General accepted accounting principles or GAAP: What does it mean?

If you have ever inquired about an accounting position at a business, you've probably seen the phrase "candidates are required to demonstrate a current knowledge of Generally Accepted Accounting Principles (GAAP)." But, what exactly is GAAP, and why is it a mandatory requirement with today's business accountants?

The principles of GAAP

Generally accepted accounting principles, or GAAP for short, are the accounting rules used to prepare and standardize the reporting of financial statements, such as balance sheets, income statements, and cashflow statements, for publicly traded companies and many private companies in the United States. GAAP-based income is measured so that the information provided on financial statements is useful to those making economic decisions about a company, such as potential investors and creditors.

GAAP is implemented through measurement principles and disclosure principles. Measurement principles recognize and determine the timing and basis of items that enter the accounting cycle and impact the financial statements, such as the period in which transactions will be recorded. Disclosure principles determine what specific numbers and other information are essential to be presented in financial statements. Basically, GAAP is concerned with:

• the measurement of economic activity
• the time when such measurements are to be made and recorded
• the disclosures surrounding this activity and
• the preparation and presentation of summarized economic information in financial statements

Why GAAP?

Without GAAP, companies would be free to decide for themselves what financial information to report and how to report it, making things quite difficult for investors and creditors who have a stake in that company. Because financial statements prepared under GAAP are intended to reflect economic reality, GAAP makes a company's financials comparable and understandable so that investors, creditors, and others can make a rational investment, credit, and other financial decisions. In order to be useful and helpful to users, GAAP requires information on financial statements to be relevant, reliable, comparable, and consistent.

Regulating GAAP

Although it is not written in law, the U.S. Securities and Exchange Commission (SEC) requires publicly traded companies and other regulated companies to follow GAAP for financial reporting. Although smaller companies are not required to use GAAP, there are certain situations, such as obtaining credit or seeking investors, which require, by contract, those companies to also follow GAAP when preparing their financial statements.

The SEC does not set GAAP; GAAP is primarily issued by the Financial Accounting Standards Board (FASB). Government entities, however, must follow a different set of GAAP standards as determined by the Governmental Accounting Standards Board (GASB).

How to apply GAAP

Accountants apply GAAP through FASB pronouncements called Financial Accounting Standards (FASs). Since its formation in 1973, the FASB has issued over 100 formal FAS pronouncements. Before the FASB was formed, its predecessor, the Accounting Principles Board (APB), issued 31 opinions between 1959 and 1973. The APB was preceded by the Committee on Accounting Procedure, which issued 51 pronouncements known as Accounting Research Bulletins (ARBs) from 1939 to 1959. Some of the APB opinions and ARBs are still in force today.

Although the rules found in the formal pronouncements of the FASB and its predecessors are the main sources of GAAP, GAAP rules are also found in statements from the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants; pronouncements by expert accountants; and other practices that are not found in formal pronouncements but are generally accepted because they represent a common practice in a particular industry. For example, there is a general assumption that financial statements must be based on the premise that a company will continue in existence unless there is substantial evidence to the contrary.

Because of the myriad of GAAP sources, accountants must rely on their own knowledge and professional judgment when deciding how the GAAP concepts should be interpreted and applied.

Why should I know GAAP?

If you have anything to do with the financial reporting of a company or government entity, you should understand the principles of GAAP. However, if you are simply preparing your individual income tax statements, understanding GAAP probably isn't as important to you.

Usually, financial statements prepared for income tax purposes are significantly different than statements prepared under GAAP, mainly because they each measure income differently. The FASB measures GAAP-based income so that the information provided is useful to those making economic decisions (i.e., investors and creditors). The IRS, on the other hand, uses income tax reporting to achieve social and economic objectives, such as reducing unemployment and encouraging investment in capital assets.

The following Web sites give more information and new announcements on GAAP:

Financial Accounting Standards Board, www.fasb.org

U.S. Securities and Exchange Commission, www.sec.gov

American Institute of Certified Public Accountants, www.aicpa.org

As with any accounting matter, you should always discuss accounting issues with your certified public accountant.