Definition
Generally Accepted Accounting Principles (GAAP) refer to the standard framework of guidelines for financial accounting used in any given jurisdiction. The Financial Accounting Standards Board (FASB) issues these standards and rules in the United States. GAAP encompasses detailed accounting standards and principles aimed at improving the consistency, comparability, and transparency of financial statements.
Examples
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Revenue Recognition
- Under GAAP, revenue should only be recognized when it is realized and earned, not necessarily when cash is received. For instance, a company that receives a payment in advance for services performed over several months must recognize revenue incrementally as the services are rendered.
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Depreciation Methods
- GAAP allows for various methods of depreciation, including straight-line depreciation, declining balance depreciation, and units of production depreciation. A manufacturing company using machinery for production might use straight-line depreciation to evenly spread the cost of the asset over its useful life.
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Inventory Valuation
- Companies under GAAP can choose different methods for inventory valuation such as FIFO (First-In, First-Out), LIFO (Last-In, First-Out), or weighted average cost. Retailers frequently leverage FIFO accounting during periods of rising prices to show higher profits, as older, cheaper costs are matched against current revenues.
Frequently Asked Questions
Q1: What is the primary objective of GAAP?
A1: The primary objective of GAAP is to ensure that financial reporting is transparent, consistent, and comparable across companies, aiding stakeholders in making informed economic decisions.
Q2: Is compliance with GAAP mandatory for all companies?
A2: Compliance with GAAP is mandatory for all publicly traded companies in the United States. Private companies are not legally required to follow GAAP but may do so to present their financials more reliably.
Q3: How is GAAP different from IFRS?
A3: GAAP is primarily used in the United States, while the International Financial Reporting Standards (IFRS) are utilized globally. The two systems differ in aspects like revenue recognition, lease accounting, and inventory valuation methods, among others.
Q4: Who sets GAAP?
A4: In the United States, the Financial Accounting Standards Board (FASB) is the primary body responsible for creating and updating GAAP.
Q5: Are changes in GAAP frequent?
A5: GAAP evolves through the issuance of new statements, interpretations, and technical bulletins by the FASB and industry consensus, reflecting changes in business practices and economic environments.
Related Terms
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Fiscal Year: A one-year period that companies use for financial reporting and budgeting. GAAP rules must be applied consistently within the same fiscal year.
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Accrual Accounting: A method mandated by GAAP where revenues and expenses are recorded when they are earned or incurred, regardless of when the cash transactions occur.
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Income Statement: A financial statement required by GAAP that provides a summary of a company’s revenues and expenses over a specific period.
Online References
- Financial Accounting Standards Board - FASB
- U.S. Securities and Exchange Commission - SEC
- American Institute of Certified Public Accountants - AICPA
Suggested Books for Further Studies
- “Intermediate Accounting” by Donald E. Kieso, Jerry J. Weygandt, and Terry D. Warfield
- “Financial Accounting: An Introduction to Concepts, Methods, and Uses” by Roman L. Weil, Katherine Schipper, and Jennifer Francis
- “Wiley GAAP 2023: Interpretation and Application of Generally Accepted Accounting Principles” by Joanne M. Flood
Accounting Basics: “Generally Accepted Accounting Principles (GAAP)” Fundamentals Quiz
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