In 1999, NASA famously lost the $125 million Mars Climate Orbiter in flight—not because of a rogue asteroid or a heat shield failure. It was due to the Lockheed Martin engineering team using the imperial system of measurement to build the craft while NASA’s flight team used the metric system to operate it.
The lesson? It’s important to use the same language—and the same systems of measurement—when communicating across organizations.
To avoid financial disasters of this scale, the United States Securities and Exchange Commission (SEC) requires public companies to adhere to a common set of standards in their accounting and reporting processes. Known as “generally accepted accounting principles” (GAAP), this set of standards is designed to facilitate transparency and consistency when it comes to financial information.
Following GAAP principles can also help small-business owners communicate with accountants and bookkeepers, and it can ease the transition process if you experience turnover in your accounting team. Because many accountants are familiar with GAAP accounting standards, adopting a GAAP-compliant accounting system from the outset will help you make sure that the language you use to communicate your financial information is clear and useful for you, your business partners, and any vendors with whom you collaborate in the future.
What are generally accepted accounting principles (GAAP)?
Generally accepted accounting principles are a set of standards outlining the processes of business accounting. GAAP standards are maintained by the Financial Accounting Standards Board (FASB), a private-sector nonprofit that exists to improve financial reporting standards and to educate stakeholders on their use.
10 Principles of GAAP
GAAP standards are based on 10 principles. Taken together, these principles outline the accounting rules, practices, and methods required in a GAAP-compliant accounting system. Here’s an overview of each one.
1. Principle of consistency
GAAP rules require businesses to use the same accounting standards from year to year. For example, if a business chooses the declining balance method for calculating depreciation on an asset, that method should be applied to all depreciating assets every year, with both depreciation and historical cost appearing on the company’s balance sheet.
This principle allows stakeholders to compare financial reports over time and prevents companies from disguising information (intentionally or otherwise) by changing the way that information is recorded.
2. Principle of permanent methods
The principle of permanent methods is related to the consistency principle, but it applies specifically to accounting practices and methods, which should be consistent from year to year. For example, once a company adopts a particular profit and loss template, it should continue to use the same template in each subsequent reporting period instead of alternating between different presentations of the same data.
Like the principle of consistency, this principle increases transparency and facilitates long-term comparison of financial performance.
3. Principle of non-compensation
The principle of non-compensation requires an organization to provide a thorough and comprehensive accounting of all debts and assets. This prevents businesses from using assets to offset debts (or vice versa) in their financial statements.
For example, if a business owes $30,000 on a startup loan and holds $50,000 of working capital in reserve, GAAP rules require that the business report both of those numbers rather than subtracting the liability from the asset and reporting the net balance alone.
4. Principle of prudence
The business world loves starry-eyed dreamers, but the accounting world lives in the realm of facts. The principle of prudence requires a factual basis for all financial reporting and cautions against understating losses or overstating gains. Requiring that assets be valued using historical cost—the price of an asset at the time of purchase—is one way GAAP rules prevent the overvaluation of assets.
5. Principle of regularity
The principle of regularity requires that all accountants in an organization follow the principles of GAAP consistently. Compliant organizations should not use tactics that violate GAAP principles in any of their financial record keeping or reporting.
6. Principle of sincerity
The principle of sincerity requires that accountants must be honest (and avoid bias) in the reporting of financial information.
7. Principle of utmost good faith
Borrowed from the insurance industry, the principle of utmost good faith states that accountants should both act honestly and assume that other parties are acting honestly as well.
8. Principle of materiality
GAAP rules require that accounts disclose fully and accurately all financial data relevant to a company’s performance—that means not omitting outstanding loan obligations from reports, for example, or holding back a portion of profits from the balance sheet.
9. Principle of continuity
This principle states that all valuations should be based on the assumption that a business will continue to operate in the future as it has in the past.
This principle is particularly clear when considering the valuation of assets like common stock. If an accountant were to assume that Apple was going out of business tomorrow (or acquiring Amazon tomorrow), the value of the Apple stock held by the company would change significantly. GAAP principles require that this asset’s value be based on the assumption that Apple will continue to operate in a manner consistent with its current performance.
10. Principle of periodicity
The principle of periodicity states that organizations should abide by regular and commonly accepted accounting periods, such as monthly, annually, or quarterly. Organizations should not implement atypical reporting periods (say, every 37 days) or inconsistent reporting periods (such as alternating between weekly, monthly, and quarterly reports).
How does GAAP work?
In the United States,GAAP is the generally accepted method of ensuring accuracy and transparency in financial reporting. GAAP rules are maintained by the Financial Accounting Standards Board and updated through Accounting Standards Updates (ASUs). A 2014 ASU, for example, replaced industry-specific revenue recognition guidelines with a universal revenue recognition framework. ASUs are issued when the FASB has changes to communicate. In 2018, the FASB issued 20 updates, while 2021 saw only 10.
GAAP bears a relationship to the International Financial Reporting Standards (IFRS), a set of rules maintained by the International Accounting Standards Board (IASB) that specify how transactions should be reported on financial statements. Like GAAP, IFRS standards exist to increase transparency and facilitate the communication of financial information.
Although both GAAP and IFRS exist to meet similar goals, their precise disclosure requirements differ. Therefore, GAAP-compliant companies are not automatically IFRS compliant, and issuing IFRS-compliant statements requires companies to include additional information.
Who follows GAAP?
The Securities and Exchange Commission requires that all publicly traded companies in the US adhere to GAAP principles and file GAAP-compliant financial statements.
Companies that are not publicly traded are not required to follow GAAP rules, but many elect to follow them anyway—GAAP-compliant financial reports are attractive to lenders and investors, and companies that may someday go public benefit from establishing a GAAP-compliant accounting system from the start.
To achieve compliance, companies must follow all 10 GAAP rules and validate compliance through an external audit. Some companies also assemble an internal auditing team, which is responsible for reviewing statements and practices prior to third-party certification. If issues are found during the audit process, external auditors can work with your organization to remedy problems and allow for certification at a future date.
Although the federal government requires that all publicly traded companies adhere to GAAP standards, financial reporting requirements for state and local governments differ based on location. US states are classified as either fully GAAP compliant, mostly GAAP compliant, somewhat GAAP compliant, or not at all GAAP compliant.
In fully GAAP compliant states, all local and county governments are required to adhere to GAAP principles. In mostly and somewhat compliant states, requirements differ by region.
There are many reasons to adopt a GAAP-compliant accounting system, including adhering to SEC regulations, positioning yourself to take your company public, and providing clear, trusted financial information to potential investors.
Incorporating GAAP principles into your accounting practice also makes good business sense. By ensuring accuracy and transparency in financial reporting, GAAP principles can help you identify and correct for errors or oversights and provide you with the information you need to meet your business goals.