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What Is GAAP? A Guide to Generally Accepted Accounting Principles
Learn how GAAP standards work and what that means for your business.
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If you run a small business, you may not know much about the Generally Accepted Accounting Principles (GAAP). After all, GAAP standards apply mainly to publicly traded companies, so these rules don’t always feel relevant to your small business.
However, it’s a good idea to have a basic understanding of GAAP standards. Knowing the fundamentals will help you improve your accounting skills, understand accounting principles, and determine how your business should track and measure its financial information.
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What is GAAP?
GAAP refers to the rules and standards used for financial reporting in the United States. These standards were developed by the Financial Accounting Standards Board (FASB) and the Governmental Accounting Standards Board (GASB); they apply to corporate, government and nonprofit accounting.
The U.S. Securities and Exchange Commission (SEC) requires all publicly traded companies to adhere to GAAP standards. When each company reports and maintains its financial records the same way, it’s easier for investors to compare companies and make informed investment decisions.
GAAP requires publicly traded companies to follow four main standards:
- Recognition: Financial statements should accurately reflect your company’s assets, liabilities, revenue and expenses.
- Measurement: Financial statements should measure your organization’s financial results in accordance with GAAP standards.
- Presentation: For each reporting period, your business will present an income statement, balance sheet, cash flow statement and statement of shareholder equity.
- Disclosure: All financial statements will include any notes necessary to help users interpret the information.
What are the 10 principles of GAAP?
These 10 principles will help you understand the purpose of GAAP:
- Regularity: Your accountant has followed all GAAP rules and regulations.
- Consistency: Accountants commit to applying the same standards from one period to the next. This consistency makes it easier to avoid errors and ensure financial comparability. If an accountant makes a change, they must disclose it in the financial statement footnotes.
- Sincerity: Your accountant will provide an impartial and accurate view of your company’s financial situation.
- Permanence of methods: There should always be a focus on consistency in the methods used during the accounting cycle.
- Noncompensation: Your accountant will report all financial information transparently, outlining the positives and negatives. This report is made without the expectation of debt compensation.
- Prudence: All financial data must be reported based on actual figures, not speculation.
- Continuity: This principle assumes your business will continue operating into the foreseeable future.
- Periodicity: All accounting entries are reported during the appropriate periods. For example, both revenue and expenses will be reported during the correct periods.
- Materiality: Accountants must disclose all relevant financial information accurately in reports.
- Utmost good faith: This principle emphasizes honesty and full disclosure among all parties during financial transactions.
The importance of GAAP compliance
If you run a publicly traded company, the SEC requires your business to follow GAAP standards. You must complete GAAP-compliant financial statements to remain listed on the stock exchanges.
GAAP compliance is not required for private companies, but many lenders prefer it. If you plan to apply for a business loan, you may be required to file GAAP-compliant financial statements.
Additionally, investors are often wary of businesses that don’t follow GAAP standards. That’s because the consistency of GAAP standards makes it easier to compare financial statements. If you ever plan to take your company public, it’s smart to begin adopting GAAP standards now.
“GAAP compliance is important because it ensures consistency, audit readiness and regulatory compliance,” said Armine Alajian, founder and CPA at Alajian Group, Inc. “It ensures consistency, matching revenues with expenses, so true profit is reported.”
Non-GAAP reporting and limitations of GAAP
GAAP standards are based on principles like accrual accounting, revenue recognition and expense matching. However, Alajian cautioned that GAAP does come with certain limitations.
“There can be limitations with cash flow reports,” Alajian explained. “It can be difficult to see how a business is doing from an accrual or cash flow [standpoint], and it can also be costly and time-consuming.”
For that reason, some companies supplement their financial reports with non-GAAP statements, often referred to as pro forma statements. The goal is to present a more accurate and complete view of the company’s underlying operations.
Non-GAAP statements can include the following:
- Free cash flow
- Earnings before interest and taxes (EBIT)
- Earnings before interest, taxes, depreciation and amortization (EBITDA)
- Adjusted earnings
- Funds from operations
Proponents of non-GAAP reporting believe that including this information presents a more nuanced view of the company to investors. Critics argue that using non-GAAP financial statements could result in misleading or fraudulent reporting. In particular, the SEC has issued a statement advising caution when it comes to pro forma statements.
GAAP FAQs
- Revenue recognition principle: This principle states that any revenue should be recorded once your buyer receives the good or service your company provides ― not after your business is compensated. This is what's known as accrual accounting.
- Cost principle: Your accountant should record an expense when your company accepts goods or services from another business — whether or not payment has been made.
- Matching principle: All expenses should match the revenue received during a given accounting period. If your company recognizes revenue, it should also acknowledge the associated costs.
- Full disclosure principle: Financial statements should include accurate and complete information so stakeholders have all relevant information about your company.
- Objectivity principle: All accounting data should be fact-based and free of assumptions. All financial data should be supported by receipts, invoices and vouchers.
| IFRS | GAAP |
| Issued by the IASB | Issued by the FASB |
| Doesn't allow the last-in, first-out (LIFO) method to estimate inventory | Allows use of either the last-in, first-out (LIFO) or first-in, first-out (FIFO) method to estimate inventory |
| Intangible assets are assessed based on future economic benefit | Intangible assets are measured based on their fair market value |
| Allows companies more flexibility in interpreting financial statements | Follows a specific set of rules and procedures for financial statements |
| Revenue can be reported once value is delivered | Revenue can be reported once goods or services are delivered |
| Groups all liabilities together | Groups liabilities as either current or noncurrent |
- Inventory reporting: One of the most significant differences between GAAP and IFRS is how the two standards treat inventory reporting. With IFRS, you can't use the LIFO method to measure inventory. IFRS standards maintain that LIFO doesn't portray inventory flow accurately and could make your company's income appear lower than it is. In comparison, GAAP standards allow your company to track its inventory using either LIFO or FIFO.
- Intangible assets: GAAP and IFRS approach intangible assets differently. Under IFRS, intangible assets can be recognized if they offer a probable future economic benefit to your firm. However, GAAP recognizes intangible assets based on their current fair market value — without assessing future benefits.
- Financial reporting: GAAP standards follow a highly specific set of rules and procedures with little room for interpretation. These rules are designed to prevent accountants from inflating your business's financial records to mislead investors. However, IFRS would give your company more room for interpretation in your financial reporting.
- Revenue recognition: GAAP has specific standards for recognizing revenue across different industries. Generally, revenue cannot be reported until the buyer has received the goods or services purchased from your organization. IFRS states that revenue can be recognized once the value has been delivered to your clients, even if payment hasn't yet been received.
- Liabilities classification: Under GAAP standards, liabilities are classified as either current or noncurrent based on how long your business has to repay its debts. Debt due within the next 12 months is considered a current liability, while debt with a repayment period longer than 12 months is considered long-term debt. IFRS, by contrast, groups all liabilities together without this distinction.
