If your company hopes one day to issue stock or participate in mergers and acquisitions, knowledge of generally accepted accounting principles (GAAP) is critically important. While responsibility for GAAP falls on accountants, a general familiarity with the system and its pros and cons can help you hire excellent financial services and may ultimately affect your company's long-term sales and stock valuation potential.
GAAP is a term that refers to a set of rules, standards and practices used throughout the accounting industry to prepare and standardize financial statements that are issued outside the company. These standards help investors and creditors better compare companies. Companies are expected to follow generally accepted accounting principles when they report their financial information.
GAAP affects the following activities:
- Measuring economic activity
- Disclosing information about an activity
- Preparing and summarizing economic information
- Recording measurements at regular intervals
How GAAP is regulated
Before the stock market crash of 1929 and the Great Depression, the government passed laws to create a standard for accounting practices among publicly held companies. While GAAP itself is not government-regulated, it exists because of the combined efforts of government and business.
The use of GAAP is not mandatory for all businesses, but the U.S. Securities and Exchange Commission (SEC) requires publicly traded and regulated companies to follow GAAP for the purpose of financial reporting. Companies that issue stock are held to this standard by the Securities Act and the Securities Exchange Act, which require yearly external audits by independent accountants. Companies without external investors are not obliged to follow this standard.
Despite the mandate, the SEC is not responsible for the standards associated with GAAP. Instead, the Financial Accounting Standards Board (FASB) actively influences any changes in financial reporting standards used at the corporate level. The Financial Accounting Standards Advisory Councils (FASAC) advises the FASB on all matters that may influence GAAP rules.
Government entities, on the other hand, are influenced by a set of standards that are slightly different from GAAP. The Government Accounting Standards Board (GASB) manages those standards.
Other countries have their own GAAP rules, which differ from those in the United States. Each country's own version of the FASB, such as the Canadian Institute of Chartered Accountants (CICA), creates these rules.
Applying GAAP in the workplace
Accountants apply GAAP through FASB pronouncements referred to as Financial Accounting Standards (FAS). Since its establishment in 1973, the FASB has issued more than 100 FAS pronouncements. Prior to the formation of the FASB, other bodies previously either set or helped set GAAP, including the AICPA Accounting Standards Committee. The Accounting Principles Board (APB) and the Committee on Accounting Procedure (CAP) issued pronouncements that date as far back as 1939. Some accounting standards established by the APB and CAP are still in effect.
While the standards set forth by the FASB and its predecessors account for the majority of GAAP, other rules can be found in statements from the Financial Reporting Executive Commitee (FinREC) of the American Institute of Certified Public Accountants. Additional best practices exist outside formal pronouncements and are commonly accepted, due to their mainstream use. For example, it is generally assumed that financial statements are based on the belief that a company will continue to conduct business.
Accounting professionals with job duties related to reporting a company's financial information are well-versed in GAAP accounting. However, due to the many different standards affiliated with GAAP, accountants are expected to rely on their own knowledge and understanding of finance to determine how a given principle is to be understood and applied. This implies that while GAAP allows financial results to be compared against other companies within an industry, GAAP rules may also be subject to various interpretations and potential manipulation.
For companies, the pressure to hire good accountants is intense, as the costs for falsifying records or having inadequate accounting services is high. Companies like Enron manipulated and omitted financial information to create the illusion of financial stability, which ultimately resulted in legal backlash and insolvency.
If you believe your small business may eventually be subject to GAAP, you may wish to get in the habit of reporting to that standard early on. If it's within your budget, your company can retain the services of an experienced finance lawyer to assist you in vetting the accountant candidates during the interview process. This professional will be able to assist you in asking questions to determine your applicant's level of familiarity with GAAP.
GAAP vs. IFRS
Some countries and multinational companies would like to see the differences between GAAP and IFRS — the International Financial Reporting Standards — eliminated. Fusing the two would ease comparisons between companies based in differed regions. Advocates of the merger contend that it would also simplify management, investment, transparency and accountant training.
Currently, the main difference between these two standards is that IFRS is principles-based, while GAAP relies on guidelines and rules. The goal of the IFRS is to provide good information, and the standards offer guidelines on how to achieve that goal. GAAP, on the other hand, relies on setting adequate rules and guidelines to ensure good reporting.
Despite improved ease of management, accounting and investment, some argue that combining the standards would lead to new issues. The difficulty of merging cross-cultural business ethics and processes into one codified standard could prove insurmountable. Vast differences between political and tax systems could also be prohibitive. More concretely, the time it would take to merge the systems and adopt a universal standard could result in financials losses that exceed the promised gains accrued through simplified standards.
Additional information about the GAAP concept, including overviews of its rules and principles, can be found on the following websites:
- Introduction to Accounting Principles (AccountingCoach)
- Generally Accepted Accounting Principles in the United States (CPA Class)
- The Impact of Combining the U.S. GAAP and IFRS (Investopedia)
- 2014 US GAAP Financial Reporting Taxonomy (Financial Accounting Standards Board)
Additional reporting by Ryan Goodrich, Business News Daily contributor.
Originally published on Nov. 18, 2013. Updated April 16, 2015.