Whether you intend to prepare your financial statements with the intention to issue public stock one day or simply want bigger investment opportunities, understanding and actively applying generally accepted accounting principles (GAAP) equips you for future success. Let’s take a closer look at what GAAP entails and how you can use it to your advantage.
The ins and outs of generally accepted accounting principles (GAAP)
Generally Accepted Accounting Principles—commonly referred to as GAAP—are standardized rules and principles that dictate how all U.S.-based, publicly-traded companies report their financial health.
The goal of GAAP is to establish a layer of financial transparency and consistency across companies, which is why these accounting standards are used to prepare financial reports like income statements, balance sheets, and cash flow statements.
The same set of accounting standards is also used by many private companies that want to follow standardized accounting principles. Doing so enables investors and other stakeholders to make evidence-based decisions regarding a company’s financials.
Where GAAP comes from
The standardization of all accounting principles dates back several decades: Generally accepted accounting principles (GAAP) were established in response to the Stock Market Crash of 1929 and the Great Depression.
In the wake of these financial catastrophes, the U.S. government created the Securities and Exchange Commission (SEC) in 1934 to enforce laws, protect investors, and create accounting standards. Not long after, other financial organizations—like the Financial Accounting Foundation (FAF)—founded the Financial Accounting Standards Board (FASB), which is responsible for creating GAAP.
GAAP, in turn, emerged with legislative acts like the Securities Act of 1933 and the Securities Exchange Act of 1934. Those same accounting principles for financial transactions have evolved over the years and continue to apply to businesses across industries.
Why companies use GAAP
Because it’s such a foundational part of accounting, GAAP can impact several business activities, including:
- Aiding in preparing accurate financial statements and data
- Reducing accidental fraudulent reporting
- Providing consistency when comparing to other GAAP-compliant companies
GAAP is used because of what’s called “comparability.” Compatibility allows for easier comparison when looking at a company’s financial reporting data when that business uses the same accounting principles and reporting standards as most other companies.
This comparability is also what makes using GAAP so practical.
For example, suppose you’re a small business with plans to seek funding opportunities to raise capital. In that case, you must ensure that your financial statements are straightforward for potential investors, lenders, shareholders, prospective buyers, and potential partners.
This way, each listed stakeholder can look at your company’s financial statements and easily compare them to other companies they may consider working with to determine the best fit for their investment resources.
- Consistency: GAAP ensures consistency by establishing standardized practices rooted in transparency and honesty. This means that all financial records are disclosed, complete, and accurate.
- Accountability: It holds organizations accountable to clear financial reporting requirements.
- Birds’ eye-view: A standardized set of accounting and financial reporting rules makes it easy for others, such as investors, to read that financial information and learn about the company’s financial performance.
- Relevancy and reliability: GAAP reduces the risk of error because it has several safeguards and checkpoints.
- Non-global recognition: GAAP’s financial reports are not necessarily recognized globally like the International Financial Reporting Standards (IFSB), which are more commonly used worldwide.
- One-size-fits-all method: This accounting method does not account for the diversity of needs among different companies. For example, small businesses might find it more challenging to incorporate all GAAP principles into an otherwise established financial framework.
- Long-waiting time for new standards: Rigorous processes to establish new GAAP standards hinder efficiency and require approval before implementation.
The ten principles of GAAP
If you’re unsure of the difference between the terms “principles,” “guidelines,” and “standards,” then you’re not alone.
Before we get into the ten principles of GAAP, let’s break down what the difference is when considering these versus these other methodologies:
- Principles are rules that must be followed when preparing financial statements and can contain a mixture of standards and guidelines
- Guidelines are not so different from principles but are a bit more flexible in the fact that they are broader and can be adopted over time
- Standards offer clear benchmarks and considerations for what should and shouldn’t be performed or common practice
These ten basic principles are a blueprint for what your company should follow when required to comply with GAAP:
1. The principle of regularity
This accounting principle asserts that adhering to GAAP is an around-the-clock job, not just an ad-hoc occurrence. In other words, when preparing financial statements, accountants must always follow GAAP standards and regulations.
How it works
Say that you have two accountants located in different locations. One is in New York, and the other one is in California. If the U.S. didn’t have established accounting rules and principles—cue GAAP—and each accountant used the accounting rules normalized in their region, it would be impossible for these two accountants to understand each other’s work.
