Generally Accepted Accounting Principles (GAAP) are also referred to as standard accounting practice or simply as accounting standards. They are sets of guidelines for financial accounting that include standards, instructions and agreements for accountants in recording and summarizing financial data and information in the USA. GAAP determine how balance sheets, finance notes, income statements, among a myriad other financial statements, are reported and interpreted. The basic objectives of GAAP include having financial reporting that is useful to potential investors, creditors and other users enabling them to make financial decisions, assess the trends of prospective cash receipts and Return on Investment (ROI), and also help improve the business performance (Bragg, 2013).
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GAAP in the USA isderived from the following:
- Issuances from statements of the Financial Accounting Standards Board, the body designated to administer GAAP by the American Institute of Certified Public Accountants(AICPA).
- Opinions of AICPA’s Accounting Principles Board
- AICPA’s Accounting Research bulletins
- Other AICPA issuances such as AICPA Industry Guides
- Industry practice
- Accounting literature such as books and journals
Though GAAP are prevalently used in the USA, these are not the only accounting standards. Indeed most countries have adopted the London-based International Financial Reporting Standards (IFRS) accounting standards – especially for large, listed and or multinational companies. These include all companies in the European Union and manyin Canada. Some countries have tweaked IFRS to have local versions suitable to their situations, including many in Asia and Africa (Benston, Bromwich, Litan, Wagenhofer, 2006).
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The United States, through US Securities and Exchange Commission (SEC), acknowledges and supports IFRS as “a single set of high-quality, globally accepted accounting standards,” but its adoption has been uncertain to say the least.Notably, GAAP varies considerably from IFRS.Whereas GAAP is rules-based with complex guidelines that try and cover every contingency, IFRS is principle-based built around good reporting via guidance on how a specific standard relates to an arising situation(Benston et al., 2006).
History of GAAP
GAAP can be traced back to 1939,when AICPA, urged by SEC, created the Committee on Accounting Procedure (CAP). CAP issued 51 Accounting Research Bulletins addressing various pertinent problems in accounting. But this problem-based approach did not develop the needed structure of accounting principles.
This led to AICPA replacing CAPwith Accounting Principles Board (APB) in 1959. APB was mandated to develop a conceptual structure of accounting principles. The board issued 31 opinions but because oflittle productivity and lack of decisiveness, APBwas dissolved in 1973 as one of the recommendations of the Wheat Committee.
The Wheat Committee was appointed by the accounting profession to study establishment of accepted accounting principles. The committee recommended creation of a new structure composed of a foundation, council and board. This includes the Financial Accounting Foundation (FAF) that is responsible for the board insofar as funding, oversight and selecting members is concerned. The structure would also be composed of the Financial Accounting Standards Advisory Council (FASAC) and the Financial Accounting Standards Board (FASB). FASB became the major operating organization in the structure, and is responsible for administration and development of Generally Accepted Accounting Principles (GAAP) to date.Since it was formed in 1973, FASB has made over 200 Financial Accounting Standards (FASs) pronouncements (Bragg, 2013).
Hence AICPA, in conjunction withSEC, have been the leading lights in development of accounting standards in the US.SEC was created as a result of the Great Depression when there was no accounting standards structure. Hence,through AICPA and later the FASB,SEC encouraged establishment of accounting standards by the private sector in the belief that the sector had the necessary talents and resources. Up to today, SEC closely works with the various private organizations that set GAAP (Tracy, 2013).
FASB remains the main administrator and developer of GAAP, and most private entities in the USA apply FASB’s GAAP in their accounting. In 1984, FASB created the Emerging Issues Task Force (EITF) to deal with new, unusual financial transactions with the potential to become common. Examples include business processes and transactions enabled by the Internet of Things. EITF hence quickly resolves short-term problems, with FASB acting on the more long-term accounting standards issues.
Other organizations involved in development and administeringaccounting standards in the US include the Governmental Accounting Standards Board (GASB)which was created in 1984. With a structure similar to FASB, GASB caters for state and local government financial reporting standards.
Public Company Accounting Oversight Board (PCAOB) is another organization involved in GAAP. As its name suggests, this caters for public companies.
Since October 1999, AICPA recognizes the Federal Accounting Standards Advisory Board (FASAB) as a standard-setting body for federal governmental entities. However, certain federal government entities such as US Postal Service and Department of Treasury continue to apply FASB GAAP.
Other organizations that influence development and administration of GAAP in the USA include Accounting Standards Executive Committee, American Accounting Association, Financial Executives Institute, Government Finance Officers Association (GFOA) and Institute of Management Accountants.
Basic Concepts of GAAP
There arecertainaccounting assumptions, principles, and constraintsthat form the basis of GAAP.The following is a summary of these guidelines and principles.
The main assumptions include that an economic entityis separate from its owners or other entities. Hence the finances of the entity should be separated from personal expenses. Another assumption is that the business entity will operate indefinitely – or at least in the foreseeable future – an assumption that only ceases to apply whenliquidation of the business is certain(Tracy, 2013).
GAAP also assumes that the business records will be in a stable currency. The US dollar’s nominal value is accepted as the recording monetary unit.Another main assumption is that business economic activities are divisible into artificial time periods, say a financial year.
