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The essentials of GAAP: How it shapes fundamental data

  • Wealth Management Systems Inc. Financial Communications
  • Accounting Method
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Generally accepted accounting principles establish the framework for financial reporting in the United States. Abbreviated as GAAP (rhymes with sap), this collection of official edicts and pronouncements is maintained by the Financial Accounting Standards Board to set the context for the income statements and balance sheets released by U.S.-based public companies.

But while GAAP may strive to be a firm and universal standard in financial accounting it can leave significant room for variance, much as the rules of English grammar do in day-to-day language. This conceptual overview of GAAP can help you understand what GAAP-compliant reports might tell you, or not tell you.

The intentions behind the GAAP process

GAAP-based reports are meant to give their users a level playing field for evaluating company financial performance across time periods and to allow users to make meaningful, like-on-like comparisons among companies. GAAP reports are also intended to help managers make appropriate strategic decisions and improve business efficiency. To that end, GAAP's authors and compilers assume:

  • The firm generating the report is a going concern that expects to operate indefinitely. That generally means the reporting firm can consume or dispose of only the minimally necessary portions of its assets in any period and is not expected to abandon significant asset value or liquidate significant inventory at fire-sale prices. It also means that the firm can make business investments that may not be expected to bear immediate fruit.
  • The report is compiled using a stable currency whose values do not need to be continually adjusted in order to provide meaningful period-to-period comparisons. The U.S. dollar is the default reporting currency. U.S. dollar amounts are consistently reported at nominal values, that is, without adjustment for actual or potential changes in relative purchasing power.
  • A GAAP report covers the activity of a viable accounting entity, in which business revenues and expenses are clearly distinguishable from personal revenues and expenses. It also means that the reporting entity's financial activities are clearly distinguishable from other entities' activities.
  • The company's overall flow of activities can be broken down into discrete, uniform time periods and that data can generally be segmented or apportioned so that the pieces of data fit entirely within those time periods. For example, under GAAP, the cost of a large volume of supplies would normally be apportioned over all the periods in which those supplies are consumed. The total cost would not ordinarily be added only to the period in which the supplies were ordered or received.

GAAP's decision rules for accountants

Financial statements that are prepared according to GAAP are expected to comply with a number of essential principles. Chief among them is the concept of accrual, which is assigning revenue and expense values to the time periods in which the business activities are performed, independently of when the cash actually might have flowed.

For example, a company may do considerable work in advance of a payment, or it may receive a large sum in advance of a delivery or completion date. In either case, the revenue and costs associated with the deal would be formally recognized on income statements gradually as the work was performed, not all at once when the payments were made or received. And if later events were to cause a deviation from an assumed plan, the company would normally be required to restate prior reports or to recognize adjustments in the next report.

Among the other principles are:

  • Companies should use historical cost when accounting for hard assets such as real estate, factories, warehouses, and machinery (known as property, plant and equipment). These assets are generally recorded on the books at their actual value as of the date of acquisition or creation. In normal circumstances, historical cost values are not subsequently adjusted for inflation or for changes in market value or replacement cost.
  • Financial assets, on the other hand, may be marked to market (increased or decreased in value on the company books) to reflect objectively verifiable changes in their actual market value. Gains and losses that are recorded when assets are marked to market ultimately serve to adjust reported net income.
  • Companies have a general obligation to make a full disclosure of their financial affairs. This information may be included in the main body of financial statements, in the notes, or reported as supplementary information.

Other factors shaping the GAAP process

Financial reports prepared under GAAP should be:

  • Objective, or based as much as possible on independently verifiable facts;
  • Material, which means that accountants should strive to include all factors that could impact the decision making of a reasonable individual;
  • Consistent in their application of definitions and concepts from period to period and report to report;
  • Conservatively biased, using the narrowest generally accepted definitions and the most pessimistic estimates and projections available.

Remember, this is an overview of significant GAAP features. Each has important exceptions and conditions. You can find more detailed information about financial reporting rules and conventions on the websites of the Financial Accounting Standards Board and the Securities and Exchange Commission.

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Related Lessons

  • Normalizing the GAAP perspective on fundamentals

    Every company faces unique and nonrecurring situations in its normal course of business. The impacts of these circumstances must be accounted for in the income statements and balance sheets that the companies provide to investors.

  • Circumstances where adjustments to GAAP figures might be useful

    While generally accepted accounting principles (GAAP) may define the lingua franca of financial reporting, investment analysts often modify GAAP-based results in order to improve the insights they can get from standard bottom-line summaries.

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Article copyright 2014 by Wealth Management Systems Inc. Reprinted with permission from Wealth Management Systems Inc. The statements and opinions expressed in this article are those of the author. Fidelity Investments cannot guarantee the accuracy or completeness of any statements or data.
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