GAAP (generally accepted

accounting principles)

By

• Stephen J. Bigelow, Senior Technology Editor

What is GAAP (generally accepted accounting principles)?

GAAP (generally accepted accounting principles) is a collection of commonly followed
accounting rules and standards for financial reporting. The acronym is pronounced gap.

GAAP specifications include definitions of concepts and principles, as well as industry-

specific rules. The purpose of GAAP is to ensure that financial reporting is transparent and
consistent from one public organization to another, and from one accounting period to
another.

GAAP emerged in the 1970s and involved the following four major rules and standards:

• Accrual accounting methods. GAAP uses accrual accounting, which records

revenue when a service or good is sold but not when payment is received; direct
expenses for goods sold are recorded when a sale is transacted, and indirect
expenses are recorded when expenses are paid.

• Depreciation and capital expenditures. Costs of major asset acquisitions are

accounted for over the entire life of the asset. For example, an item with a 10-
year life is accounted for at 10% for 10 years.

• Reporting of historical costs. Some assets -- such as property, equipment,

and facilities -- are accounted for using original purchase costs rather than
current market values.
 • Reporting of bad debts. Companies with significant money owed by
customers, or accounts receivable, must report the possibility that some or all of
that money may not be received and becomes lost revenue.

What are the 10 principles of GAAP?

GAAP is outlined by the following 10 general concepts or principles.

1. Regularity. The business and accounting staff apply GAAP rules as standard
practice.

2. Consistency. Accounting staff apply the same standards through each step of
the reporting process and from one reporting cycle to the next, paying careful
attention to disclose any differences.

3. Sincerity. Accounting staff provide objective and accurate information about

business finances.

4. Permanence. Accounting staff use consistent procedures in financial reporting,

enabling business finances to be compared from report to report.

5. No compensation. Accountants provide complete transparency of positive and

negative factors without any compensation. In other words, they do not get paid
based on how good or bad the reporting turns out.

6. Prudence. Financial data is based on documented facts and is not influenced

by guesswork.

7. Continuity. Financial data collection and asset valuations should not disrupt
normal business operations.

8. Periodicity. Financial data should be organized and reported according to

relevant accounting periods. For example, revenue or nses should be reported
within the corresponding quarter or other reporting period.

9. Materiality. Accountants must rely on material facts and disclose all material
financial and accounting facts in financial reports.

10. Good Faith. There is an expectation of honesty and completeness in financial

data collection and reporting.
Organizations that follow GAAP rules and standards adhere to these 10 concepts.

Beyond these 10 general principles, public U.S. companies adhering to GAAP are
expected to observe the following four additional guidelines to support the consistency and
accuracy of financial statements.

• Recognition. Financial reporting should recognize and include all business

assets, revenue, liabilities, and expenses.

• Measurement. Financial statements should report financial results following

GAAP standards.

• Presentation. Financial statements should include four major elements: income

statement, balance sheet, cash flow statement, and a summary of shareholder
equity or ownership.

• Disclosure. Financial reporting should include any notes and descriptions

needed to completely explain financial information contained in reports.

Who uses GAAP?

Accountants and other financial professionals use GAAP rules and standards to organize
and present the financial reporting periodically required by publicly traded companies
within the U.S.

Since GAAP is intended to ensure complete, accurate and consistent financial reporting
between businesses, it affects investment decisions by enabling investors to objectively
compare business performance and influences the stability of the investment market.
There is no universal GAAP standard, and the specifics vary from one geographic location
or industry to another. The U.S. Securities and Exchange Commission (SEC) mandates
that financial reports adhere to GAAP requirements. The Financial Accounting Standards
Board stipulates GAAP overall and the Governmental Accounting Standards Board
stipulates GAAP for state and local government. Publicly traded companies must comply
with both SEC and GAAP requirements.

GAAP vs. IFRS: What is the difference?

Many countries around the world have adopted International Financial Reporting
Standards (IFRS). IFRS is designed to provide a global framework for how public
companies prepare and disclose their financial statements. Today, IFRS is the preeminent
international accounting standard for financial reporting, and 144 out of 166 countries or
jurisdictions around the world use IFRS. Although GAAP and IFRS serve the same
fundamental purposes, there are some key differences between them, including the
following.

• How inventory cost is handled. GAAP enables the last-in/first-out inventory

cost method, but IFRS does not.

• How development costs are handled. GAAP treats development costs, such
as the creation of software or other intellectual property as expenses, but IFRS
treats development as a capital investment that is expensed and amortized over
time.

• How write-downs are handled. GAAP does not allow inventory or asset write-
downs or reductions in value to be reversed, but IFRS allows write-downs to be
reversed if inventory or asset values change.

• How fixed assets are handled. GAAP records and reports fixed assets,
including property, facilities, and equipment at historical cost, while IFRS
enables businesses to adjust fixed assets at fair market value.

Adopting a single set of worldwide standards simplifies accounting procedures for

international countries and provides investors and auditors with a cohesive view of
finances. IFRS provides general guidance for the preparation of financial statements,
rather than rules for industry-specific reporting.