GAAP is anchored on four basic principles. These are the cost principle, revenue recognition principle, matching principle and full disclosure principle.
The cost principle obligates companies to account and report acquisition costs of assets and liabilities and not the fair market value. Whereas this principle ensures the information provided is reliable, it is however usually irrelevant, resulting to many companies resorting to report at fair market values.
According to the revenue recognition principle, companies should record revenue when earned rather than when received. Hence business cash flowdoes not impact on revenue recognition: the essence of accrual basis accounting. On the other hand, loss recognition happens when they become probable, whether or not the losses have actually occurred. Hence revenue reflection is inconsistent with lossreflection.
In matching principle, expenses are matched with revenues insofar as it is reasonable. Hence expenses are recognized when the service or product that incurred the expense contributes to revenue. However, if there is noestablished connection between the expense and revenue, the expense is then charged to the current period. The matching principle hence enables better evaluation of performance and profitability.
That information is expensive means that the amount and type of information disclosed is decided based on trade-off analysis. This full disclosure principle requires that disclosed information should enable decision-making whilst keeping the costs of the information preparation and use low.
The main constraints of GAAP include objectivity where acompany’s financial reports need to beanchored on objective evidence.Another constraint is materiality that requires an item’s significance to be considered during reporting. If an item would affect a reasonable individual’s decision, then it is significant (Bragg, 2013).
A company’s financial reporting is also constrained to employ the same accounting principles and methods from one period to the next. This is referred to as the consistency principle.Another GAAP constraint is conservatism. In choosing between two solutions or among various solutions, the solution with less or the least favorable outcome is chosen.Cost is another major constraint that involves a cost-benefit analysis where the benefits of financial reportinghave to outweigh the cost of supplying it to justify the reporting.
AICPA’s Code of Professional Ethics lays down situations that allow members to depart from GAAP; situations usually occasioned by new legislation, new forms of business transactions or contradictory industry practices (Bragg, 2013).In such situations, compliance to GAAP often leads to misleading financial statements.However, when a member departs from GAAP, they need to disclose why compliance to the accounting principles would lead to misstatement.
Sources of Accounting Standards
FASB has four major sources of accounting standards that are summarized below.
- Statements of Financial Accounting Standards (SFAS) – These are the most authoritative and main source of GAAP. Having been issued consistently since December 1973, there are now over 200 SFAS.
- Statements of Financial Accounting Concepts – First published in 1978, these arenot part of GAAP but rather part of FASB’s conceptual framework. They state theimportant objectives and concepts that FASB considers in developing future accounting standards.
- Interpretations – These modify or extend existing standards. Over fifty interpretations of GAAP have been published to date.
- Technical Bulletins – These bulletins usually offer solutions to very specific accounting issuesand hardly have a significant, lasting effect. The bulletins contain guidelines on applying standards, interpretations and opinions(Flood, 2014).
Around 2008, FASB issued the FASB Accounting Standards Codification, reorganizing thousands of GAAP pronouncements into about ninety accounting topics displayed in a consistent structure. The codification also includes relevant SEC guidance in the same topical structure. At the same time, SEC issued a preliminary “roadmap” aimed at making USA jointhe more than 100 countries around the world who use the IFRS rather than GAAP(Tracy, 2013). Though SEC aimed to fully adopt IFRS by 2014, this has not happened; mainly because of the earlier mentioned differences between GAAP and IFRS.
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FASB Accounting Standards Codification is effective for interim and annual periods ending after September 15, 2009. As per the codification, FASB Statement Number 168 and the Hierarchy of GAAP, FASB Accounting Standards Codification supersedes all existing accounting standards documents with all accounting literature that is not included in the codification being non-authoritative.
The codification did not change GAAP but rather introduced a new structurewith a user-friendly online research system. The system reduced the time and effort required to research an accounting issue, immediately updates GAAP with new standardsand increases GAAP compliance(Pilot, 2014).
After creation of FASB, AICPA established the Accounting Standards Executive Committee (AcSEC). This committee contributes to GAAP by publishing the following:
- Audit and Accounting Guidelines – These guidelines are a summary of accounting practices for specific industries such as hospitality, airlines or education services. . The guidelines provide particular guidance on issues not addressed by FASB or GASB.
- Statements of Position – These provide guidance on emerging financial reporting issues that FASB or GASB are yet to set standards.
- Practice Bulletins – These bulletins indicate AcSEC’s views on specific financial reporting issues that FASB or GASB have not considered(Flood, 2014).
The FASAB Handbook of Accounting Standards and Other Pronouncements, As Amended (FASAB Handbook) is the most authoritative source of GAAP for federal entities. The FASAB Handbook is updated annually to reflect the latest pronouncements and amendments to financial accounting standards.
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Previous editions of FASAB Handbooks, starting with the 2004 version, are archived and are available online for historical recording and reference purposes(Pilot, 2014). These are especially important when backing up a past audit.
GAAP is crucial to accounting standards in the USA. Without GAAP, business entities and other organizations would be free to report what they want, when they want to; making decision-making for investors, creditors and other stakeholders nearly impossible. Whereas IFRS is a viable alternative to GAAP, the latter has been developed and adopted in the USA for a long time and will remain the accounting standard for a majority of entities in the country for the foreseeable future. GAAP ensures that financial reports are relevant reliable and consistent.