If you run a small business, you may not know much about the Generally Accepted Accounting Principles (GAAP). After all, GAAP standards apply to publicly traded companies, so these rules don't always feel relevant to your small business.
However, it's a good idea to have a basic understanding of GAAP standards. This information will help you improve your accounting skills, understand accounting principles, and pinpoint how your business should track and measure its financial information.
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What are Generally Accepted Accounting Principles (GAAP)?
Generally Accepted Accounting Principles are a set of rules and standards used for financial reporting in the United States. GAAP standards were developed by the Financial Accounting Standards Board (FASB) and the Governmental Accounting Standards Board. These standards apply to corporate, government and nonprofit accounting.
The U.S. Securities and Exchange Commission (SEC) requires all publicly traded companies to adhere to GAAP standards. When each company reports and maintains its financial records the same way, it's easier for investors to compare companies to make investment decisions.
GAAP requires companies adhere to these four standards:
- Recognition: Financial statements should accurately reflect your company's assets, liabilities, revenue and expenses.
- Measurement: Financial statements should measure your organization's financial results in accordance with GAAP standards.
- Presentation: For each reporting period, your business will present an income statement, balance sheet, cash flow statement and statement of shareholder's equity.
- Disclosure: All financial statements will include any notes necessary to help users interpret the information.
Bottom line: GAAP ensures accurate financial reporting and helps investors make more informed investment choices. In addition, these factors can help improve consumer confidence in the financial markets.
What are the 10 principles of GAAP?
These 10 principles can help you understand the purpose of GAAP.
- Principle of regularity: Your accountant has followed all GAAP rules and regulations.
- Principle of consistency: Accountants commit to using the same standards from one period to the next. This consistency makes it easier to avoid errors and ensure financial comparability. If your accountant needs to make a change, they will disclose why in the footnotes.
- Principle of sincerity: Your accountant will provide an impartial and accurate view of your company's financial situation.
- Principle of permanence of methods: There should always be a focus on consistency in the methods used during the accounting process.
- Principle of non-compensation: Your accountant will report all financial information transparently – outlining both the positives and negatives. This is done without the expectation of debt compensation.
- Principle of prudence: All financial data is reported as it currently is, without any speculation.
- Principle of continuity: This principle takes the assumption that your business will continue to operate in the future.
- Principle of periodicity: All accounting entries are reported during the appropriate time periods. For example, both revenue and expenses will be reported during the correct periods.
- Principle of materiality: Your accountant will accurately disclose all accounting information in the financial reports.
- Principle of utmost good faith: This principle states that all parties will remain honest in their transactions.
FYI: GAAP standards assume an accountant is in place to ensure accurate financial reporting. If you need to hire the right accountant for your business, it's best to find someone experienced who can explain accounting concepts clearly.
What are the basic principles of accounting?
If you aren't a publicly traded company, it may not be necessary for you to follow GAAP standards. But all businesses should be familiar with these five basic principles of accounting.
- Revenue recognition principle: This principle states that any revenue should be recorded once your buyer receives the good or service your company provides; not once your business is compensated. This is what's known as accrual accounting.
- Cost principle: Your accountant should record an expense when your company accepts goods or services from another business – whether they've paid for the transaction or not.
- Matching principle: All expenses should match the revenue received during a given accounting period. If your company receives revenue, it should also acknowledge the associated costs.
- Full disclosure principle: Financial statements should include accurate and complete information so stakeholders will know any relevant information about your company.
- Objectivity principle: All accounting data should be fact-based and free of assumptions. All financial data should be supported by receipts, invoices and vouchers.
Did you know? Most companies operate on either a cash or accrual accounting basis. Small businesses often use cash-basis accounting, which records revenue once the business receives the cash. In contrast, accrual accounting records the revenue once the buyer receives the goods or services – whether the company has received the cash or not.
GAAP and compliance
If you run a publicly traded company, the SEC requires that your business follows GAAP standards. In this case, you have to complete GAAP-compliant financial statements to remain listed on the stock exchanges.
GAAP compliance is not required for private companies, but most lenders prefer it. If you plan to apply for a small business loan, you may be required to file GAAP-compliant financial statements.
Additionally, investors are often wary of businesses that don't follow GAAP standards. That's because the consistency of GAAP principles makes it easier to compare financial statements. In case your company ever goes public, you should begin adopting GAAP standards now.
Bottom line: If you're considering applying for a small business loan, seeking out investors, or eventually going public, your company should use GAAP-based reporting. GAAP reporting is seen as more credible by investors, and it will make the transition from a private to a public company easier.