2. The principle of consistency
The consistency principle asserts the need to apply consistent standards and practices across all accounting periods and financial statements.
Any changes in your typical accounting practices need to be noted (with an explanation and justification) in the footnote section of the financial statements. These footnotes can give business leaders and investors greater visibility into account balances, practices, and potential risk factors.
How it works
Say that you are a small business and your accountant, Raphael, uses the cash-basis accounting method to create a profit and loss statement.
Over time, as your small business grows into a larger, publicly-traded business, you’re required to become GAAP-compliant. Unfortunately, the cash-basis accounting method is not accepted under GAAP, so Raphael must switch to the accrual accounting method and use it for all future financial recordings.
When switching to the accrual method, Raphael must document this change in your business’ footnotes and accounting policies. He should explain the change and how it might impact future reports.
3. The principle of sincerity
Sincerity refers to the honest documentation and disclosure of the company’s financial health. This means that the accountant isn’t misleading business leaders, investors, creditors, or shareholders by ensuring that all information is presented fairly and as accurately as possible.
How it works
Imagine your business, NextGen Lenders, struggled to reach its sales goals this year. But luck knocked on the door, and an investment opportunity from Gama appeared.
Raphael, who is still your accountant, is preparing the income statement and other relevant financial statements so Gama can look at them. Now, he can easily misrepresent information and showcase a higher revenue to put NextGen Lenders in a more favorable investment position.
But he can’t—and most importantly—shouldn’t do that. As an accountant, Raphael is obliged under GAAP to prepare financial reports fairly and accurately without misleading anyone.
4. The principle of permanence of methods
It’s also necessary for accountants to use the same financial reporting methods across financial statements. Committing to a single method when preparing financial reports makes it easier to compare them when required—and it also proves that the company only uses consistent and best practices.
How it works
Raphael has decided to take a three-month sabbatical. You bring in another accountant, Ben, to substitute him for the time being. Now Ben should be able to look at your company’s books and reach the same conclusions as Raphael did because the same accounting methods were used throughout the history of the business’ operations.
5. The principle of non-compensation
This principle asserts that accountants must report all positive or negative financial performance with no prospect of debt compensation across accounting records.
How it works
Your new, albeit temporary, accountant Ben has noticed that you have some debts that will not make your company look good in front of shareholders. He thinks that it’s okay to hide the increasing debts behind the revenue, but little does he know that GAAP will have none of it. Accountants should not cover up any accounting facts for any reason—and no exception is made for Ben either.
6. The principle of conservatism
The conservatism principle states that financial statements should not include any speculation.
How it works
Say Red Inc. is suing Blue Inc. for patent infringement and foresees winning a considerable settlement. Since the settlement is uncertain, Red Inc. does not record this anticipated gain in its financial statements.
The reason why Red Inc. isn’t recording this potential gain is that it might not end up seeing this gain at all. And a sizable financial settlement can easily skew the company’s financial statements misleading users, which is why the potential gain is not included in the books.
This obviously isn’t good practice: Instead, good practice would say that Red Inc. must report any type of speculation of a likely outcome in the footnotes for investors.
7. The principle of continuity
Also called the “going concern” principle, continuity maintains the need for accountants to prepare financial statements assuming that the business will not cease to operate in the foreseeable future.
How it works
Your company, Limitless, makes plastic bottles. Then, suddenly, plastic bottles become illegal. Limitless only produces plastic bottles, so you cannot apply the principle of continuity when preparing the company’s financial statements because Limitless will soon be out of business.
8. The principle of periodicity
This principle requires companies to stick to a standard accounting period when providing financial reports. It can be divided into specific periods, fiscal quarters, or even years.
How it works
Say your company is preparing its financial statements. It decides to do so for July but misses August and continues to provide another report in the middle of September. This does not work: If your company reports its cash flow monthly, it needs to do so for a consistent period, with no ad-hoc reporting for the sake of convenience.
9. The principle of materiality
The principle of materiality refers to reporting transactions that have a material impact on either the financial statements or future performances of a business.
In other words, this principle states that any item (usually one likely to impact an investor’s decision on a business) must be recorded in detail on financial statements.
How it works
Your company purchases office chairs for $500. Under the materiality principle, you would record the entire $500 purchase in the year it was purchased.
