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Generally Accepted Accounting Principles (GAAP) Explained
Business Essentials · Chapter 20: Accounting FundamentalsSection 20.3 · lesson 88 of 10512 min · free with a free account
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In this lesson
The common rules that make financial statements comparable.
- Explain what GAAP is and why common rules exist
- Describe its 4 assumptions, 4 principles, and 2 constraints
- Show how a permitted choice of method changes a result
- Compare GAAP with IFRS, and state what GAAP can't do
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Accounting Fundamentals
Generally Accepted Accounting Principles Explained
Two retailers, same market, similar sales, similar supplier costs. Their gross margins are very different. Neither made a mistake. The difference is in the rules each chose to apply. This section is educational, and isn't accounting, tax, or legal advice. Standards are amended over time, so a business should confirm current requirements with a qualified accountant. We'll see why a common set of rules exists, and who sets it in the United States. We'll work through GAAP's four assumptions, four principles, and two constraints. We'll watch a permitted choice of method change reported profit on identical activity. And we'll compare GAAP with international standards, and be clear about what GAAP can't do.
The Problem
Why a Common Set of Rules Exists
Imagine there were no common accounting rules. Two businesses could report identical economic activity in completely different ways. One might record revenue the moment an order is placed. Another, only once the cash is collected. A reader comparing their results would be comparing figures built on different assumptions. And they'd have no way of knowing it. So the purpose of common rules is comparability and reliability. Not accuracy in some absolute, philosophical sense. Here's the counter-intuitive part. There's rarely one single, objectively correct way to measure a business's activity. What there can be is a shared, disclosed method. That lets different businesses, and the same business across periods, be read on a consistent basis.
GAAP Defined
Who Sets the Rules
GAAP stands for generally accepted accounting principles. It's the body of standards, principles, and conventions governing financial reporting in the United States. Standards for public companies are set by the Financial Accounting Standards Board, known as the FASB. It's a private-sector body, and its standards make up the bulk of GAAP. The Securities and Exchange Commission is a federal agency. It holds statutory authority over financial reporting by companies whose securities are publicly traded. And it has designated the FASB to set the standards those companies must follow. So a private body writes the rules, under the authority of a public one. Standards are amended as the FASB issues new guidance. This course describes the framework, not any current standard in detail. So anyone relying on a specific standard should confirm its current form.
Table 20.3.1 (1 of 2)
4 Underlying Assumptions
GAAP rests on four foundational assumptions. The economic entity assumption keeps a business's activity separate from its owners, and from other businesses. That holds even for a sole proprietorship, which has no legal existence apart from its owner. So an owner's personal car isn't recorded as a business asset. The going concern assumption says the business will keep operating for the foreseeable future, unless evidence suggests otherwise. That's why equipment is reported near its cost less depreciation, not at a rushed liquidation price. The monetary unit assumption records only what can be expressed in money, and treats the currency as stable. So a skilled, loyal workforce, however valuable, appears nowhere on the balance sheet. The periodicity assumption divides continuous activity into discrete periods, like a quarter or a year. A business doesn't naturally pause at those boundaries. The reports do anyway. So a long construction project is reported in installments across several years, not only when it finishes.
Table 20.3.1 (2 of 2)
4 Principles of Measurement and Recognition
Four principles govern how specific items are measured and recognized. Historical cost records assets at their original acquisition cost, not their current market value. That gives a verifiable, objective starting point. Land bought decades ago stays at its old price. For certain specified items, a fair value alternative applies instead. There, current market value is judged more relevant, even though it's harder to verify. Revenue recognition says revenue is recorded when the business satisfies its obligation to the customer. So a deposit for goods not yet delivered isn't revenue yet. That's the accrual idea from earlier in the chapter. The matching principle puts expenses in the same period as the revenue they helped produce. A salesperson's commission belongs to the period of the sale, not necessarily when it's paid out. Full disclosure requires reporting anything that affects a user's understanding, usually in the notes. A pending lawsuit with a material possible outcome gets disclosed, even with no liability recorded yet.
Limits And Consistency
2 Constraints and a Consistency Rule
Two constraints limit how far those principles are pushed. Materiality, from the previous subchapter, limits reporting to information that could reasonably influence a decision. Trivial items don't need the same rigor as significant ones. The cost-benefit constraint says information shouldn't cost more to provide than it's worth to users. That's why standards don't demand unlimited precision, whatever the expense. Then there's consistency. A business should apply the same methods from one period to the next. That way, changes in results reflect changes in the business, not changes in how it's measured. A business can still change a method. It might better reflect the business's activity, or a new standard might require it. But the change, and its effect on results, must be disclosed. Otherwise a reader could mistake a change in method for a change in performance.