Non-GAAP reporting and limitations of GAAP
GAAP standards are based on principles like accrual accounting, revenue recognition and expense matching. However, some people believe that financial statements prepared according to GAAP standards don't always accurately reflect a company's performance.
For that reason, some companies supplement their financial reports with non-GAAP statements. These are often referred to as pro forma statements. The goal is to present a more accurate and complete view of the company's underlying operations.
According to a FactSet study of 30 companies listed on the Dow Jones, 20 companies included non-GAAP financial statements in addition to their regular financial statements.
Non-GAAP statements can include these items:
- Free cash flow
- Earnings before interest and taxes (EBIT)
- Earnings before interest, taxes, depreciation and amortization (EBITDA)
- Adjusted earnings
- Funds from operations
Proponents of non-GAAP reporting argue that including this information presents a more nuanced view of the company to investors. Critics argue that using non-GAAP financial statements could result in fraudulent reporting. In particular, the SEC has issued a statement advising caution when it comes to pro forma statements.
What is IFRS?
International Financial Reporting Standards (IFRS) is a set of accounting principles for publicly traded companies. IFRS is issued by the International Accounting Standards Board (IASB) and it has been adopted by 120 countries – including those in the European Union.
These rules are designed to increase consistency and transparency for publicly traded companies worldwide. Like GAAP, IFRS outlines how companies should maintain their financial records, and report income and expenses. It creates a global accounting language that investors, auditors and government regulators can understand.
IFRS vs. GAAP
|Issued by the IASB||Issued by the FASB|
|Doesn't allow LIFO (last in, first out) method to estimate inventory||Uses LIFO or FIFO (first in, first out) to estimate inventory|
|Intangible assets are assessed for their future economic benefit||Intangible assets are measured for their fair market value|
|Allows companies more room for interpretation on financial statements||Follows a specific set of rules and procedures on financial statements|
|Revenue can be reported once value is delivered||Revenue can be reported once goods or services are received|
|Groups all liabilities together||Groups liabilities as either current or noncurrent|
Public companies in the U.S. must follow GAAP standards, and the SEC has stated that it will not switch to IFRS. But the SEC is reviewing a proposal to allow U.S. companies to include IFRS information in their annual filings.
These are some of the main differences between GAAP and IFRS:
One of the most significant differences between GAAP and IFRS is how the two standards treat inventory reporting. IFRS would not allow your company to use the LIFO (last in, first out) method to measure inventory.
That's because IFRS standards maintain that LIFO doesn't accurately portray inventory flow, and could make your company's income appear lower than it actually is. In comparison, GAAP standards would allow your company to track its inventory using either LIFO or FIFO (first in, first out).
GAAP and IFRS approach intangible assets differently. Under IFRS, intangible assets can be recognized if they offer a future economic benefit to your firm. However, GAAP recognizes intangible assets at their current fair market value – without any additional assessment.
GAAP standards follow a highly specific set of rules and procedures, with little room for interpretation. These rules are designed to keep your accountants from attempting to inflate your business's financial records to mislead investors. However, IFRS would give your company more room for interpretation in your financial reporting.
GAAP has specific standards for how revenue can be recognized across different industries. In general, revenue cannot be reported until the buyer has received the goods or services it purchased from your organization. IFRS states that revenue can be recognized once the value is delivered to your clients.
Under GAAP standards, liabilities are either classified as current or noncurrent liabilities. This depends on how long your business has to repay your debt. Debt that you must repay within the next 12 months is considered a current liability.
Debt with a repayment period longer than 12 months is considered long-term debt. IFRS doesn't draw any distinctions between current or noncurrent liabilities, and groups them all together.
Why is GAAP important?
GAAP standardizes the process of financial reporting and creates a common accounting language that all U.S.-based businesses can follow. It ensures that all companies follow the same reporting procedures, making it easier for investors to understand and compare financial statements.
GAAP requires that all companies report their financial data fairly and accurately. By maintaining GAAP standards, it's easier to trust the financial market and invest in companies.
Where are Generally Accepted Accounting Principles (GAAP) used?
GAAP principles are required for all publicly traded companies in the United States, but many private companies also follow these standards. GAAP standards apply to all corporate, nonprofit, and government accounting practices.
Who created Generally Accepted Accounting Principles?
The Financial Accounting Standards Board and the Governmental Accounting Standards Board created GAAP standards in response to the stock market crash of 1929 and the Great Depression. At the time, many publicly traded companies were not always accurate in reporting their financial data, which likely contributed to the stock market crash. GAAP was later established under the Securities Act of 1933 and the Securities Exchange Act of 1934.