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What is GAAP?
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WHAT IS GAAP?
IN YOUR STATE

Accounting students and current professionals are expected to have a strong knowledge of
generally accepted accounting principles (GAAP). These rules and standards are mandated for
RESOURCES
the creation of uniform nancial reports by publicly traded companies. Private U.S. businesses
are not required to follow GAAP, though many do.

Accountants adhere to GAAP for consistency, fairness, honesty and accuracy in measuring and
disclosing nancial information. A company’s scal reports have a signi cant impact on the
decisions made by investors, employees and nancial institutions; GAAP provides the set of
foundational guidelines used to support these analyses.

HISTORY OF GAAP

Without regulatory standards, companies would be free to present nancial information in

whichever format best suits their needs. With carte blanche to portray a company’s scal
standing in the most ideal light, investors could be easily misled. The Great Depression in 1929, a
nancial catastrophe which caused years of hardship for millions of Americans, was primarily
attributed to faulty and manipulative reporting practices among businesses. In response, the
federal government, along with professional accounting groups, set out to create standards for
the ethical and accurate reporting of nancial information.

According to Stephen Ze in The CPA Journal, GAAP terminology was rst used in 1936 by the
American Institute of Accountants (AIA). Federal endorsement of GAAP began with legislation
like the Securities Act of 1933 and the Securities Exchange Act of 1934, laws enforced by the U.S.
Securities and Exchange Commission (SEC) that target public companies. Today, the Financial
Accounting Standards Board (FASB), an independent authority, continually monitors and updates
GAAP.

Today, all 50 state governments prepare their nancial reports according to GAAP. While a little
less than half of U.S. states o cially require local governments to adhere to GAAP, the
Governmental Accounting Standards Board (GASB) estimates that approximately 70% of county
and local nancial o ces do anyway.

GAAP REQUIREMENTS BY STATE

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FULLY GAAP COMPLIANT

Local and county governments and school districts are required to prepare nancial reports under GAAP.

MOSTLY GAAP COMPLIANT

Two of three regulated state governing boards and districts must comply to GAAP.

SOMEWHAT GAAP COMPLIANT

One of three regulated state governing boards and districts must comply to GAAP.

NOT GAAP COMPLIANT

Local and county governments and school districts are not formally required to comply to GAAP.

Source: Government Accounting Standards Board

WHO DETERMINES GAAP?

While the federal government requires public companies to le nancial reports in compliance
with GAAP, they are not responsible for its creation or maintenance. Instead, a few independent
boards serve as authorities on these principles, continually updating them to accommodate
changing business practices and evolving organizations. For example, goodwill and interest rate
swap standards are among several recent changes to provide alternatives for private companies.
Below, we have created an overview of the boards that oversee GAAP pronouncements.

Financial Accounting Foundation (FAF) – This organization was formed in 1972 as the
administrative corporation that oversees the Financial Accounting Standards Board (FASB) and
the Governmental Accounting Standards Board (GASB) . The FAF is responsible for appointing
board members and ensuring that these boards operate in a fair and transparent manner.
Members of the public are invited to attend FAF organization meetings in person or through live
webcasts.

FINANCIAL ACCOUNTING STANDARDS BOARD

On the recommendation of the American Institute of CPAs (AICPA), the FASB was formed as an
independent board in 1973 to take over GAAP determinations and updates. The board is
comprised of seven full-time, impartial members, ensuring it works for the public’s best interest.
In addition, the board is monitored by the 30-person Financial Accounting Standards Advisory
Council (FASAC). FASB is responsible for the Accounting Standards Codi cation, a centralized
resource where accountants can nd all current GAAP.
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The FASB Standards-Setting Process

1 Identify current investor issues

2 Draft issue agenda and hold public meetings

3 Publish Exposure Draft for investor commentary

4 Propose new standards and invite business feedback

5 Weigh all public responses and revise accordingly

6 Announce nal revisions to the ASC

MAJOR PROJECTS IN 2015

Proposed Standards Update: Disclosures about Hybrid Financial Instruments with

Bifurcated Embedded Derivatives
Organizations would be required to make the connections between bifurcated embedded
derivatives and host contracts known in their nancial reporting.
E ects on Historical Earnings Per Unit of Master Limited Partnership Dropdown
Transactions
Creating a standardized reporting process for historical earnings before general partners
transfer assets once a master limited partnership is created.

