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GAAP: Understanding It and

the 10 Key Principles
Table of Contents U.S. public companies must follow GAAP for
What Is GAAP? their financial statements
Understanding GAAP By JASON FERNANDO Updated June 28, 2022
Reviewed by DAVID KINDNESS
The 10 Key Principles of
GAAP Fact checked by SUZANNE KVILHAUG

Compliance With GAAP

Selecting GAAP Principles

GAAP vs. IFRS

GAAP FAQs

Theresa Chiechi / Investopedia

What Are the Generally Accepted Accounting

Principles (GAAP)?
Generally accepted accounting principles (GAAP) refer to a common set of
accounting rules, standards, and procedures issued by the Financial
Accounting Standards Board (FASB). Public companies in the U.S. must follow
GAAP when their accountants compile their financial statements.

GAAP is guided by ten key tenets and is a rules-based set of standards. It is

often compared with the International Financial Reporting Standards (IFRS),
which is considered more of a principles-based standard. IFRS is a more
international standard, and there have been recent efforts to transition GAAP
reporting to IFRS.
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KEY TAKEAWAYS
GAAP is the set of accounting rules set forth by the FASB that U.S.
companies must follow when putting together financial statements.
GAAP aims to improve the clarity, consistency, and comparability of
the communication of financial information.
GAAP may be contrasted with pro forma accounting, which is a non-
GAAP financial reporting method.
The ultimate goal of GAAP is to ensure a company's financial
statements are complete, consistent, and comparable.
GAAP is used mainly in the U.S., while most other jurisdictions use the
IFRS standards.

GAAP

Understanding GAAP
GAAP is a combination of authoritative standards (set by policy boards) and the
commonly accepted ways of recording and reporting accounting information.
GAAP aims to improve the clarity, consistency, and comparability of the
communication of financial information.

GAAP may be contrasted with pro forma accounting, which is a non-GAAP

financial reporting method. Internationally, the equivalent to GAAP in the U.S.
is referred to as International Financial Reporting Standards (IFRS). IFRS is
currently used in 166 jurisdictions. [1]

GAAP helps govern the world of accounting according to general rules and

guidelines. It attempts to standardize and regulate the definitions,
assumptions, and methods used in accounting across all industries. GAAP
covers such topics as revenue recognition, balance sheet classification, and
materiality.

The ultimate goal of GAAP is to ensure a company's financial statements are

complete, consistent, and comparable. This makes it easier for investors to
analyze and extract useful information from the company's financial
statements, including trend data over a period of time. It also facilitates the
comparison of financial information across different companies.

The 10 Key Principles of GAAP

There are 10 general concepts that lay out the main mission of GAAP. [2]

1. Principle of Regularity
The accountant has adhered to GAAP rules and regulations as a standard.

2. Principle of Consistency
Accountants commit to applying the same standards throughout the reporting
process, from one period to the next, to ensure financial comparability
between periods. Accountants are expected to fully disclose and explain the
reasons behind any changed or updated standards in the footnotes to the
financial statements.

3. Principle of Sincerity
The accountant strives to provide an accurate and impartial depiction of a
company’s financial situation.

4. Principle of Permanence of Methods

The procedures used in financial reporting should be consistent, allowing a
comparison of the company's financial information.

5. Principle of Non-Compensation
Both negatives and positives should be reported with full transparency and
without the expectation of debt compensation.

6. Principle of Prudence
This refers to emphasizing fact-based financial data representation that is not
clouded by speculation.

7. Principle of Continuity
While valuing assets, it should be assumed the business will continue to
operate.

8. Principle of Periodicity
Entries should be distributed across the appropriate periods of time. For
example, revenue should be reported in its relevant accounting period.

9. Principle of Materiality
Accountants must strive to fully disclose all financial data and accounting
information in financial reports.

10. Principle of Utmost Good Faith

Derived from the Latin phrase uberrimae fidei used within the insurance
industry. It presupposes that parties remain honest in all transactions.

Compliance With GAAP

If a corporation's stock is publicly traded, its financial statements must adhere
to rules established by the U.S. Securities and Exchange Commission (SEC). The
SEC requires that publicly traded companies in the U.S. regularly file GAAP-
compliant financial statements in order to remain publicly listed on the stock
exchanges. [3] GAAP compliance is ensured through an appropriate auditor's
opinion, resulting from an external audit by a certified public accounting (CPA)
firm.

Although it is not required for non-publicly traded companies, GAAP is viewed

favorably by lenders and creditors. Most financial institutions will require
annual GAAP-compliant financial statements as a part of their debt covenants
when issuing business loans. As a result, most companies in the United States
do follow GAAP.

If a financial statement is not prepared using GAAP, investors should be

cautious. Without GAAP, comparing financial statements of different companies
would be extremely difficult, even within the same industry, making an apples-
to-apples comparison hard. Some companies may report both GAAP and non-
GAAP measures when reporting their financial results. GAAP regulations require
that non-GAAP measures be identified in financial statements and other public
disclosures, such as press releases.

