What is GAAP and Why is it Important?
Financial reporting is an important part of business that communicates the financial performance and results of a company. It records and presents information about the company’s financial position, revenues, expenses, and related disclosures.
While financial reporting is essential for internal management for measuring and analyzing operations, assets, financial obligations, and success, it is also important for stakeholders outside the company. Financial reports are needed for tasks such as raising capital, initial public offerings (IPOs), transactions such as mergers or acquisitions, applying for lines of credit (LOC), and even the latest events such as qualifying for the recent stimulus loans, grants, and loan forgiveness.
For both inward and outward-facing purposes, a standardized, comparable accounting method helps maintain consistency month to month and allows the performance of the company to be compared with the performance of others.
This is where GAAP comes in.
What is GAAP?
GAAP stands for “Generally Accepted Accounting Principles” and are the guidelines by which most finance professionals in the United States record and report financial performance in a company. These principles were created in the 1970s in a joint effort between the Financial Accounting Standards Board (FASB) and the Governmental Accounting Standards Board (GASB). The purpose of these standardized practices is to ensure consistency and completeness in financial reporting, and to set a basis by which performance can be compared across multiple companies.
The SEC (Securities & Exchange Commission) only requires publicly traded companies and companies obligated to publicly release their financial statements to adhere to GAAP. However, most finance professionals including accountants, CPAs, bookkeepers, controllers, and CFOs still choose to follow these guidelines. This is especially true if a company has ambitions of one day going public or engaging in a transaction such as a merger, acquisition, or raising capital.
The Generally Accepted Accounting Principles (GAAP) is presented in a document approximately 2,400 pages long and consists of a number of topics, including:
- Financial statement presentation
- Business combinations
- Derivatives and hedging
- Fair value
- Foreign currency
- Nonmonetary transactions
- Subsequent events
- Industry-specific accounting
It is maintained and updated by the Financial Standards Accounting Board (FSAB), which has extensive protocols for making and presenting changes to GAAP.
The Core Principles of GAAP
Below are what are considered the core principles of GAAP.
- Principle of Regularity. All accountants will adhere to the standards set forth by GAAP.
- Principle of Consistency. Finance professionals are committed to applying the same accounting standards from one period to the next. This ensures comparability between periods.*
- Principle of Sincerity. Accountants strive to produce accurate and impartial depictions of the company’s financial performance.
- Principle of Permanence of Methods. Like the principle of consistency, the principle of permanence states that uniform procedures and practices should be applied in financial accounting and reporting to ensure comparability.
- Principle of Non-Compensation. This principle means that all aspects of an organization’s finances should be reported. An asset should not be used to offset (compensate for) a liability.
- Principle of Prudence. All aspects of financial reporting should be fact-based, reasonable, and prudent—not based on speculation.
- Principle of Continuity. This means that all assets should be valued based on the assumption that the company will continue to operate moving forward.
- Principle of Periodicity. This principle refers to the standardization of time periods for financial reporting—such as annually, quarterly, or monthly.
- Principle of Materiality. The financial reports for a company should provide full disclosure and present the organization’s genuine financial position.
- Principle of Utmost Good Faith. All organizations should be honest and complete in their financial reporting.
*If there are ever any changes in the standards used in accounting, the finance professional is expected to fully disclose this change and explain the reasons behind this change in the footnotes to the financial statements.
Why is GAAP Important?
The purpose of GAAP is to create a consistent, clear, and comparable method of accounting. It ensures that a company’s financial records are complete and homogeneous. This is important to business leaders because it gives a complete picture of the company’s health. Because GAAP ensures consistency, it also means business leaders can more accurately compare company performance month over month.
In addition, GAAP is important for external activities such as raising capital, public trading, preparing for a transaction, or even competitive comparisons. This is because GAAP ensures consistency in reporting in all businesses, making the financial reports that are produced complete and comparable. This is especially important in publicly traded companies or in companies required to publicly release their financial statements.
Should my Company Use GAAP?
While GAAP is not regulated by the government, it was created through a collaboration between business and government. It isn’t mandatory for all businesses, but is highly recommended, especially if you plan to eventually go public or if you expect to be raising capital or preparing for another transaction in the near future.
If you are required to release your financial statements publicly or are a publicly traded company in the United States, you are required to follow GAAP in financial reporting. This is according to the SEC, which requires yearly external audits by independent auditors. However, companies without external investors are not obligated to follow GAAP.
Even when GAAP is not governmentally required, it can have a significant benefit to businesses. This is because GAAP helps to:
- Improve consistency in financial information and accounting records
- Summarize accounting records into complete and consistent financial statements
- Provide a basis of comparison between multiple companies
GAAP is meant only to improve the standards of comparability and transparency in financial statements. They do not guarantee that the financial documents are free from errors or omissions.
In addition, while GAAP applies to companies in the United States, the SEC (Securities & Exchange Commission) presented a roadmap in 2008 to join more than 100 countries in the move to the International Financial Reporting Standards (IFRS). However, progress on this progress has been slow.
About the Author
Michael Flint is an experienced CFO with over 20 years in financial management. His expertise includes budgeting and forecasting, business process and systems improvement/automation, and technical accounting compliance. Michael is a VentureCapital.org Mentor and holds a Master’s in Accounting from Brigham Young Utah.
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