These rules are designed to ensure that investors can rely on the information provided by public companies, which has been established as a cornerstone principle in the securities laws.
The goal is to promote transparency and fair dealing in capital markets, thereby providing investors with more complete information about investment risks and opportunities.
This article will cover why we have GAAP, how it’s developed, its roles and responsibilities, as well as key terms related to GAAP such as Financial Statements. We will also discuss what type of financial statements need to be prepared under GAAP standards
What is GAAP?
Generally accepted accounting principles are the standardized rules that guide business financial transactions. They are an integral part of public company accounting and provide a common language for business to communicate their basic financial information to investors, creditors, regulators, managers, and other stakeholders.
GAAP is like the rules of the road for people who are driving on the same street. It is the most basic level of information that is needed by anyone who works with financial reports.
GAAP was initiated in 1936 to ensure investors and other stakeholders are better able to understand a company’s performance, and it serves a similar purpose today.
GAAP establishes common practices for measuring business performance using financial statements. Without these standards, companies could make decisions and report results any way they see fit, which means stakeholders would have no idea how the business actually runs.
Most countries have developed similar sets of principles for use by the business community. The frameworks are generally presented in a body of authoritative literature such as the Generally Accepted Accounting Principles (United States), Financial Reporting Act (New Zealand), or Companies Act 1981 (Australia). Most countries have adopted some form of GAAP, but even when there are similarities in the principles set out, there can be differences in how the rules are applied.
Why do we need GAAP?
Having a single set of standards creates a common standard for measuring performance and helps ensure uniformity. This ultimately makes the financial statements more useful to all stakeholders and reduces the potential for disputes when it comes to preparing and reviewing financial information.
Maintaining consistency in both presentation and accounting methods benefits investors, creditors, taxpayers, regulators, supervisors, managers, and other stakeholders by making financial reports more relevant, comparable, reliable, understandable, and clear.
With two sets of standards – one for public companies and another for private businesses – it would be difficult to compare the information within each. It would also add an additional layer of complexity in terms of compliance efforts because a business owner would have to knowboth sets of rules.
How are GAAP developed?
GAAP is a rule-based system for financial accounting and reporting that provides principals for consistently describing business transactions in accounting reports. The standards-setting process may happen at several levels.
For example, the International Accounting Standards Board (IASB), formed in 2001 as a standard setter for business entities across borders, is widely known as the body that sets GAAP standards and principles for private companies around the world to follow.
The Financial Accounting Standards Board (FASB), an independent organization that is responsible for establishing and improving financial accounting and reporting standards in the United States, first published the Statements of Financial Accounting Concepts to provide guidance about proper methods of recording transactions. This conceptual framework served as a guide when formalizinfinancial reporting standards were needed.
Roles and responsibilities of the Financial Accounting Standards Board (FASB)
The FASB is responsible for setting standards in both private company and public company accounting. As an independent organization, it does not directly create GAAP or require its application. Instead, it focuses on broad-based initiatives to improve financial reporting.
The IASB’s standards are focused on general-purpose financial reporting by private entities, while the FASB is responsible for developing standards focused on publicly traded companies.
The IASB and the FASB work together to provide a single set of high-quality, understandable, enforceable global accounting standards that cover financial and managerial accounting issues in both public and private sectors.
How is GAAP applied?
While a business may have its own set of principles that it applies internally, these are not generally shared with outside stakeholders. A company’s internal accounting policies must usually follow regulatory requirements but do not always have to comply with GAAP standards; however, when deciding what accounting methods to implement on an internal level, management should consider how those choices would affect reporting to external stakeholders.
The primary purpose of financial reporting is to provide information that is useful in making decisions about allocating resources. When GAAP are applied correctly, they can provide a clear understanding of the business’s activities and results of operations during any given period.
Types of financial statements needed under GAAP standards
For public companies, the FASB issued Financial Reporting Release No. 77 (FRR 77) to address the need for a comprehensive set of financial statements that report business activity in a complete and consistent manner by both presenting a wide range of information about the reporting entity and eliminating substantial diversity in practice.
The release has four broad types of financial statements:
The income statement, which reports economic performance
The balance sheet, which reports an entity’s financial position
The statement of cash flow, which shows changes in cash or cash equivalents over time; and
The statement of changes in owner’s equity, which illustrates how an organization’s claims on assets change over time.
More specifically, FRR 77 specifies that the income statement should report revenue, expenses and gains, and losses. Revenue is the gross inflow of economic resources during a period arising from transactions and other events that result in an increase in assets or a decrease in liabilities, or which give rise to a right to receive payments that are unconditional as to future performance
Expenses represent outflows for economic resources used by an organization during an accounting period to provide goods or services, or reduce other assets; expense recognition does not require current cash outflows but does require a measurable sacrifice of economic benefits available for use by the organization in its operations.
Gains are increases in equity (assets minus liabilities) from peripheral or incidental transactions of an entity; losses are decreases in equity from peripheral or incidentaltransactions of an entity.
The balance sheet reports assets, liabilities and equity (which is defined as the residual interest in the assets of the business after deducting all of its liabilities).
Assets are resources controlled by the organization as a result of past events and from which future economic benefits are expected to flowto the organization; liabilities are present obligations of the business arising from past transactions that will require settlement in the future.
The statement of cash flow reports the cash inflow and outflow for an accounting period, detailing the effects of transactions, events, and other changes in assets and liabilities.