GOVERNMENTAL ACCOUNTING STANDARDS BOARD

The GASB was established in 1984 as a policy board charged with creating GAAP for state and
local government organizations. Many di erent parties rely on government nancial statements,
including constituents and lawmakers. Fairness and transparency are a priority of the GASB, and
their own processes and communications are available for public review.

The GASB Standards-Setting Process

1 Create an independent task force

2 Conduct research on the subject of the new standard

3 Engage the public through published commentary

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4 Create an Exposure Draft of planned standard

5 Host public hearings before a standard is nalized

MAJOR PROJECTS IN 2015

Other Postemployment Bene t Accounting and Financial Reporting - Employer

This initiative is designed to increase accountability among government employers and
address the e ectiveness of the reported data.
Other Postemployment Bene t Accounting and Financial Reporting - Plan
Assessing how e ective the other postemployment bene t (OPEB) standards are.
Pensions Not Within Statement 68 Scope
Addressing amendments to Statements 67 and 68 that pertain to expenditures and liabilities
for bene ts and pensions.

GAAP VS. NON-GAAP

While publicly-traded companies are required to follow GAAP for the creation of nancial reports,
they have the freedom to release additional reports prepared using non-GAAP principles.
According to Investopedia, many businesses assert that non-GAAP earnings more accurately
re ect their positions. The two approaches can lead to vastly di erent numbers, though,
especially in the short term.

As The Wall Street Journal reported, 40 companies that had initial public o erings in 2014
reported losses under standard accounting rules, but showed pro ts using their own tailor-made
measures, according to consulting rm Audit Analytics.

The main di erence between preparing reports with GAAP versus without has to do with when
revenue and expenses are recognized. GAAP requires that companies use accrual accounting,
which di ers from cash accounting in that related revenues and expenses are reported together
at the time of transaction rather than simply when cash is exchanged. This is especially impactful
for purchases made on credit or paid for over a long period of time. If a product is purchased on
credit, cash accounting would call for recording the purchase once cash is received. This may be
much later than the transaction itself. Accrual accounting under GAAP strives to more closely
re ect a company’s nancial position, regardless of cash- ow.

The method used for preparing nancial reports matters most to investors when it comes to
earnings per share (EPS) reported by companies. Non-GAAP methods for calculating EPS often
seek to more closely re ect cash ow, so EPS tends to be higher under these methods than
under GAAP. EPS values prepared under non-GAAP are often referred to as “adjusted” earnings.

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The example below shows the degree to which earnings for one company can di er depending
on whether or not they are prepared using GAAP:

GAAP VS. NON-GAAP CASE STUDY: PEGASYSTEMS 2010-11

$ in ' s GAAP non-GAAP GAAP non-GAAP

Total Revenue $ , $ , $ , $ ,

Operating Income $( , ) $ , $ , $ ,

Net Income $( , ) $ , $ , $ ,

Basic Earnings per

$( . ) $ . $ . $ .
Share

Source: Pegasystems Inc. All $ amounts in thousands, except per share data.

There is some discrepancy in reported revenue when comparing GAAP and non-GAAP values.
The real di erence between the two methods shows up in operating income. Operating income
is everything that is left after operating expenses have been subtracted. For both years, the non-
GAAP values are considerably higher than the GAAP values, and GAAP operating income is
even negative in one year. The large di erence is likely because the non-GAAP calculation did
not include several expenses, either because they are not recurring or because the company is
not matching related revenues and expenses. The discrepancy between GAAP and non-GAAP
operating income leads to very di erent EPS, which is largely thought of as the most important
determinant of a share’s price. Clearly, whether EPS was calculated using GAAP principles or not
can greatly impact an investor’s decision.

While the SEC prohibits false or misleading information in all nancial reports, GAAP and non-
GAAP methods can still lead to di erent valuations. For investors, it is important to check
footnotes to see how reports were prepared.