Selecting GAAP Principles

The hierarchy of GAAP is designed to improve financial reporting. It consists of
a framework for selecting the principles that public accountants should use in
preparing financial statements in line with U.S. GAAP. The hierarchy is broken
down as follows: [2]

1. Statements by the Financial Accounting Standards Board (FASB) and

Accounting Research Bulletins and Accounting Principles Board opinions by
the American Institute of Certified Public Accountants (AICPA)
2. FASB Technical Bulletins and AICPA Industry Audit and Accounting Guides
and Statements of Position
3. AICPA Accounting Standards Executive Committee Practice Bulletins,
positions of the FASB Emerging Issues Task Force (EITF), and topics
discussed in Appendix D of EITF Abstracts
4. FASB implementation guides, AICPA Accounting Interpretations, AICPA
Industry Audit, and Accounting Guides, Statements of Position not cleared
by the FASB, and accounting practices that are widely accepted and
followed

Accountants are directed to first consult sources at the top of the hierarchy and
then proceed to lower levels only if there is no relevant pronouncement at a
higher level. The FASB's Statement of Financial Accounting Standards No. 162
provides a detailed explanation of the hierarchy. [4]

GAAP vs. IFRS

GAAP is focused on the accounting and financial reporting of U.S. companies.
The Financial Accounting Standards Board (FASB), an independent nonprofit
organization, is responsible for establishing these accounting and financial
reporting standards. [5] The international alternative to GAAP is the
International Financial Reporting Standards (IFRS), set by the International
Accounting Standards Board (IASB). [6]

The IASB and the FASB have been working on the convergence of IFRS and
GAAP since 2002. [7] Due to the progress achieved in this partnership, the SEC,
in 2007, removed the requirement for non-U.S. companies registered in
America to reconcile their financial reports with GAAP if their accounts already
complied with IFRS. [8] This was a big achievement because prior to the ruling,
non-U.S. companies trading on U.S. exchanges had to provide GAAP-compliant
financial statements.

Some differences that still exist between both accounting rules include:

LIFO Inventory: While GAAP allows companies to use the Last In First Out
(LIFO) as an inventory cost method, it is prohibited under IFRS.
Research and Development Costs: These costs are to be charged to
expense as they are incurred under GAAP. Under IFRS, the costs can be
capitalized and amortized over multiple periods if certain conditions are
met.
Reversing Write-Downs: GAAP specifies that the amount of write-down of
an inventory or fixed asset cannot be reversed if the market value of the
asset subsequently increases. The write-down can be reversed under IFRS.

As corporations increasingly need to navigate global markets and conduct

operations worldwide, international standards are becoming increasingly
popular at the expense of GAAP, even in the U.S. Almost all S&P 500 companies
report at least one non-GAAP measure of earnings as of 2019. [9]

Key Differences
There are some important differences in how accounting entries are treated in
GAAP vs. IFRS. One major issue is the treatment of inventory. IFRS rules ban the
use of last-in, first-out (LIFO) inventory accounting methods. GAAP rules allow
for LIFO. Both systems allow for the first-in, first-out method (FIFO) and the
weighted average-cost method. GAAP does not allow for inventory reversals,
while IFRS permits them under certain conditions.

When a company holds investments such as shares, bonds, or derivatives on its

balance sheet, it must account for them and their changes in value. Both GAAP
and IFRS require investments to be segregated into discrete categories based
on asset type. The main differences come in recognizing income or profits from
an investment: under GAAP it's largely dependent on the legal form of the asset
or contract; under IFRS the legal form is irrelevant and only depends on when
cash flows are received. [2]

Other differences appear in the treatment of extraordinary items and

discontinued operations. In practice, since much of the world uses the IFRS
standard, a convergence to IFRS could have advantages for international
corporations and investors alike.

Important: GAAP is only a set of standards. Although these

principles work to improve the transparency in financial statements,
they do not provide any guarantee that a company's financial
statements are free from errors or omissions that are intended to
mislead investors. There is plenty of room within GAAP for
unscrupulous accountants to distort figures. So even when a
company uses GAAP, you still need to scrutinize its financial
statements.

Some Key Differences Between IFRS and GAAP

Where Are Generally Accepted Accounting Principles

(GAAP) Used?
GAAP is a set of procedures and guidelines used by companies to prepare their
financial statements and other accounting disclosures. The standards are
prepared by the Financial Accounting Standards Board (FASB), which is an
independent non-profit organization. The purpose of GAAP standards is to help
ensure that the financial information provided to investors and regulators is
accurate, reliable, and consistent with one another.

Why Is GAAP Important?

GAAP is important because it helps maintain trust in the financial markets. If
not for GAAP, investors would be more reluctant to trust the information
presented to them by companies because they would have less confidence in
its integrity. Without that trust, we might see fewer transactions, potentially
leading to higher transaction costs and a less robust economy. GAAP also helps
investors analyze companies by making it easier to perform “apples to apples”
comparisons between one company and another.

What Are Non-GAAP Measures?

Companies are still allowed to present certain figures without abiding by GAAP
guidelines, provided that they clearly identify those figures as not conforming
to GAAP. Companies sometimes do so when they believe that the GAAP rules
are not flexible enough to capture certain nuances about their operations. In
that situation, they might provide specially-designed non-GAAP metrics, in
addition to the other disclosures required under GAAP. Investors should be
skeptical about non-GAAP measures, however, as they can sometimes be used
in a misleading manner.

What Is the Difference between IFRS and GAAP?

Conceptually, GAAP is more rules-based while IFRS is more guided by
principles. GAAP is used mainly in the U.S. and IFRS is an international
standard. The two standards treat inventories, investments, long-lived assets,
extraordinary items, and discontinued operations, among others.

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Related Terms
Understanding International Accounting Standards (IAS)
International Accounting Standards (IAS) were a set of rules for financial reporting that
were replaced in 2001 by International Financial Reporting Standards (IFRS). more

What Are International Financial Reporting Standards

(IFRS)?
International Financial Reporting Standards (IFRS) are a set of accounting rules currently
used by public companies in 166 jurisdictions. more

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Accounting policies are the specific principles and procedures implemented by a Get daily insights on what's moving the markets
company's management that are used to prepare financial statements. more and why it matters..

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Government Accounting Standards Board (GASB) Definition
The Government Accounting Standards Board is a private organization creating generally
accepted accounting principles for state and local governments. more

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