chapter 01
Understanding GAAP Fundamentals
What is GAAP and Why Was It Developed?
Get Accounting HelpGAAP is a set of guidelines and procedures designed to create a comprehensive financial reporting framework that facilitates transparent, consistent and comparable financial statements for internal and external users.
In simpler terms, GAAP is a rulebook you can follow to make your financial statements as accurate and useful as possible.
The Financial Accounting Standards Board (FASB) and the Governmental Accounting Standards Board (GASB) developed GAAP primarily to help external parties analyze and compare publicly traded companies.
Before its creation, accounting standards varied greatly between businesses, making it difficult for investors, regulators and other stakeholders to assess their finances and make informed decisions.
The Role of the Financial Accounting Standards Board
Empowered by the SEC, the FASB is responsible for creating and maintaining GAAP. The GASB and the American Institute of Certified Public Accountants (AICPA) may influence its decisions and opinions, but the FASB is the ultimate authority.
SEC
The Securities and Exchange Commission empowers FASB to set GAAP standards for public companies.
FASB
The Financial Accounting Standards Board creates and updates GAAP standards for businesses, receives input from AICPA for non-public companies and works with GASB on government-related standards.
GAAP
Generally Accepted Accounting Principles are adopted by public companies and many SMBs for financial reporting.
The FASB formally documents its standards in the FASB Accounting Standards Codification (ASC), also known as the FASB Codification. It’s an authoritative, searchable database that organizes and presents GAAP in a relatively digestible way.
Importantly, the FASB regularly updates the FASB Codification to:
- Respond to new developments in the financial landscape
- Enhance the clarity and consistency of existing accounting guidance
- Align GAAP closer with international standards to enhance comparability
As a result, keeping up to date with new developments is a significant part of GAAP compliance. One of the best ways is to subscribe to the FASB’s Accounting Standards Updates (ASUs), which explain how and why they’ve changed GAAP, when the change takes effect and how best to adopt the new rules.
GAAP vs. OCBOA vs. IFRS
GAAP may be the default accounting standard for public companies, but many private businesses in the U.S. use one of the following instead. Each is considered an Other Comprehensive Basis of Accounting (OCBOA):
Cash basis of accounting
Modified cash basis of accounting
Income tax basis of accounting
OCBOAs have more straightforward requirements than GAAP, often making them easier to understand and cheaper to implement. However, the statements they produce aren’t as detailed or comparable as GAAP statements, which can limit their usefulness.
Another notable accounting standard is the International Financial Reporting Standard (IFRS), the most popular option outside the U.S. It’s considered as robust as GAAP, but uses a principles-based approach.
|
GAAP |
OCBOA |
IFRS |
|
|---|---|---|---|
| Purpose |
To maximize transparency, consistency and comparability of financial statements |
To organize financial reporting when GAAP is unnecessary or inappropriate |
To bring transparency, accountability and efficiency to global financial markets |
| Followed By |
Public companies and some private businesses in the U.S. |
Private businesses seeking a simpler alternative to GAAP |
Public companies and some private businesses outside the U.S. |
| Developer |
FASB |
AICPA |
IASB |
| Approach |
Rules-based |
Depends on the basis |
Principles-based |
Fundamental GAAP Principles
While not officially included in the FASB Codification and therefore not strictly authoritative, the FASB Concepts Statements are valuable resources that can help you understand the core GAAP principles.
The most recent explains that GAAP is fundamentally a framework for creating useful financial information. And to be useful, that information must follow two primary principles: relevance and faithful representation.
1. Relevance
Meaning:
Capable of affecting a user’s decisions
Requirements:
Predictive value – Information can be used to predict future outcomes,
helping users make informed decisions.
Confirmatory value – Information can provide feedback about past predictions, helping users evaluate previous decisions.
Materiality – If the information were misstated or omitted from the financial statements, it would likely mislead a reasonable user.
2. Faithful Representation
Meaning:
Accurately represents the economic phenomenon
it claims to represent
Requirements:
Complete – Information includes all details a user would need to
understand the phenomenon it depicts.
Neutral – Information is without bias in its selection or presentation, providing an impartial view of the phenomenon it depicts.
Free from Error – There are no errors or omissions in the description of the phenomenon or the process used to produce the description.
In addition, the FASB outlines four secondary principles that improve the usefulness of relevant and faithfully represented financial information. GAAP is designed to facilitate these too, whenever possible. They include:
Financial information should be readily comparable with financial information from other entities. This concept is closely related to consistency, which refers to an entity’s information being comparable across multiple periods.
Financial information is verifiable if separate knowledgeable observers can agree that it’s a faithful representation of the underlying phenomenon.
Financial information is available to decision makers in time to influence their decisions. Generally, older information is less useful.
Financial information should be presented clearly and concisely, making it accessible to users with reasonable financial knowledge.
Keep these core principles in mind as you learn GAAP’s rules and procedures more specifically. It will help you understand their purpose and appreciate how they contribute to producing useful financial information.
