What are Generally Accepted Accounting Principles (GAAP)?
Generally accepted accounting principles (GAAP) are a commonly followed collection of guidelines — both set by policy boards and adopted by general practice — that organizations use in reporting their financial numbers.
Generally accepted accounting principles (GAAP) are a commonly followed collection of guidelines used to report a company’s financial information. The purpose of GAAP is to make the reporting of a company’s finances transparent and uniform. In the United States, all publicly listed companies or organizations that report their numbers to the public must follow GAAP guidelines. They must include three important financial statements: The balance sheet (what the company owns and owes), the cash flow statement (the money coming in and going out), and the income statement (the money it makes). GAAP enables investors to compare a company’s performance across different industries and years. It also aims to protect investors’ interests.
Let’s look at a real-life example and peek into Microsoft’s income statement for the fiscal year ending on June 30, 2019.
Microsoft’s Income Statement:
|Diluted Earnings Per Share (EPS)||$5.06||$4.75|
The net income (aka "bottom line") is the final line in an income statement. According to disclosures in Microsoft's income statement, the difference between GAAP and non-GAAP net income comes from a $2.6B tax benefit and a net income tax charge of $157M. Tax benefits are considered in GAAP, while they are excluded from non-GAAP. So, the net income is different depending on whether a GAAP or non-GAAP measure is used.
GAAP is like the grammar of financial reporting. Grammar enables us to understand better and communicate clearly. Similarly, GAAP provides a common structure to financial statements, and gives investors a base to evaluate and compare financial information.
GAAP is like the grammar of financial reporting...
Grammar is the foundation of any language. It also enables us to understand it better and communicate clearly. Similarly, GAAP guidelines provide a common structure to financial statements, establishing consistency, and giving investors a base to evaluate and compare financial information from different companies.
GAAP guidelines are set by the Financial Accounting Standards Board (FASB) and are a part of the Accounting Standards Codification (ASC). GAAP is recognized as an accounting standard by the Securities and Exchange Commission (SEC) — The highest government agency in the U.S. that is in charge of protecting investors and creating laws for the financial markets.
In addition to the balance sheet, cash flow statement, and income statement, GAAP also requires companies to reveal any information that may impact their business. These are called disclosures. For example, in Apple’s annual report for the fiscal year ending September 29, 2018, the company had to state that a 1% increase in interest rates would result in a decline of $6B in the value of its portfolio. This disclosure was a part of a “sensitivity analysis” that companies generally perform.
GAAP’s strength comes from its ten principles.
Principle of regularity: This principle declares that accountants must always follow GAAP guidelines.
Principle of consistency: Accountants must always use the same standard of accounting principles. If the rules change, update or the accountants move away from them, you’ll find their reasons in the footnotes of the financial statements.
Principle of sincerity: Accounts must be sincere and free from bias while reporting an organization’s finances.
Principle of permanence of records: The method used to report finances must be consistent throughout the report.
Principle of non-compensation: At times, senior managers own shares in the company where they work. During a tough time for a company, its managers may be tempted to conceal problems instead of reporting them to protect their shares in the company. Such hiding of facts is not allowed, and accountants must reveal both the good and bad news in the financial reports.
Principle of prudence: Accountants must use facts and not their assumptions and biases while reporting financial data.
Principle of continuity: While calculating the value of a company’s assets, the accountants must assume that the company will keep running.
Principle of periodicity: Financial numbers reported must be for specific time frames such as a quarter or a fiscal year. For example, cash received by a company in the year 2018 should not be reported as cash received in 2019.
Principle of materiality: Accountants must reveal all material information (anything which, if omitted or misstated, may affect an investor’s decision).
Principle of utmost good faith: As the name suggests, it is assumed that everyone involved in the process of financial reporting acts honestly.
Despite GAAP guidelines, accountants may find loopholes and report the company's numbers in a favorable light to gain an advantage. This tactic is called creative accounting. To limit it, GAAP has three rules in addition to its ten principles.
Basic accounting principles and guidelines: Accounts must follow the ten GAAP principles and keep the organization’s money separate from its owners, use a common currency, and state appropriate disclosures in the financial report.
Standards issued by the governing bodies: Accountants must be aware of the latest GAAP guidelines, which are updated in the FASB Accounting Standards Codification by the FASB.
Generally Accepted Industry Practices: GAAP guidelines are not always the same for all industries. They take into account the unique nature of different fields and may have industry-specific rules.
The American Institute of Accountants (AIA) used the term ‘GAAP’ for the first time in 1936. The AIA set up the Committee on Accounting Procedure (CAP) in 1939, which established accounting rules. Eventually, in 1972, the FASB introduced GAAP the way we know of it today. The FASB updates and supervises GAAP even today.
Non-GAAP measures are like the side dish served along with your main order — You did not ask for it, but you are happy to get it, and it somehow makes the meal complete. Ninety-seven percent of the companies in the S&P500 include both GAAP and non-GAAP metrics while reporting numbers. If an accountant adds or deletes something from a comparable GAAP number’s calculation, it will become a non-GAAP number.
Some non-GAAP figures may be adjusted to represent an accurate picture of a company's finances. That's why non-GAAP numbers are usually called 'adjusted.'
Here’s a real-life example of non-GAAP accounting. According to Uber’s financial statement for the quarter that ended on March 31, 2019, it generated a revenue of $3.09B (GAAP number). Uber also published its ‘Adjusted Net Revenue’ (a non-GAAP comparable number to revenue).
Uber’s Adjusted Net Revenue Calculation:
|-||December 2018 – March 2019 Quarter|
|1. Excess driver incentives||($303M)|
|2. Driver referrals||($35M)|
|Adjusted Net Revenue||$2.76B|
Organizations have to explain the reason for a difference in GAAP and non-GAAP numbers, which they generally do in their financial statements. Uber reported Adjusted Net Revenue to inform its investors how changing drivers’ incentives would impact its revenue.
International Financial Reporting Standards (IFRS) is an accounting standard used in more than 110 countries, such as Canada, China, Australia, and members of the European Union. GAAP is used in the United States.
In general, GAAP is a more rules-based accounting system; IFRS is a more principles-based system. In GAAP, accountants have no scope to interpret rules; while IFRS allows accountants to use their judgment.
GAAP aims to reduce incorrect financial reporting and protect investor interest, but it still does not guarantee that a company's reported finances are entirely error-free. With companies becoming globalized and IFRS (International Financial Reporting Standards) being the international standard, investors and businesses around the world may face problems while reporting and comparing GAAP and IFRS numbers as they are calculated differently.
GAAP’s regulatory bodies have useful information on financial reporting. You can check it out here:
FASB Handbook: Standards guidelines for reporting finances at federal organizations. Accounting Standards Codification: GAAP’s ten principles are published here. The Sarbanes-Oxley Act of 2002: Federal legislation on accounting and IT requirements and full disclosure for public companies.
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