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What Is GAAP? A Guide to Generally Accepted Accounting Principles
Learn how GAAP principles work and what that means for your business.
Table of Contents
If you run a small business, you may not know much about the Generally Accepted Accounting Principles (GAAP). After all, GAAP standards apply to publicly traded companies, so these rules don’t always feel relevant to your small business.
However, it’s a good idea to have a basic understanding of GAAP standards. This information will help you improve your accounting skills, understand accounting principles and pinpoint how your business should track and measure its financial information.
Editor’s note: Looking for the right accounting software for your business? Fill out the below questionnaire to have our vendor partners contact you about your needs.
What is GAAP?
GAAP refers to the rules and standards used for financial reporting in the United States. GAAP standards were developed by the Financial Accounting Standards Board (FASB) and the Governmental Accounting Standards Board (GASB). These standards apply to corporate, government and nonprofit accounting.
The U.S. Securities and Exchange Commission (SEC) requires all publicly traded companies to adhere to GAAP standards. When each company reports and maintains its financial records the same way, it’s easier for investors to compare companies to make investment decisions.
GAAP requires publicly traded companies to adhere to these four standards:
- Recognition: Financial statements should accurately reflect your company’s assets, liabilities, revenue and expenses.
- Measurement: Financial statements should measure your organization’s financial results in accordance with GAAP standards.
- Presentation: For each reporting period, your business will present an income statement, balance sheet, cash flow statement and statement of shareholder’s equity.
- Disclosure: All financial statements will include any notes necessary to help users interpret the information.
What are the 10 principles of GAAP?
These 10 principles can help you understand the purpose of GAAP:
- Principle of regularity: Your accountant has followed all GAAP rules and regulations.
- Principle of consistency: Accountants commit to using the same standards from one period to the next. This consistency makes it easier to avoid errors and ensure financial comparability. If your accountant must make a change, they will disclose why in the footnotes.
- Principle of sincerity: Your accountant will provide an impartial and accurate view of your company’s financial situation.
- Principle of permanence of methods: There should always be a focus on consistency in the methods used during the accounting cycle.
- Principle of noncompensation: Your accountant will report all financial information transparently, outlining the positives and negatives. This report is made without the expectation of debt compensation.
- Principle of prudence: All financial data is reported as it currently is, without any speculation.
- Principle of continuity: This principle takes the assumption that your business will continue to operate in the future.
- Principle of periodicity: All accounting entries are reported during the appropriate periods. For example, both revenue and expenses will be reported during the correct periods.
- Principle of materiality: Your accountant will disclose all accounting information in the financial reports accurately.
- Principle of utmost good faith: This principle states that all parties will remain honest in their transactions.
The importance of GAAP compliance
If you run a publicly traded company, the SEC requires that your business follows GAAP standards. You must complete GAAP-compliant financial statements to remain listed on the stock exchanges.
GAAP compliance is not required for private companies but most lenders prefer it. If you plan to apply for a small business loan, you may be required to file GAAP-compliant financial statements.
Additionally, investors are often wary of businesses that don’t follow GAAP standards. That’s because the consistency of GAAP principles makes it easier to compare financial statements. In case your company ever goes public, you should begin adopting GAAP standards now.
Non-GAAP reporting and limitations of GAAP
GAAP standards are based on principles like accrual accounting, revenue recognition and expense matching. However, some believe financial statements prepared according to GAAP standards don’t always reflect a company’s performance accurately.
For that reason, some companies supplement their financial reports with non-GAAP statements, often referred to as pro forma statements. The goal is to present a more accurate and complete view of the company’s underlying operations.
Non-GAAP statements can include the following:
- Free cash flow
- Earnings before interest and taxes (EBIT)
- Earnings before interest, taxes, depreciation and amortization (EBITDA)
- Adjusted earnings
- Funds from operations
Proponents of non-GAAP reporting argue that including this information presents a more nuanced view of the company to investors. Critics argue that using non-GAAP financial statements could result in fraudulent reporting. In particular, the SEC has issued a statement advising caution when it comes to pro forma statements.
