GAAP: A Comprehensive Guide
If you’re a small business owner or entrepreneur, you’ve probably heard of GAAP, the Generally Accepted Accounting Principles. This set of accounting principles provides standard rules and methods for businesses to collect and report financial information.
In the United States, the Securities and Exchange Commission (SEC) requires publicly-traded companies to follow GAAP in their financial reporting. However, because these accounting principles are so widely accepted, many other companies choose to do so when compiling and producing financial information. Adhering to these generally accepted accounting practices allows businesses to display financial transparency and consistency to potential investors or other outside parties.
What is GAAP?
GAAP is a set of accounting standards developed by the Financial Accounting Standards Board (FASB) and enforced by the U.S. Securities and Exchange Commission (SEC). Although the FASB is a private, nonprofit enterprise, its authority to set these rules comes directly from the SEC. Publicly-traded companies that violate GAAP can face discipline and steep fines from the SEC. For example, in 2019, Hertz was fined $16 million for inaccurate financial reporting.
GAAP accounting standards exist so that investors, creditors, and the public can better compare different companies’ financial situations. By standardizing how financial information is collected, compiled, and reported, GAAP promotes common understanding and trust in the accuracy of financial reports.
GAAP standards evolve, with the FASB regularly issuing updates. These updates typically include any changes to the rules along with implementation timelines that give businesses time to prepare for compliance with the new regulations.
While GAAP is widely followed in the United States, it is not a worldwide standard. The International Financial Reporting Standards (IFRS) are the most commonly used accounting laws worldwide. The countries that adhere to the IFRS are Canada, India, Japan, and the European Union.
The 10 Principles of GAAP
These ten principles represent the most important conventions of GAAP and serve as general accounting guidelines for companies to follow. Being GAAP compliant requires adhering to each of these accounting principles.
In addition to these ten principles, GAAP includes a long list of more specific rules and accounting standards published by the FASB. GAAP also includes a third component known as generally accepted industry practices. These industry-specific practices allow GAAP to be flexible enough to be used across different types of businesses.
Nevertheless, the ten principles of GAAP represent the foundation of all its other accounting rules. They date back to the period immediately following the Wall Street Crash of 1929.
1. Principle of Regularity
Businesses and accountants must follow GAAP at all times. None of its principles or regulations can be ignored or modified. GAAP is not intended to be flexible; instead, it is a strict set of principles that must be followed at all times to maintain compliance.
2. Principle of Consistency
Businesses and accountants must use consistent standards when documenting and reporting company finances. Any changes or updates to an accounting method or procedure must be thoroughly documented and justified in writing. This principle ensures that a company’s financial information is comparable over different periods. If a company does make any changes to its accounting method, a clear record of that change is publicly available.
3. Principle of Sincerity
Simply put, this principle requires accountants to do unbiased, accurate work. Accountants are responsible for creating accurate financial records and reports that provide an honest picture of a company’s financial situation.
4. Principle of Permanence of Methods
Similar to the principle of consistency, this principle requires accountants to use consistent methods for all financial reporting. While the principle of consistency ensures that the same accounting methods are used across time, the principle of permanence of methods is more specifically focused on financial reports. Adherence to this principle ensures that all of a company’s financial reports are comparable.
5. Principle of Non-Compensation
Accountants must disclose both positive and negative financial information. Relatedly, an accountant cannot use an asset to compensate for a debt; for instance, a company can’t manipulate a balance sheet by using cash reserves to cover up an expense or a debt.
6. Principle of Prudence
This principle requires financial reporting to be clear and fact-based. It prevents accountants from speculating when representing a business’s finances on financial statements. The principle of prudence does not prevent businesses from engaging in financial forecasting, but forecasts and speculation cannot be included in formal financial statements.
7. Principle of Continuity
The principle of continuity requires accountants to value assets as if a business will continue on with normal business operations. As with the principle of prudence, this principle ensures that accountants do not take speculation or plans into account when valuing assets.
8. Principle of Periodicity
Businesses must provide financial reporting regularly and correctly report financial figures during the relevant accounting period. This principle prevents businesses from changing reporting periods or fudging dates to make financial numbers look better.
9. Principle of Materiality and Good Faith
The two-in-one principle requires accountants to include all relevant financial data in financial reports and do their best to obtain all of that data. GAAP requires this data to be reported, whether it reflects positively or negatively on the business.
10. Principle of Utmost Good Faith
The final principle sets an ethical standard for all parties involved in financial transactions and reporting, requiring that all parties act honestly and truthfully.
Advantages and Disadvantages of Using GAAP
Adhering to GAAP standards has many advantages for your business.
- Trust: Because GAAP is a widely-used and respected accounting method, abiding by its principles will increase confidence in the accuracy of your financial information. This can be extremely useful when presenting financial information to potential investors, loan officers, and other interested parties.
- Accuracy: GAAP provides clear and consistent standards for gathering and reporting financial information. Adhering to these standards can give you confidence that your business’s financials are accurate. It decreases the chances that you’ll be blindsided by bad financial news or buy into unrealistically rosy projections.
- Fraud protection: Operating with clear and consistent accounting procedures protects your business against fraud and misrepresentation. It’s much easier to spot financial wrongdoing when implementing a proven method for accurate financial accounting.
- Comparability: GAAP standards are GAAP standards regardless of who is doing your company’s books. When you have a consistent method of putting together financial reports, you can be confident that you’ll always be able to compare your current financial situation with your financial situation from past periods. An accurate picture of your business’s financial trajectory can help you make the best decisions for moving forward.
While GAAP unquestionably has advantages, it’s also important to consider its limitations and potential disadvantages for certain businesses.
- Rigidity: GAAP rules don’t provide any specific allowances for small businesses or sole proprietorships. For instance, GAAP requires the use of accrual basis accounting. For some small businesses, this can present a significant burden or may not work as well as cash basis accounting.
- Resources: Adhering to GAAP requires investment and resources, including using accountants and software systems and creating detailed policies and procedures. Resources cost money, so businesses must weigh that investment’s importance when deciding whether to become GAAP compliant.
- Not Global: GAAP compliance is required explicitly for publicly-traded companies in the United States. Globally, however, most jurisdictions use the International Financial Reporting Standards (IFRS). As such, international businesses are more likely to be familiar with and guided by the rules set out in IFRS.
Choosing a Remote Bookkeeper Who Can Help With GAAP
For many businesses, the upsides of GAAP compliance will outweigh the downsides. If your business is likely to expand in the future, the earlier you align your accounting practices with GAAP, the smoother and less expensive that transition will be.
Working with an accountant familiar with GAAP accounting principles can help you move towards implementing accounting principles that will work best for your business. Remote Quality Bookkeeping has the expertise to ensure that your accounting and financial reporting systems are GAAP compliant. And if your business situation doesn’t require adherence to GAAP, we can still help you create a clear and structured process for financial reporting that will meet your needs.
Contact Remote Quality Bookkeeping today for a demo of our products and services and learn how our highly-trained, professional team can help your business.
