The Financial Accounting Standards Board sets accounting standards to prevent fraud and clerical errors. The standards are also known as the Generally Accepted Accounting Principles (GAAP). They help reduce losses from company resource theft.
GAAP is a detailed set of rules developed by the accounting profession and Securities and Exchange Commission (SEC). The SEC operates in an oversight capacity. It allows the Governmental Accounting Standards Board (GASB) to implement the requirements.
GAAP also encompasses the details, legalities, and complexities of business and corporate accounting for internal controls. The U.S. law mandates businesses that release their financial statements to the public to follow the GAAP guidelines. This also applies to companies that are publicly traded on the stock exchange and indices.
Compliance with GAAP standards makes the process of financial reporting more transparent. It also helps in standardizing assumptions, terminologies, methods, and definitions. It is easy for external parties to compare financial statements from GAAP-compliant entities. The records provide some consistency that lacks in financial records from non-GAAP compliant companies.
The transparency and continuity that GAAP standards provide enable investors and stakeholders to make well-informed decisions. The consistency also allows companies to evaluate their business options strategically.
The Basic Values of GAAP
GAAP is a broad concept but segmenting it into the following major concepts makes it easier to comprehend.
- Principle of utmost good faith: this is the assumption that all parties involved in the financial transactions remain faithful
- Principle of materiality or good faith: it requires that accountants provide full disclosure in financial reports
- Principle of periodicity: when accountants report revenues or entries, they must divide them by the standard accounting periods like fiscal quarters or years.
- Principle of prudence: it is expected that speculation does not affect or influence the reporting of financial data
- Principle of non-compensation: accountants should report the performance of an organization in all its aspects. The reporting should capture both the positives and negatives, with no prospect of debt compensation.
- Principle of permanence of methods: accountants should adhere to a consistent procedure when preparing all financial reports.
- Principle of sincerity: accountants that comply with the GAAP standards are expected to be committed to accuracy and impartiality.
- Principle of consistency: all financial reporting activities must be consistent to prevent errors or discrepancies. They must fully disclose or explain the reasons behind any updated or changed standards.
- Principle of regularity: accounts strictly follow the laid-down rules of accounting as standards.
Basic Principles of Accounting
In addition to the 10 GAAP guidelines above, accounting also has a foundation in three rules that enhance financial reporting practices. They serve to eliminate misleading accounting and also create consistent accounting and reporting standards. They are the basis upon which prospective and existing investors evaluate the financial standing of an organization. Without these three rules, accountants could paint a deceptive picture of a company by using misleading methods.
Generally Accepted Industry Practices
Unfortunately, no standard GAAP model applies to all organizations in all industries across the board. Instead, individual businesses follow industry-specific best practices that reflect the nuances and complexities of various business aspects. For example, banks use a different set of accounting procedures and reporting than those used by retailers.
Rules and Standards Issued by the FASB and the Accounting Principles Board (APB)
The Financial Accounting Standards Board is an officially endorsed and regularly updated collection of principles. Also known as the FASB Accounting Standards Codification, it includes standards based on the best practices established by the APB. Both organizations are well-rooted in the historic regulations that govern financial reporting. They were both implemented by the federal government before the Great Depression.
Basic Accounting Principles and Guidelines
These are the 10 guidelines that separate the transactions of an organization from the owners’ personal transactions. They also standardize the currency units used in reporting and disclose the periods covered by each report. The principles also bring out the established best practices governing:
- Going concern
- Revenue recognition
- Professional judgment
Limitations of GAAP
GAAP strives to prevent incidents of inaccurate financial reporting. Unfortunately, the guidelines are not comprehensive. Companies can still experience challenges not covered in GAAP’s scope depending on business categorization, size, and location. The limitations are as follows:
Diversity of Companies
In most cases, GAAP seems to take a one-size-fits-all approach to account services, which can be a bit limiting for some distinct industries. For example, state and local governments struggle with implementing GAAP because of their unique environments. Consequently, there has been a new GAAP hierarchy proposal to accommodate federal entities.
Small businesses also struggle with the guidelines as they may be too complex for them. Hiring personnel to implement the GAAP standards is expensive. The Private Company Council is working on updating the GAAP to accommodate small businesses.
Finalizing a single standard in the GAAP guidelines can take months or years. This is due to the comprehensive process involved. These periods of long waiting may not work well for some companies complying with GAAP.
Global vs. Domestic
GAAP is not an international accounting standard. Businesses are therefore facing challenges as they expand their horizons. The International Financial Reporting Standards (IFRS) is the universally recognized set of guidelines outside the United States.
The GAAP standards help accountants record and report financial information accurately and consistently. Compliance with the standards can help a company prevent fraud and losses that arise from inconsistent reporting.