What is GAAP?
GAAP is short for Generally Accepted Accounting Principles. GAAP is a cluster of accounting standards and common industry usage that have been developed over many years. It is used by organizations to properly organize their financial information into accounting records, summarize the accounting records into financial statements, and disclose certain supporting information.
One of the reasons for using GAAP is so that anyone reading the financial statements of multiple companies has a reasonable basis for comparison, since all companies using GAAP have created their financial statements using the same set of rules.
The Core GAAP Principles
GAAP is set forth in 10 primary principles, as follows:
- Principle of consistency: This principle ensures that consistent standards are followed in financial reporting from period to period.
- Principle of permanent methods: Closely related to the previous principle is that of consistent procedures and practices being applied in accounting and financial reporting to allow comparison.
- Principle of non-compensation: This principle states that all aspects of an organization’s performance, whether positive or negative, are to be reported. In other words, it should not compensate (offset) a debt with an asset.
- Principle of prudence: All reporting of financial data is to be factual, reasonable, and not speculative.
- Principle of regularity: This principle means that all accountants are to consistently abide by the GAAP.
- Principle of sincerity: Accountants should perform and report with basic honesty and accuracy.
- Principle of good faith: Similar to the previous principle, this principle asserts that anyone involved in financial reporting is expected to be acting honestly and in good faith.
- Principle of materiality: All financial reporting should clearly disclose the organization’s genuine financial position.
9 Principle of continuity: This principle states that all asset valuations in financial reporting are based on the assumption that the business or other entity will continue to operate going forward.
- Principle of periodicity: This principle refers to entities abiding by commonly accepted financial reporting periods, such as quarterly or annually.
Why Is GAAP Important?
GAAP is important because it helps maintain trust in the financial markets. If not for GAAP, investors would be more reluctant to trust the information presented to them by companies because they would have less confidence in its integrity. Without that trust, we might see fewer transactions, potentially leading to higher transaction costs and a less robust economy. GAAP also helps investors analyze companies by making it easier to perform “apples to apples” comparisons between one company and another.