The rules set forth in GAAP improve consistency and clarity of financial communication by ensuring that all public U.S. companies report their financial status in either identical or very similar manners. These principles were determined by the Financial Accounting Standards Board (FASB).
10 Key Principles of GAAP
- Principle of Regularity
- Principle of Consistency
- Principle of Sincerity
- Principle of Permanence of Methods
- Principle of Non-Compensation
- Principle of Prudence
- Principle of Continuity
- Principle of Periodicity
- Period of Materiality
- Principle of Utmost Good Faith
GAAP ensures the key topics of revenue recognition, balance sheet classification and materiality are easy to understand across all documents from all companies.
GAAP includes both strict rules and best practices, thereby providing both specific requirements and flexible guidance for atypical situations. These regulations ensure that investors can easily understand the financial health of each company, and easily compare companies before making investment decisions.
Are GAAP Standards Legally Required?
U.S. law requires all publicly traded companies, or companies releasing financial statements to the public, to follow GAAP principles.
What Are the Generally Accepted Accounting Principles (GAAP)?
There are 10 fundamental principles behind GAAP. The rules are designed to enforce following these principles. For atypical situations, when companies need to use more flexible reporting methods, they are expected to follow these guidelines.
- Principle of Regularity: The accountant must adhere to all GAAP rules and regulations.
- Principle of Consistency: Accountants presenting financial information commit to using the same methods and regulations both within one, and across several, time periods. If the accountant changes methods between time periods they will leave a clear declaration of how and why they used a different approach.
- Principle of Sincerity: Accountants must provide an accurate and impartial view of a company’s financial health.
- Principle of Permanence of Methods: All principles used in financial accounting are to be consistent, which enables comparison across both companies and time periods.
- Principle of Non-Compensation: Accountants will report both negative and positive aspects of a company’s financial health with full transparency. The accountant shall not expect additional compensation for presenting a company’s financial health in a positive light.
- Principle of Prudence: All presented information is to be fact-based and shall not include speculation.
- Principle of Continuity: All estimates of asset values are to assume that the company continues to operate. This principle is especially important for companies that are at risk of shutting down in the near future.
- Principle of Periodicity: Revenue and expense entries are to be tracked in the appropriate time period. Both revenues and expenses are tracked in the time period in which they occurred.
- Period of Materiality: Accountants are to present all appropriate data and accounting information in the reports.
- Principle of Utmost Good Faith: Accountants are required to always act in good faith and present information honestly when preparing and reviewing company financial documents.
Why Is GAAP Compliance Important?
GAAP helps maintain trust in financial markets by ensuring that public companies’ financial information is accurate and easy to understand. When companies use GAAP, investors can trust that the information they receive is accurate, thereby enabling clear, easy comparisons between multiple companies. The ease of comparison enables investors to make decisions based on an accurate understanding of organizations’ financial health.
GAAP vs. IFRS: What’s the Difference?
GAAP is a U.S.-based set of rules and regulations. The International Accounting Standards Board creates a similar set of guidelines and principles, the International Financial Reporting Standards (IFRS), which is used in a similar way internationally. While GAAP is a rules-based set of regulations, IFRS is a less strict set of principles companies are encouraged to follow.
There are several differences between the two, including:
- GAAP allows companies to use last in, first out (LIFO) inventory cost tracking, which is prohibited in IFRS.
- GAAP requires that research and development costs are charged as an expense during the period in which they occurred, while IFRS allows amortizing the expenses over multiple periods if certain conditions are met.
- GAAP requires that value write downs are permanent, and cannot be reversed if the value of an item later increases, while IFRS allows reversal of write downs.