Best accounting software for GAAP compliance
The best accounting software solutions are designed in accordance with GAAP principles and can help simplify your financial accounting. Many accounting platforms are affordable, easy to use and integrate with your other business software.
We’re highlighting the following options to help you choose the right accounting software and ensure GAAP compliance:
- QuickBooks: QuickBooks Online is one of the most popular accounting options for small business owners. It’s an excellent option for businesses of all sizes â you can start with essential features in the beginning and continue adding more as your business grows. Our QuickBooks Online review explains how to use the software to collaborate with your accountant and generate GAAP-friendly reports.
- Xero: Xero’s cloud-based software is easy to use, has more than 1,000 app integrations and can help you comply with GAAP and various regulatory requirements. Every subscription plan allows unlimited users. Read our in-depth Xero review to learn about its mobile app and robust reporting features.
- Freshbooks: Freshbooks is another excellent option that can help you or your accountant prepare GAAP-compliant financial statements. Its custom invoice creation tools stand out. Its mobile app will alert you once an invoice has been viewed and you can answer customer questions directly within the app. Our Freshbooks review details the platform’s pricing and additional functionality.
GAAP FAQs
- Revenue recognition principle: This principle states that any revenue should be recorded once your buyer receives the good or service your company provides ― not after your business is compensated. This is what’s known as accrual accounting.
- Cost principle: Your accountant should record an expense when your company accepts goods or services from another business ― whether they’ve paid for the transaction.
- Matching principle: All expenses should match the revenue received during a given accounting period. If your company receives revenue, it should also acknowledge the associated costs.
- Full disclosure principle: Financial statements should include accurate and complete information so stakeholders know all relevant information about your company.
- Objectivity principle: All accounting data should be fact-based and free of assumptions. All financial data should be supported by receipts, invoices and vouchers.
| IFRS | GAAP |
|---|---|
| Issued by the IASB | Issued by the FASB |
| Doesn’t allow last-in, first-out (LIFO) method to estimate inventory | Uses LIFO or first-in, first-out (FIFO) to estimate inventory |
| Intangible assets are assessed for their future economic benefit | Intangible assets are measured for their fair market value |
| Allows companies more room for interpretation on financial statements | Follows a specific set of rules and procedures on financial statements |
| Revenue can be reported once value is delivered | Revenue can be reported once goods or services are received |
| Groups all liabilities together | Groups liabilities as either current or noncurrent |
- Inventory reporting: One of the most significant differences between GAAP and IFRS is how the two standards treat inventory reporting. With IFRS, you can't use the LIFO method to measure inventory. IFRS standards maintain that LIFO doesn’t portray inventory flow accurately and could make your company’s income appear lower than it is. In comparison, GAAP standards allow your company to track its inventory using either LIFO or FIFO.
- Intangible assets: GAAP and IFRS approach intangible assets differently. Under IFRS, intangible assets can be recognized if they offer a future economic benefit to your firm. However, GAAP recognizes intangible assets at their current fair market value ― without any additional assessment.
- Financial reporting: GAAP standards follow a highly specific set of rules and procedures with little room for interpretation. These rules are designed to prevent accountants from inflating your business’s financial records to mislead investors. However, IFRS would give your company more room for interpretation in your financial reporting.
- Revenue recognition: GAAP has specific standards for recognizing revenue across different industries. Generally, revenue cannot be reported until the buyer receives the goods or services purchased from your organization. IFRS states that revenue can be recognized once the value is delivered to your clients.
- Liabilities classification: Under GAAP standards, liabilities are classified as current or noncurrent depending on how long your business has to repay its debt. Any debt you must repay within the next 12 months is considered a current liability. Debt with a repayment period longer than 12 months is considered long-term debt. IFRS doesn’t distinguish between current and noncurrent liabilities and instead groups them together.
