What It Is
Generally Accepted Accounting Principles, or GAAP, is the standard set of rules and guidelines that “specify the financial accounting principles and procedures that firms must use, and the kinds of estimates and judgments that managers must make in applying those principles.” There are different sets of accounting rules used in other countries, but GAAP is used primarily in the United States.
Why It Matters
If your company prepares financial statements, then GAAP is applicable to you. In fact, you may already be using GAAP.
Under laws set by the U.S. Securities and Exchange Commission (SEC) and the Financial Accounting Standards Board (FASB), publicly-traded firms in the U.S. are required to follow GAAP when they prepare their financial statements. But, for consistency, relevancy, and credibility, even privately-held companies may want to follow the same principles. For example, take a case in which your company wants or needs to share its financial statements with another party. If those statements are prepared using GAAP, the other party will have an easier time interpreting the financial records and assessing the business.
Beyond the preparation of financial statements, accounting principles affect how a company appears to be performing based on the information that is provided in the statements. For example, by using different accounting principles, an airline can change how it accounts for the depreciation of its planes in such a way that can increase its on-the-book profits without any physical or business changes.
To illustrate just now much these accounting rules can change how a firm appears on paper, take leases. Traditionally, GAAP allowed for two kinds of leases: capital leases and operating leases. Capital leases appear on the balance sheet, while operating leases do not. For example, let’s say you are leasing heavy machinery, and have to pay monthly payments to do so. Under operating lease rules, you would record only those payments. But for capital leases, you would record the full value of the machinery as debt, and the payments would go to reducing that debt.
This may not sound like a very important difference, but as a recent article from Economist explained, proposed new laws that would require firms to use capital lease rules would have major effects. PriceWaterhouseCoopers, an accounting firm, estimated that shifting all leases to capital leases would add about 58 percent more debt to the average firm’s balance sheet. Like the airline example, nothing in the real world actually changed for the business, but the way in which things are accounted for can dramatically change how a business looks on its financial statements.
If your company prepares financial statements, then you are most likely already using GAAP. To begin:
- Step One: Determine whether your company prepares financial statements.
- Step Two: Check with the preparer (person or firm) on how it’s being done.
- Step Three: Become familiar with some basic accounting practices.
Step One: Determine whether your company prepares financial statements.
If your company is publicly-traded, then you should use GAAP; in fact, by law, publicly-traded companies are required to use GAAP. If your company is privately-held, you are not required to prepare financial statements, and therefore not required to use GAAP. But, as stated above, it may still be a good idea to use GAAP if external parties ever look at your records.
Step Two: Check with your preparer.
Assuming you already prepare financial statements, check with your accountant or the individual who prepares those statements to confirm that you are using GAAP.
Step Three: Become familiar with basic accounting.
While not everybody enjoys accounting, understanding some of the basics can be valuable in understanding how a business appears on paper. Click here to find helpful resources for beginners.
According to a 2008 report by the financial consulting firm Deloitte, the SEC has proposed transitioning the U.S. away from GAAP and toward the internationally-used International Financial Reporting Standards (IFRS): “A ‘roadmap’ has been proposed which acknowledges that IFRSs have the potential to become the global set of high-quality accounting standards and which sets out seven milestones that, if achieved, could lead to mandatory adoption from 2014.” 
More recently, in 2010, the deputy chief accountant at the SEC hinted at a more “elastic IFRS conversion process” that would avoid any abrupt change in accounting policy.
In other words, if the proposals are adopted it will be important for your company to be prepared to transition into using IFRS.
Assuming your company is already preparing financial statements:
- Step One: Speak with the person/firm who prepares your financial statements.
- Step Two: Be aware of how changes in the accounting principles will affect your own income statements.
Step One: Speak with the person/firm who prepares your financial statements.
The person/firm who is currently preparing your financial statements may already be using both GAAP and IFRS. They should be aware of any possible changes in the accounting principles. Confirm that they will be able to handle the transition smoothly, if it happens.
Step Two: Be aware of how changes in the accounting principles will affect your own financial statements.
Speak with a professional about how the possible change to IFRS may affect your company’s financial statements. As stated above, a change in how things are accounted for may actually change how things are valued on paper.
Resources for More Information
- Financial Accounting: An Introduction to Concept, Methods, and Uses, by Stickney, Weil, Schipper, and Francis
- Accounting for Dummies, by John A Tracy
- Accounting Made Simple, by Mike Piper
- Accounting.com provides some basic lessons and videos on accounting.
GAAP, along with other accounting methods, affects not only how you prepare financial statements, but how a company is valued on paper. Using GAAP not only keeps your financial records consistent for your own purposes, but for the purposes of partnering with other businesses.
Glossary of Related Terms
Depreciate – Diminish in value over a specified period of time. There are various methods of depreciation, which can affect the financial statements.
FSAB – Financial Accounting Standards Board; an independent board since 1973, responsible for setting the standards of US GAAP.
GAAP – Generally Accepted Accounting Principles; the general rules and accounting principles used by businesses for financial record keeping.
IASB – An organization that is responsible for setting the international accounting standards.
IFRS – International Financial Reporting Standards; accounting standards that are internationally recognized.
SEC – Securities and Exchange Commission; an agency authorized by the U.S. Congress to regulate, among other things, the financial reporting practices of most public corporations.
 Stickney, Weil, Schipper, and Francis, Financial Accounting: An Introduction to Concepts, Methods, and Uses (Mason, OH: South-Western Cengage Learning, 2010), 3. Preview available at: http://books.google.com/books?id=M72b6tXgT1MC&lpg=PP1&dq=financial%20accounting&pg=PP1#v=onepage&q&f=false
 Bob Cook, “Do privately-owned companies need to use the new lease accounting?” Corporate Real Estate Strategy, 27 December 2010, http://bobcook1234.wordpress.com/2010/12/27/do-privately-owned-companies-need-to-use-the-new-lease-accounting/, accessed 7 August 2013.
 “You Gonna Buy That?” The Economist, 19 August 2010, http://www.economist.com/node/16847810, accessed 7 August 2013.
 “IFRSs and US GAAP: A Pocket Comparison,” IAS Plus, July 2008, http://www.iasplus.com/dttpubs/0809ifrsusgaap.pdf, accessed 7 August 2013.
 Robert Kugel, “IFRS for the U.S.? Yes – But When and How Are Still Iffy,” Ventana Research, 18 July 2011, http://robertkugel.ventanaresearch.com/2011/07/18/ifrs-for-the-u-s-yes-%E2%80%93-but-when-and-how-are-still-iffy/, accessed 7 August 2013.