What is GAAP?
/GAAP is short for Generally Accepted Accounting Principles. GAAP is a cluster of accounting standards and common industry usage that have been developed over many years. It is used by organizations to properly organize their financial information into accounting records, summarize the accounting records into financial statements, and disclose certain supporting information.
One of the reasons for using GAAP is so that anyone reading the financial statements of multiple companies has a reasonable basis for comparison, since all companies using GAAP have created their financial statements using the same set of rules.
Sources of GAAP
GAAP is derived from the pronouncements of a series of government-sponsored accounting entities, of which the Financial Accounting Standards Board (FASB) is the latest. The Securities and Exchange Commission also issues accounting pronouncements through its Accounting Staff Bulletins and other announcements that are applicable only to publicly-held companies, and which are considered to be part of GAAP. GAAP is codified into the Accounting Standards Codification (ASC), which is available online and (more legibly) in printed form.
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GAAP Topics
GAAP covers a broad array of topics, including the topics noted below:
Financial statement presentation
Assets
Liabilities
Equity
Revenue
Expenses
Business combinations
Derivatives and hedging
Fair value
Foreign currency
Leases
Nonmonetary transactions
Subsequent events
Industry-specific accounting, such as airlines, extractive activities, and health care
The industry-specific accounting that is allowed or required under GAAP may vary substantially from the more generic standards for certain accounting transactions. The FASB has worked to reduce the amount of industry-specific accounting rules in recent years, especially in the area of revenue recognition.
Users of GAAP
The users of GAAP include a wide range of stakeholders who rely on standardized financial information to make informed decisions. Key users include the following:
Investors. They use GAAP-compliant financial statements to assess the financial health, profitability, and growth potential of companies, guiding investment decisions.
Creditors and lenders. Banks, bondholders, and other creditors analyze GAAP financials to evaluate a company's ability to meet debt obligations and determine creditworthiness.
Regulators and government agencies. Regulatory bodies like the U.S. Securities and Exchange Commission (SEC) require publicly traded companies to adhere to GAAP to ensure transparency and protect investors.
Management and executives. Company management uses GAAP-compliant financial data for strategic planning, performance assessment, and internal decision-making.
Analysts and financial advisors. Financial analysts and advisors rely on GAAP-based financials for consistent, comparable data to assess trends, make forecasts, and provide recommendations.
Auditors. Auditors use GAAP as a standard for evaluating the accuracy and compliance of a company’s financial statements during external audits.
Employees and labor unions. Employees, especially through unions, use financial information to understand company profitability and negotiate wages, benefits, and job security.
Suppliers and business partners. Suppliers and potential partners review GAAP financials to assess a company’s stability and determine the feasibility of long-term business relationships.
Customers. In cases of long-term contracts or large transactions, customers may review financial statements to ensure the stability of a company they rely on.
Academics and researchers. Researchers, economists, and students use GAAP financial data to study economic trends, business cycles, and industry-specific financial performance.
GAAP provides these stakeholders with a standardized framework that enhances the reliability, comparability, and consistency of financial statements across different companies and industries.
GAAP Convergence with IFRS
There are several working groups that are gradually reducing the differences between the GAAP and IFRS accounting frameworks, so eventually there should be minor differences in the reported results of a business if it switches between the two. There is a stated intent to eventually merge GAAP into IFRS, but this has not yet occurred. Given recent differences of opinion arising during several joint projects, it is possible that the frameworks will never be merged.
Why is GAAP Important?
GAAP is important, because compliance with it enhances the investing community’s faith in the reported financial results of businesses. Otherwise, there would be great uncertainty about whether financial statements could be trusted, resulting in lower company valuations and lower acquisition prices. Lower company valuations means that the share holdings of investors have lower value, which reduces their net worth. Thus, there is a direct link between GAAP and the wealth of the country.
Another reason why GAAP is important is that it mandates the consistent treatment of accounting transactions across businesses. This makes it easier to compare and contrast the results of these entities, which is a valuable activity for industry analysts in the financial markets.