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Importance of GAAP & Why We Use It

In 1971, Coca-Cola launched a campaign to unite the world by sharing a coke. GAAP, in the broadest sense, is similar but rather than joining the world through carbonated sugar water, the purpose of the Financial Accounting Standards Board (FASB) has been to establish and implement the uniformity of accounting principles worldwide.

What is GAAP

While 100 percent consistency has yet to be achieved worldwide, GAAP (generally accepted accounting principles), or simply accounting standards, are the framework for the rules and standards that dictate how financial statements are prepared.

GAAP addresses four concepts of financial accounting:

1. Revenue Recognition
Revenue Recognition is the accounting principle defining what earned revenue is, when to recognize or account for that revenue, and how much of it is measurable.

2. Measurement
Measurement is the accounting principle stating that assets and liabilities are recorded at the market value (actual cost) of the item on the date of acquisition. In short, only record transactions concerning real money. Factors that can indirectly impact the financial results of a business’s revenue (e.g., highly skilled employee equaling a predicted increase in sales), expenses, assets, or liabilities cannot be recorded.

3. Expense (aka The Matching Principle)
The expense recognition (also called the matching principle) addresses when to recognize expenses. Since this concept is considered one of the essential principles of GAAP, we discuss it further below.

4. Full Disclosure
Full disclosure principle states that all financial statements must present all the information needed for an individual to make an informed, economic decision. Required disclosures can come in many forms such as (but not limited to) financial statements, earnings reports, press releases, or footnotes.

The Matching Principle

We promised there’d be more. One of the essential GAAP principles in accounting is the matching principle (or expense recognition). The concept states that expenses are to be recognized in the same accounting period as related revenues.

Matching is critical because it creates consistency in the financial statement, which can be skewed if expenses are recognized either in earlier or later months. The matching principle ties the revenue recognition and expense principles together.

GAAP incorporates a general guideline known as the prudence concept which states that a company should be conservative when recording its profits while undervaluing when recording expenses and losses. Under this concept of accounting, the final accounts of a business must show caution (prudence) where income and expenses are impacted.

To understand the prudence concept a bit more, read here.

Why we need GAAP

Commonly referred to as the language of business, the primary purpose of accounting is to communicate the financial results of the business to the owners or other individuals involved.

The purpose of GAAP is to ensure that financial statements of U.S businesses (and perhaps worldwide one day) are consistent and comparable. Why does this matter? Globalization has created international companies. GAAP is making it possible for people across the world to interpret the accounting data used by other countries to make informed financial decisions.

For instance, an American investor is interested in investing in a business in Japan. If the investor is unable to interpret the business’s financial statements, how do they know the financial health of a business and whether or not it’s worth investing?

Without uniformity of accounting principles, investors are unable to interpret an international company’s accounting information.

Enforcement of GAAP

Does anyone enforce GAAP? Accounting principles are determined by private sectors which means they are not mandated and have no authoritative requirement, but are instead generally accepted (i.e., Generally Accepted Accounting Principles – GAAP). However, because most accountants were taught these accounting principles in formal education, most companies follow GAAP as though they are the law.

What accounting method is accepted under GAAP?

GAAP affects what is disclosed in financial statements. Therefore, going back to the financial accounting concept of recognition (which indicates items are recorded on the financial statement), GAAP focuses on accrual accounting rather than cash accounting.

GAAP and accrual accounting

The annual financial report (which contains elements such as income statement, balance sheet, and statement of cash flows) is prepared by applying GAAP. The accrual basis of accounting reflects a better association of revenues and expenses with the appropriate accounting period, which is why it’s preferred over cash accounting.

U.S. GAAP and IFRS

While U.S. based companies are required to abide by GAAP, IFRS (International Financial Reporting Standards) is the accounting method used throughout most of the world.

The primary difference between IFRS and GAAP is IFRS accounting is based on principle while GAAP is based on rules. IFRS guidelines provide far less detail than GAAP; however, it may more accurately represent the economics of business transactions. If your company is involved in any international business, it’s important to understand the differences between GAAP and IFRS.

The process of managing financial reports is not easy for most small and mid-size business owners – especially when it’s necessary to it accurately on a consistent basis. If you need assistance in managing financial statements to ensure they adhere GAAP, contact us today.

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