor agreements, audits, and internal decision-making.
As a means to provide a uniform financial reporting process, GAAP serves as a set of principles that a company applies to their reporting practices. The FASB provides GAAP guidance throughout the United States, and the GASB provides guidance to local governments which differs from state to state. Some local governments allow businesses to choose between cash basis accounting and accrual basis accounting, however GAAP’s language applies specifically to accrual basis accounting. Therefore, those businesses are better off using accrual accounting to eliminate any complexities or discrepancies in reporting.
The two methods of accounting differ most significantly with regards to when an accountant reports on income and expenses. Cash basis accounting records income and expenditures only once an exchange of currency has occurred. Accrual accounting, on the other hand, records income and expenditures immediately, when an invoice is received or work is completed, whether or not there has been an actual exchange of currency.
Why is GAAP so important?
Despite the fact that GAAP is not required for smaller private businesses, implementing it may still prove to be beneficial and necessary. While speculating, investors rely on GAAP practices for decision making. When they are able to compare like businesses with consistent financial information, they can more accurately choose one business over another. Where a company has not implemented GAAP, an investor may see this as a red flag. Most importantly, GAAP aims to minimize egregious errors, intentional or otherwise, in financial disclosures and accounting practices. Reporting with GAAP implemented also provides more comprehensive data that a business itself can use to make financial decisions.
GAAP is not law, rather a set of principles that are applied to the reporting process. That said, misuse of GAAP guidelines can lead to loss of credibility if a company is seeking lenders or investors. Those who are interested in your business want honesty and transparency, and GAAP helps to ensure those pillars of accountability. Failure to apply GAAP appropriately may also lead to financial ramifications. Historically, companies that have failed to uphold one or more of the GAAP principles have faced millions of dollars in fines.
What are the 10 major principles under GAAP?
Here is a list of the ten GAAP principles that an AP department applies to their accrual basis accounting process:
- Principle of Regularity. Accounting records are updated in a timely manner and yearly reporting (federal tax filing) is completed in the time provided with GAAP regulations applied.
- Principle of Consistency. The same accounting rules and systems are used throughout a time period of reporting. They are also used over time so that reports from one time period to another are comparable. Should any changes occur, accountants are expected to explain any changes made in footnotes to the documents.
- Principle of Sincerity. Accountants should strive to objectively and impartially report the business financial situation.
- Principle of Permanence of Methods. Documentation of accounting methods is coherent and applied consistently over time.
- Principle of Non-Compensation. Reports accurately show all information, both negatives and positives, without compensation for debt by an asset or revenue by an expense.
- Principle of Prudence. Financial information reported is not based on probability or assumption.
- Principle of Continuity. When reporting assets, it is assumed that businesses are continuing to operate. Further, it is accepted that asset depreciation may be represented because these values change over time.
- Principle of Periodicity. Revenue should be allocated over the entire span of its income/expenditure and not just on the final date of a transaction. For example a subscription has several payments.
- Principle of Materiality / Good Faith. Accountants should in “good faith” make all financial data available.
- Principle of Utmost Good Faith. From the Latin phrase “uberrimae fidei,” this principle presumes that all involved parties are honest.
Because GAAP is a more complex system of reporting applied to accrual accounting, it may not be the primary choice for a smaller business to implement. The process requires a larger, skilled staff who are able to dedicate their time and resources to that primary task. However, the benefit of uniformity on a national level and the appeal to investors means that businesses that have the ability to implement GAAP to their accounting practices are setting their business up for growth and viability.