Generally Accepted Accounting Principles (GAAP) is a set of accounting rules created to govern financial reporting for corporations in the United States. Publicly traded companies, and some others, are required by law to use GAAP for their reporting. Here's the history of how GAAP became the standard financial reporting measure for the U.S.
Understanding GAAP
Following the Stock Market Crash of 1929 and the ensuing Great Depression, the U.S. government sought ways to regulate the practices of publicly traded companies and other major market participants. The government believed that at least some of the causes for the crash were due to less than above board practices by publicly traded companies.
Authority to set standards on accounting practices was granted to the Securities and Exchange Commission (SEC). The SEC decided to delegate this responsibility to the private sector auditing community, and in 1939, the American Institute of Accountants (precursor to the American Institute of Certified Public Accountants) created the Committee on Accounting Procedure (CAP).
CAP was replaced by the Accounting Principles Board (APB) 20 years later. The APB began issuing opinions about major accounting topics to be adopted by business accountants, which could then be imposed on publicly traded companies by the SEC. In 1973, the APB gave way to the Financial Accounting Standards Board (FASB).
The FASB has been the major policymaking body on acceptable accounting practices ever since. Other governmental and non-governmental organizations influence FASB decisions, but the FASB is responsible for issuing opinions and rendering judgments. The collective decisions passed down from the APB and FASB form GAAP.
The American Institute of Certified Public Accountants (AICPA), the SEC, and the Governmental Accounting Standards Board (GASB), are the core organizations that influence GAAP in addition to the FASB. In 1984 the FASB created the Emerging Issues Task Force (EITF) to deal with new and unique accounting that will most likely become standard in the future, such as accounting for the technology sector.
GAAP Objectives and Core Principles
GAAP represent objectives and guidelines for financial statements and reporting calculations. There are three major sets of rules covered in GAAP: basic accounting principles and guidelines, detailed standards of the FASB, and generally accepted industry practices.
The 10 core principles of GAAP are:
- Consistency
- Permanent Methods
- Compensation
- Prudence
- Regularity
- Sincerity
- Good Faith
- Materiality
- Periodicity
- Continuity
Within the confines established by GAAP, auditors attempt to establish uniformity among the financial reports of publicly traded companies, although private companies often use GAAP as well. Through GAAP, investors can more easily compare and understand the financial health of different businesses. This uniformity also has ancillary benefits for regulators, lenders, corporate managers, and the accounting community.
Other Accounting Rules
Accounting standards in the European Union and some countries in Asia are governed by the International Financial Reporting Standards (IFRS), which is governed by the International Accounting Standards Board (IASB), created in 2001. There has been collaboration between the IASB and FASB to align the practices of GAAP and IFRS. In 2002, both bodies signed the Norwalk Agreement, with the intent to make best efforts to make their respective accounting reporting fully compatible.
FAQs
GAAP was introduced to safeguard the interests of investors from the fraudulent and deceitful reporting behaviors that organizations used to practice a century ago. The emphasis of GAAP is on reliable, consistent, fair, and honest reporting so that the investors can make informed decisions.
Why was GAAP established? ›
GAAP was introduced to safeguard the interests of investors from the fraudulent and deceitful reporting behaviors that organizations used to practice a century ago. The emphasis of GAAP is on reliable, consistent, fair, and honest reporting so that the investors can make informed decisions.
What are the reasons for GAAP? ›
The purpose of GAAP is to create transparency and consistency in financial reporting from one organization to the next. All publicly traded and regulated companies are required by the United States Securities and Exchange Commission (SEC) to follow GAAP financial reporting standards.
What is the primary purpose of GAAP? ›
GAAP sets out to standardize the classifications, assumptions and procedures used in accounting in industries across the US. The purpose is to provide clear, consistent and comparable information on organizations financials.
Why has US GAAP evolved into a rules based approach? ›
Having a set of rules can increase accuracy and reduce the ambiguity that can trigger aggressive reporting decisions by management. Compliance to GAAP helps to ensure transparency in the financial reporting process by standardizing the various methods, terminology, definitions, and financial ratios.
What are the four basic principles of GAAP? ›
What Are The 4 GAAP Principles?
- The Cost Principle. The first principle of GAAP is 'cost'. ...
- The Revenues Principle. The second principle of GAAP is 'revenues'. ...
- The Matching Principle. The third principle of GAAP is 'matching'. ...
- The Disclosure Principle. ...
- Why are GAAP Principles important?
While it is seen as a single entity, GAAP is composed of three parts:
- Principles and guidelines. This component covers the framework. ...
- Rules and standards. These are the concise, detailed collection of codes. ...
- Accepted industry practices.
The goal of GAAP is to ensure that a company's financial statements are complete, consistent, and comparable. GAAP may be contrasted with pro forma accounting, which is a non-GAAP financial reporting method.
What are three advantages of GAAP? ›
The importance of GAAP lies in the uniformity, comparability, and transparency of financial documents.
What is the major reason for the existence of generally accepted accounting principles? ›
The purpose of GAAP is to ensure that financial reporting is transparent and consistent from one public organization to another, and from one accounting period to another. GAAP emerged in the 1970s and involved the following four major rules and standards: Accrual accounting methods.
GAAP helps in ensuring that financial reporting is transparent and uniform across industries. As financial information is based on historical data, therefore in order to facilitate comparison between data from various sources, GAAP must be followed.
Who is primarily responsible for GAAP? ›
Responsibility for enforcement and shaping of generally accepted accounting principles (GAAP) falls to two organizations: The Financial Accounting Standards Board (FASB) and Securities and Exchange Commission (SEC). The SEC has the authority to both set and enforce accounting standards.
What is the GAAP required for? ›
Such legislation as the Securities Act of 1933 and the Securities Exchange Act of 1934 marked the establishment of the GAAP rules. Today, GAAP is a required accounting practice for for-profit companies, non-profits, and government entities in the United States.
What is the reason for GAAP? ›
The main GAAP purpose is to enforce clear and consistent financial reporting for companies. Public companies have a requirement to use GAAP when their companies' accountants create their financial statements.
Who came up with GAAP? ›
The US GAAP is a comprehensive set of accounting practices that were developed jointly by the Financial Accounting Standards Board (FASB) and the Governmental Accounting Standards Board (GASB), so they are applied to governmental and non-profit accounting as well.
Why do most companies adhere to GAAP? ›
This is because GAAP ensures consistency in reporting in all businesses, making the financial reports that are produced complete and comparable. This is especially important in publicly traded companies or in companies required to publicly release their financial statements.
What is the purpose of the accounting standards? ›
Their main aim is to ensure transparency, reliability, consistency, and comparability of the financial statements. They do so by standardizing accounting policies and principles of a nation/economy. So the transactions of all companies will be recorded in a similar manner if they follow these accounting standards.
What is the main goal of GAAP quizlet? ›
Generally accepted accounting principles (GAAP) are rules that govern the practice of financial accounting. The goal of GAAP is to ensure that the information generated by financial accounting is relevant, reliable, consistent, and comparable.
What is the main source of generally accepted accounting principles? ›
Sources of GAAP
The FASB Accounting Standards Codification is the source of authoritative GAAP recognized by the FASB to be applied by nongovernmental entities. Rules and interpretive releases of the SEC under authority of federal securities laws are also sources of authoritative GAAP for SEC registrants.