THE 10 BASIC TENETS OF GAAP

These 10 general principles can help you remember the main mission and direction of the GAAP
system.

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

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Professionals commit to applying the same standards throughout the reporting process to
prevent errors or discrepancies. Accountants are expected to fully disclose and explain the
reasons behind any changed or updated standards.
3. Principle of Sincerity
The accountant strives to provide an accurate depiction of a company’s nancial situation.
4. Principle of Permanence of Methods
The procedures used in nancial reporting should be consistent.
5. Principle of Non-Compensation
Both negatives and positives should be fully reported with transparency and without the
expectation of debt compensation.
6. Principle of Prudence
Emphasizing fact-based nancial 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 divided by its relevant periods.
9. Principle of Materiality / Good Faith
Accountants must strive for full disclosure in nancial reports.
10. Principle of Utmost Good Faith
Derived from the Latin phrase “uberrimae dei” used within the insurance industry. It
presupposes that parties remain honest in transactions.

LIMITATIONS OF GAAP

While GAAP strives to alleviate incidents of inaccurate reporting, it is by no means

comprehensive. Companies can still su er from issues beyond the scope of GAAP depending on
their size, business categorization, location and global presence.

DIVERSE TYPES OF COMPANIES

TIMEFRAME

GLOBAL VS. DOMESTIC

IFRS: AN ALTERNATIVE TO GAAP

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While public companies in the United States are currently required to follow GAAP standards
when ling nancial statements, private companies are still free to choose their preferred
standards system. This may soon change depending on an upcoming decision from the SEC,
which has been deliberating on whether to move forward with recommending global standards,
either partially or completely.

According to Bloomberg BNA, SEC Chief Accountant James Schnurr “stressed that the IFRS-as-
supplemental-reporting approach would be simply one alternative to full adoption of the
standards issued by the International Accounting Standards Board.” Wide acceptance of the IFRS
standards has yet to happen in the United States. The FASB and IASB are still working together
to agree on and set standards that can be applied domestically and internationally.

GAAP VS. IFRS

Many sources state that the biggest di erence between GAAP and IFRS reporting standards is
the number of rules behind the principles. According to Scott Taub at Compliance Week, this is
true, in a way; the GAAP principles are governed by more detailed rules and guidelines than
IFRS. However, both sets of standards are in place to ensure that accountants remain honest on
the job. The following is a look at what is required when reporting under the GAAP principles
versus the IFRS standards.

Balance Sheet

GAAP: Recommended that current and noncurrent asset and liability categories are
separated

IFRS: These categories are required to be separated

Intangible Assets

GAAP: Recognizes intangible assets at fair value

IFRS: Only examines intangible assets if they can be associated with a future bene t

Documentation

GAAP: A Statement of Comprehensive Income is required

IFRS: A Statement of Comprehensive Income is not required

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Inventory Write Downs

GAAP: Inventory write down reversals are not permitted

IFRS: Inventory write down reversals are possible under some conditions

Extraordinary Items

GAAP: Listed separately under new income

IFRS: Included with other items on the income statement

FURTHER READING
EXAMPLES OF FINANCIAL REPORTS

These investor reports from major publicly traded companies give a high-level example of
nancial lings that follow GAAP:

Coca-Cola
Apple
Microsoft
Nordstrom
Google

REFERENCE TOOLS

Accounting Standards Codi cation: The FASB’s centralized reference tool for GAAP
FASAB Handbook: Standards guidelines for nancial reporting at federal government
organizations
GASB Frequently Requested Materials: Links include research briefs, the annual technical
plan and a survey of users
SEC Small-Entity Compliance Guide: Recommendations for small business nancial reporting
The Sarbanes-Oxley Act of 2002: Federal legislation regarding the accounting and IT
requirements, security and disclosure requirements for public companies

YOUR ACCOUNTING
DEGREE FINDER
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1 BACHELOR'S

2 BUSINESS & MANAGEMENT

3 ACCOUNTING

FIND YOUR COLLEGE

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PAGE NAVIGATION

What is GAAP?

Who Determines GAAP?

GAAP vs. Non-GAAP

The 10 Basic Tenets of GAAP

IFRS: An Alternative to GAAP

Further Reading

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