Generally accepted accounting principles or GAAP, are a collection of followed accounting rules and standards for financial reporting. The acronym is pronounced “Gap”.
GAAP combines both standards set by a set of policy board and the generally accepted ways of recording and reporting accounting information.
The purpose of GAAP is to ensure the consistency, comparability and transparency of the financial reporting between the various financial information.
There is no universal GAAP standard, instead, the specified principles and rules are adjusted to geographic locations or from one industry to another. For instance, in the U.S the Securities and Exchange Commission (SEC) instruct companies to follow the GAAP requirements. These requirements are issued by the Financial Accounting Standard Board (FASB).
Countries like the United Kingdom have adopted the International Financial Reporting Standards (IFRS). It is generally used in the European Union as well as 120 countries globally. IFRS provides general guidance on how financial statements should be prepared and presented instead of rules. It is responsible for created a set of high-quality global accounting standards by bringing efficiency to the financial markets around the world.
It helps standardize and regulate the various definitions, assumptions and methods used in accounting across the globe. This helps investors analyze information from the company’s financial statements such as the earnings reports.
GAAP is mainly focused on the accounting and financial reporting of U.S companies. The one responsible for these regulations and standards is the Financial Accounting Standards Board (FASB). It is a nonprofit organization just like the international alternative to GAAP International Financial Reporting Standards (IFRS) set by the International Accounting Standards Board (IASB).
The two boards have been working since 2002, on the convergence of IFRS and GAAP. After the financial crisis in 2007/8, and to the progressive partnership of the two they have achieved something very important. In 2007, the SEC removed the requirement of non-U.S companies registered in America to reconcile their financial reports with its requirements if already complying with IFRS instead. This was a big establishment and benefitted many companies that were trading on the U.S stock exchange.
S&P 500 companies are slowly increasing in number and almost all of them report at least one non-GAAP measure of earnings as of 2019.
A non-GAAP is a computation used to report corporate income and earnings that are not defined by generally accepted accounting principles which is why they are called non-GAAP. Examples of non-GAAP earnings include free cash flow, core earnings, taxes, depreciation and EBITDA.
It is difficult to compare non-GAAP earnings to each other since they do not follow a specific standard method of computation.
U.S law requires companies that report financial statements to the public and are traded on the stock exchange to follow the following GAAP guidelines, which incorporate 10 key concepts.
Principle of Regularity: GAAP-compliant accountants strictly adhere to established rules and regulations.
Principle of Consistency: Consistent standards are applied throughout the financial reporting process.
Principle of Sincerity: GAAP-compliant accountants are committed to accuracy and impartiality.
Principle of Permanence of Methods: Consistent procedures are used in the preparation of all financial reports.
Principle of Non-Compensation: All aspects of an organization’s performance, whether positive or negative, are fully reported with no prospect of debt compensation.
Principle of Prudence: Speculation does not influence the reporting of financial data.
Principle of Continuity: Asset valuations assume the organization’s operations will continue.
Principle of Periodicity: Reporting of revenues is divided by standard accounting time periods, such as fiscal quarters or fiscal years.
Principle of Materiality: Financial reports fully disclose the organization’s monetary situation.
Principle of Utmost Good Faith: All involved parties are assumed to be acting honestly.
While it aims to eliminate wrongly stated and inaccurate reporting it is by no means comprehensive. Companies can still experience issues that cannot be controlled in the scope such as economic size, business sector, location and global presence along with other macroeconomic factors.