(The materiality principle should not get confused with the matching principle, which allows you to record the $500 purchase throughout its lifetime as a depreciation expense. So, if these chairs have a lifespan of 10 years, you would record $50 a year for ten years.)
10. The principle of utmost good faith
This principle requires all stakeholders (accountants, business owners, and other relevant parties) to report their financial information with the utmost honesty.
How it works
Your accountant, Ben, is responsible for reporting your company’s financial information to the best of his abilities. He needs to report profit, loss, and other relevant information accurately—no matter how good or bad that might make your company appear.
Alternatives to GAAP
Companies outside of the U.S. don’t have to use GAAP for reporting financial data. Also, private companies, which includes most small businesses, don’t have to use the generally accepted accounting principles. So let’s take a look at some alternatives to GAAP:
There are cases when GAAP does not work well to demonstrate a business’ operations. In such instances, companies can use their own accounting figures, limited to having a non-GAAP disclosure.
Non-GAAP, as per the name, results in a profit figure that does not follow the set accounting rules but provides another window into a company’s financial performance.
Unlike GAAP, non-GAAP reporting does not include non-cash or non-recurring expenses: Instead, it typically smoothes out fluctuations in high earnings that can come from temporary events, helping frame a clearer business picture.
For example, companies can add GAAP earnings with non-GAAP measures. In fact, more than 95% of S&P companies (Standard and Poor’s 500) report GAAP and non-GAAP earnings when reporting their financial information.
Such flexibility allows management to have alternative methods to showcase the true company’s performance. As a concrete example of this, we have companies that might decide to report earnings before depreciation.
Financial Reporting Framework for SMEs
The Financial Reporting Framework (FRF) was specifically designed with the small-to-medium enterprise (SME) community in mind. FRF provides a financial framework that mixes traditional accounting methods with accrual income tax methods.
FRF seeks to help businesses provide accounting information in a simple, consistent, and efficient way. And as a financial framework that has international recognition, it comes with its own set of benefits, including:
- Less demanding reporting requirements compared to GAAP
- Enhancements to the financial reporting quality
This financial framework targets companies that do not have public accountability—think unlisted companies—and typically report general purpose financial statements. To clarify, general-purpose financial statements aim to provide general information to various users who are not in the position to ask for customized reports.
FRF for SMEs is typically used when GAAP is not required and is an additional non-GAAP reporting method. Although the name says small and medium-sized entities, many entities that use FRF would not consider themselves to fall within this scope.
However, this financial framework is not recommended for companies that plan to go public.
International Financial Reporting Standards
Another alternative to GAAP on an international scale is the International Financial Reporting Standards (IFRS) for SMEs. This reporting standard was established in 2009 because SMEs represent more than 95% of companies in developing and developed countries.
Otherwise known as “IFRS light,” this is a good option for U.S. companies looking to expand overseas or enter the international market. This particular accounting standard is intended for unlisted companies, making it suitable for private small and medium enterprises.
Some targeted users include (but are not limited to) venture capital entities providing lending, vendors or suppliers assessing the financial health of foreign customers or suppliers, and lenders to multinationals, to mention just a few.
Many differences exist between the two:
- They’re used differently. Only U.S.-based publicly-traded companies must use GAAP, but if a company has foreign subsidiaries, it must follow GAAP and IFRS.
- Flexibility is different. IFRS is viewed as more dynamic, adapting to change easily, while GAAP is perceived as more rigid and slow to evolve.
- Balance sheets are reported differently. GAAP requires asset reporting in order of liquidity with current assets first. In contrast, IFRS reverses the order, starting with non-current assets first, followed by owners’ equity in the middle of the balance sheet.
- Methodological differences exist between the two. GAAP allows First in, First out (FIFO) or Last in, First out (LIFO), while IFRS banned LIFO as an inventory cost method.
GAAP and IFRS are working on merging the two accounting standards to adopt a set of globally accepted accounting standards. Doing so might benefit U.S. and global companies to prepare easy-to-read, comparable financial reports worldwide that are not limited by borders.
An example of GAAP in practice
To put GAAP into perspective, let’s look at income statements as one type of financial reporting. GAAP has two classifications for income statements that are divided between single-step and multi-step income statements.
Example #1: Single-step income statements
With a single-step income statement, otherwise known as a profit and loss statement, you get a clearer picture of where you stand financially because, compared to a multi-step income statement, it’s easy to prepare and easy to read.
