Definition of generally accepted accounting principles (GAAP): A comprehensive set of accounting and reporting standards which govern how companies financial statements record, measure, and disclose their financial transactions.
What are generally accepted accounting principles (GAAP)?
Generally accepted accounting principles is actually a meaningless term in isolation. GAAP is a phrase like ‘rules’ or ‘standards’. The question which begs to be asked is; ‘which rules, which standards?’
Typically, each country has a professional members body which sets accounting standards for that country. The rules they set are known as [Country Name] GAAP.
For example, UK companies often follow UK GAAP and US companies follow US GAAP. There are key differences between these regimes which makes the differentiation important.
In the 1970s, it became obvious that the differences between local GAAP rules meant it was very difficult for investors and banks to compare and contrast foreign companies on a like-for-like basis. The need for a global standard arose.
Fulfilling this role, the International Accounting Standards Board (the IASB) sets an international GAAP known as International Financial Reporting Standards or IFRS.
These rules are applied by most public companies which are traded on stock exchanges. Therefore if you buy shares in any company, the GAAP that they follow is likely to be IFRS.
How is the phrase GAAP used in a sentence?
“This capital expenditure disclosure isn’t a GAAP requirement, but is a mandatory disclosure driven by other company law.”
What else you should know about GAAP
GAAP rules are essentially a bible that accountants use to decide how transactions should be recorded and disclosed. An example of a GAAP rule is that deferred consideration should be recorded at its fair value.
A set of GAAP rules will contain thousands of rules like these, and it can take years for accountants to learn even the key requirements.
As a result of this complexity, it is common for minor omissions or accidental errors to creep into the financial statements of even major companies.
Accounting systems are built with GAAP requirements in mind, so that they process and record transactions in a GAAP compliant manner in the general ledger first time, without any need for judgement.
How does the definition of generally accepted accounting principles (GAAP) relate to investing?
If companies could use their own accounting rules, their financial statements could look dramatically different even though the underlying transactions were identical to each other.
- Record revenue at different points during the sale process
- Estimate the expected cost of future expenses using different measurement methods
- Recognise costs in different periods
The list is endless. By using harmonious rules, we can ensure that the results of a company are comparable year-on-year, and comparable between different companies.
Where companies do apply a legitimate accounting judgement or policy which may harm comparability, under GAAP rules they are asked to disclose this fact to allow analysts to strip out the impact effect before making comparisons.