To help ensure that financial reporting is transparent and investors have the most accurate and timely information they need to make informed investment decisions, public companies must disclose certain financial, and other information, to investors.
Therefore, preparing financial statements that are in compliance with generally accepted accounting principles (GAAP or U.S. GAAP) is paramount for accounting professionals and all of those involved in financial reporting.
For firms, this means having the right tools and resources in place for easy access to practical insight and expertise on accounting topics that are complex, undergoing changes, or challenging to apply.
Let’s take a closer look to gain a better understanding of GAAP and how to prevent the misapplication of GAAP standards.
What are the GAAP standards?
Established largely as a response to the stock market collapse of 1929 and the Great Depression, the generally accepted accounting principles (GAAP) are a set of commonly recognized accounting rules and standards for financial reporting.
It was believed by many that questionable accounting and reporting procedures by some publicly traded companies contributed, at least in part, to the stock market crash and the subsequent depression.
It was during the Great Depression that the Securities Act of 1933 and the Securities Exchange Act of 1934 were enacted. This established the Securities and Exchange Commission (SEC), which had authority to form financial accounting and reporting standards for publicly held companies.
The Financial Accounting Standards Board (FASB) is recognized by SEC as the accounting standard setter for public entities. Many other organizations, including the American Institute of CPAs and State Boards of Accountancy, recognize FASB standards as authoritative.
What is the main purpose of GAAP?
At its core, the purpose of GAAP is to bring transparency and standardization to financial reporting through commonly accepted practices, procedures, and terms.
This transparency and standardization are designed to make it easier for investors and other interested parties to fully understand a company’s financial statements and how the statements compare from one company to the next.
When financial statements are prepared under GAAP, the result is information that is:
- Relevant, representationally faithful, and reflective of economics;
- Comparable with other companies;
- Verifiable and auditable by a third party; and
- Understood by lenders, investors, and others.
What are the major GAAP principles?
The GAAP principles are a set of 10 principles outlined by FASB. These principles are:
- Principle of Regularity: The accountant must strictly adhere to all GAAP rules and regulations.
- Principle of Consistency: The same methods of reporting throughout the reporting process must be used and any changes must be disclosed.
- Principle of Sincerity: A company’s financial health must be honestly represented in its accounting.
- Principle of Permanence of Methods: Reporting methods should be consistent across time and any changes must be noted.
- Principle of Non-compensation: Current assets and expenses cannot be used to inflate a business’s finances with prospective debt compensation or revenue.
- Principle of Prudence: Only existing information may be used in accounting and nothing that is promised, expected, or speculative.
- Principle of Continuity: The accountant assumes that the business will continue to exist.
- Principle of Periodicity: Accounting entries remain in their given time period and are not moved to another.
- Principle of Materiality: All documents that are necessary to assess the business’s finances properly must be disclosed.
- Principle of Utmost Good Faith: The business and all parties that provided financial reports and documents for the business are assumed to be acting honestly and with good intentions.
Do all U.S. companies follow GAAP?
GAAP is not mandatory for all businesses. However, all public companies, those whose equity and debt securities are traded on U.S. public markets, must follow the standard. GAAP applies throughout all 50 states.
Private companies are not required to use GAAP-based financial reporting, but it is advisable since many do need loans and other funds to grow their business. Plus, some private entities may be thinking about going public.
Those private companies that do use GAAP-based financial reporting may find greater flexibility in the types of financing available to them because of the credibility provided by GAAP. They may also be able to take advantage of lower cost financing.
For private entities thinking of going public, GAAP can make the transition easier. They must immediately meet the regulatory requirements in which they are filing, which may involve submitting GAAP financial statements.
What are the differences between GAAP and IFRS?
Outside of the United States, most countries follow the International Financial Reporting Standards (IFRS). GAAP and IFRS have been working toward merging the two systems, but they do have differing guidelines, rules, and principles.
There are many differences between GAAP and IFRS. Some of the key differences include, but are not limited to:
- The International Accounting Standards Board (IASB) regulates IFRS. FASB oversees GAAP.
- GAAP is rule-based whereas IFRS is principle-based.
- GAAP favors the LIFO (Last In First Out) as an inventory method for estimating inventory. IFRS does not approve this method.
- Under GAAP, intangible assets (i.e., research and development or advertising costs) are recognized at fair market value. Under IFRS, intangible assets are valued on the basis of the future economic benefit.
- All development costs are expensed under GAAP. Under IFRS, some development costs are expensed while others are capitalized and amortized over multiple periods.
What are common GAAP violations?
Most companies obviously look to avoid GAAP violations as errors or omissions can be costly and can hurt credibility. That being said, there are some common GAAP violations that clients sometimes make. These include:
Rent incentives: It isn’t unheard of for a lessor to incentive a lessee by offering “free rent” at either the beginning or the end of the lease arrangement. GAAP accounting requires that operating lease expenses be recognized on a straight-line basis. Any difference between expenses and payments would be classified as either a current or non-current asset or liability on the balance sheet.
Depreciation: It is common for businesses to incorrectly default to using the tax method of 39 years of depreciation for GAAP reporting for leasehold improvements. GAAP stipulates that these improvements should be depreciated over the shorter of their useful life or the lease term.
Capitalization of overhead costs: Large inventory valuation errors can appear on the balance sheet and related cost of goods sold on the income statement by not applying overhead calculations.
Accrued vacation/PTO: Some companies will pay cash for unused vacation time. For those that do, a verbal and accepted policy is enough to trigger a staff member’s potential right to compensation that might need to be accrued. The liability associated with these policies can be hefty.
Uncertain tax positions: Common tax uncertainties that need analysis include, but are not limited to, transfer pricing between foreign related parties, business expenses like means and entertainment, and valuation of deferred tax assets.
What happens if you violate GAAP?
While GAAP is not a law, companies that violate GAAP can face harsh consequences. As noted earlier, errors or omissions can be costly and can hurt credibility. Companies can also be fined.
One such example is residential and commercial security company ADT. In 2018, SEC hit ADT with a $100,000 fine over its failure to give GAAP numbers equal or greater prominence in its reporting.
It should be noted that failure to comply with GAAP and Generally Accepted Auditing Standards (GAAS) standards are among the more common types of accounting malpractice.
How to prevent misapplication of GAAP standards
In today’s complex business environment, compliance with GAAP standards can be challenging, but with the right tools and resources in place, it doesn’t have to be. This involves having robust, online research tools that give you practical insight and expertise at your fingertips.
When evaluating tools and resources to find the best fit for your firm, consider an online solution that delivers the following functionalities:
- Topics can be expanded or collapsed to provide a landscape perspective on a particular topic.
- Provides practical real-life examples to explain the logic of the standards and help you put knowledge into action.
- Interactive tools, diagrams, checklists, and decision trees are embedded directly within the analysis to illustrate complex sets of rules or help break down complicated transactions.
- Detailed analysis and illustrations for transactions, industries, or instruments are discussed directly within the topic, not treated separately.
- Featured developments are presented in context of the topic to keep researchers up to date on important developments.
- Each topic has a clear date-marker so there’s no uncertainty about when the content was last reviewed or updated.
The good news is firms don’t have to go it alone. Thomson Reuters Checkpoint Catalyst: US GAAP is the next generation of online research that gives practitioners the practical insights and expertise they need to prevent GAAP violations.
To learn more about the top accounting problems firms are facing and the solutions they can put in place to remain competitive, read “Top accounting issues in 2023.”