Let’s take a look at Company A’s income statement for March 2022:
We can see from this example that there is a simple way to calculate the company’s net income—and that’s through subtracting expenses from revenues. With the main focus on the bottom line (the net income), this method is a more straightforward way to understand revenue.
This method is helpful for small businesses that want a simple glance into their current financial standing.
Example #2: Multi-step income statements
The multi-step income statement format is a bit more complex. This income statement calculates the gross profit as the cost of goods sold subtracted from sales, followed by other income and expenses, resulting in net income before tax.
Ultimately, a multi-step income statement offers more detailed information because it reports gross profit and operating income.
Let’s take a look at Company B’s income statement for March 2022:
When looking at this income statement, you can see that the financial entries are attributed differently: There’s an itemized breakdown of the company’s revenue and expenses that are split into operating and non-operating income and expenses.
This method is helpful for businesses looking to apply for a loan or present information to a potential investor—because, as always, the more information, the better.
How to make GAAP work for your business
GAAP isn’t required for every business in the U.S. (usually small to midsize privately-owned businesses), but it becomes imperative when your company is getting ready to have an initial public offering, looking for funding, or wants to merge with another business.
With GAAP guidelines, you establish better communication with accountants and ensure that the proper accounting practices are followed. In a nutshell, it helps you take control of your company’s financial information.
But it’s also a requirement to adhere to it—if you don’t, there are consequences. Costly ones. Errors, financial omissions (which can lead to lawsuits), or impacted credibility with investors and other parties are all potential consequences of not following GAAP.
So what can your company do to ensure GAAP compliance?
Step #1: Establish good hiring practices
It may seem like a no-brainer, but hiring the right individuals who align with your company’s value system is crucial.
When hiring, look for candidates who:
- Understand double-entry bookkeeping since GAAP requires this for fewer errors
- Have education in accrual-basis accounting, which is only acceptable under GAAP
- Can research and cross-reference GAAP-related standards
You should hire employees that exhibit transparency, honesty, and accuracy—all principles closely tied to GAAP.
Step #2: Provide regular company-wide training sessions
Not only does research show that training and development increase morale, productivity, and skill in their employees, but a refresher on GAAP’s standards can be an important way to stay on top.
GAAP compliance training is a must in maintaining set standards and best practices, and having regular, company-wide training diminishes the possibility of errors.
Frequent training and open-forum discussion sessions also open the floor for potential issues and questions within your accounting department.
Step #3: Schedule annual external audits
The word “audit” might make you shake your head at the thought—and while that’s understandable, an external audit actually poses incredible benefits for your organization:
- External audits provide credibility to the government, investors, customers, and stakeholders, which is essential when you’re looking for funding or partnerships
- Since you don’t know how something works until you put it to the test, an external audit can improve internal systems and the way your accounting department operates
- In performing an external audit, you might discover potential errors that have to do with your GAAP compliance, allowing you to make changes so you can stay on track
- Most business owners aren’t accounting experts, no matter how much they try to stay in the loop—but an external audit is a great learning opportunity and can further educate business owners on the ins and outs of their financials
External audits are performed by independent agencies that specialize in helping businesses understand their financial standing and compliance with U.S. law. Performing your own every year could also save you a significant headache come tax season.
How do taxes affect accounting?
Taxes are heavily reliant on accounting. What you owe and what you can deduct depend on the information you have in your accounting system. Furthermore, your business structure and accounting method affect how you file, when your taxes are due, and what taxes you are required to pay.
On the other hand, taxes impact the net income your business ends up making. Here’s how:
- Depending on your business type, what you owe for taxes directly affects your net earnings.
- Tax expenses limit the profit that may go to shareholders and investors.
Recording and tracking all of your taxable income can be difficult—especially when the numbers begin adding up and you need to record a high number of eligible deductions.
This is exactly why medium-to-large businesses and corporations have a dedicated tax accountant or tax accounting department. This subsector of accounting focuses on everything tax-related, like tax returns and payments, qualifying deductions (home offices, for example), investment gains and losses, and donations.
Use expense management software to stay compliant with GAAP
When you have a platform that makes using GAAP easier, you can maintain compliance and feel more in control of your company’s financial health.
GAAP requires using many financial statements—all of which can be recorded, tracked, and safely stored with an expense-management software like BILL Spend and Expense.