Estimates And Judgments
No Single Objectively Correct Number
It's often assumed that accounting produces one objectively correct number. It doesn't. Statements are built on estimates and judgments at many points. Useful lives of long-term assets are estimated from expected use. They decide how cost is spread through depreciation. Bad debt provisions estimate how much of what customers owe will never be collected. Inventory valuation depends on an assumption about which units count as sold first. And impairment asks whether an asset's value has fallen below its recorded amount, and by how much. Every one of those is a judgment call. Two honest, competent accountants, working from identical facts, can report different numbers. Neither has done anything wrong. That's exactly why disclosing the methods and estimates matters as much as the figures themselves.
Worked Example
Marrow Hardware Supply: One Activity, Two Methods
Here's that idea made concrete, with a fictional business called Marrow Hardware Supply. It sells identical units of inventory, bought at different costs during the period. The figures are illustrative. Under one permitted method, the earliest costs count as sold first. In this case, they're the cheaper ones. That leaves the newer, more expensive units sitting in inventory. Under the other permitted method, the most recent, more expensive costs count as sold first. Sales are one hundred thousand dollars either way, and the actual purchases are identical. With earliest costs first, gross profit is fifty-eight thousand dollars. With most recent costs first, it's forty-nine thousand. That's a nine thousand dollar gap, from nothing but a costing assumption. So compare two businesses' profits without knowing their methods, and you're partly comparing accounting choices. That's why full disclosure of methods matters as much as the headline figures.
International Standards
GAAP and IFRS
Outside the United States, much of the world uses a parallel framework. It's International Financial Reporting Standards, or IFRS, issued by the International Accounting Standards Board. There's a common summary of the difference between the two. GAAP is more rules-based, with detailed, specific guidance for many situations. IFRS is more principles-based, with broader standards that need more judgment to apply. That's a useful starting generalization. It also has real limits. Both frameworks contain detailed rules and broad principles in different areas. And how specific each one is varies by topic, rather than holding uniformly across the whole framework. The FASB and the international board have a history of convergence efforts. Some areas converged, and others remain distinct. So confirm the current alignment on any specific topic, rather than assuming it.
What GAAP Doesn't Do
3 Limits of GAAP
Three limitations of GAAP deserve plain statement. First, GAAP doesn't prevent fraud. It sets the rules for reporting legitimate transactions. Someone determined to misrepresent a business can break those rules deliberately, and GAAP itself won't stop them. Audits exist partly to catch material misstatement, but that's a separate safeguard. Second, GAAP doesn't make statements comparable across countries. A GAAP statement and an IFRS statement aren't interchangeable, even where the frameworks treat a topic similarly. So a reader comparing them should account for the difference. Third, GAAP doesn't tell you whether a business is a good one. Compliance means the statements follow a common, reliable standard. Nothing more. It says nothing about whether the business is well managed, growing, or a sound place to put your money.
Private And Small Business
Not Every Business Uses Full GAAP
Full GAAP applies most rigorously to public companies, subject to the reporting requirements of the SEC. Private companies and small businesses sit in a different category. They may follow full GAAP. They may follow modified frameworks, meant to reduce the complexity and cost of reporting. Those are designed for entities without public shareholders. And very small businesses in particular may use other bases of accounting suited to their circumstances. The choice often comes on an accountant's advice. That advice weighs the cost-benefit constraint against what the business's lenders, owners, and other users need. Which framework fits a particular business is a decision for its own accountant. It depends on the business's size, its users, and its circumstances.
Case Vignette
The Method Nobody Explained
Priya manages the books for a home goods retailer. Partway through the year, the business changes its inventory costing method. Its accountant judged the new method better reflects actual costs, given how supplier pricing had shifted. The change is properly disclosed in a note to the annual statements. Later, a board member compares this year's gross margin with last year's, and sees a meaningful difference. He assumes performance has genuinely changed, and starts asking pointed questions about what went wrong. He hasn't read the note. Priya walks him through it. Much of the shift in margin reflects the change in method, not only a change in the business. Consistency didn't forbid the change. It required that the change be disclosed, not silently absorbed. Here's the constraint. A reported figure can't show, on its face, how much is method and how much is performance. That separation exists only in the disclosure. So Priya builds a habit of flagging any method change in her own summary to the board. She no longer assumes a technically proper footnote will be read, and understood, on its own.
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