Two Accounting Principles
Evangeline Mellon
When accounting principles allow a choice among multiple methods, a company should apply the same accounting method over time or disclose the change in its accounting method in the footnotes of the financial statements.
Various bodies are responsible for setting accounting standards. In the United States, generally accepted accounting principles (GAAP) are regulated by the Financial Accounting Standards Board (FASB). In Europe and elsewhere, International Financial Reporting Standards (IFRS) are established by the International Accounting Standards Board (IASB).
IFRS is a standards-based approach that is used internationally, while GAAP is a rules-based system used primarily in the U.S. IFRS is seen as a more dynamic platform that is regularly being revised in response to an ever-changing financial environment, while GAAP is more static.
Several methodological differences exist between the two systems. For instance, GAAP allows companies to use either first in, first out (FIFO) or last in, first out (LIFO) as an inventory cost method. LIFO, however, is banned under IFRS.
Some scholars have argued that the advent of double-entry accounting practices during that time provided a springboard for the rise of commerce and capitalism. What would become the American Institute of Certified Public Accountants (AICPA) and the New York Stock Exchange (NYSE) attempted to launch the first accounting standards to be used by firms in the United States in the 1930s.
Critics of principles-based accounting systems say they can give companies far too much freedom and do not prescribe transparency. They believe because companies do not have to follow specific rules that have been set out, their reporting may provide an inaccurate picture of their financial health.
In the case of rules-based methods like GAAP, complex rules can cause unnecessary complications in the preparation of financial statements. These critics claim having strict rules means that companies must spend an unfair amount of their resources to comply with industry standards.
Generally accepted accounting principles (GAAP) comprise a set of accounting rules and procedures used in standardized financial reporting practices. By following GAAP guidelines, compliant organizations ensure the accuracy, consistency, and transparency of their financial disclosures.
Publicly traded companies, businesses operating in regulated industries, registered nonprofit groups, government agencies, and organizations that receive federal funding awards from the U.S. government are required to follow GAAP. Other businesses may also adopt the standards on a voluntary basis.
Many reputable accounting degree programs teach generally accepted accounting principles as part of their curricula. This guide for accounting students explores GAAP standards and how they continue to evolve in a changing economy.
These 10 guidelines separate an organization's transactions from the personal transactions of its owners, standardize currency units used in reports, and explicitly disclose the time periods covered by specific reports. They also draw on established best practices governing cost, disclosure, matching, revenue recognition, professional judgment, and conservatism.
Without regulatory standards, companies would be free to present financial information in whichever format best suits their needs. With the ability to portray a company's fiscal standing in a favorable light, investors could be easily misled.
The Great Depression in 1929, a financial catastrophe that caused years of hardship for millions of Americans, was primarily attributed to faulty and manipulative reporting practices among businesses. In response, the federal government, along with professional accounting groups, set out to create standards for the ethical and accurate reporting of financial information.
According to accounting historian Stephen Zeff in The CPA Journal, GAAP terminology was first used in 1936 by the American Institute of Accountants. Federal endorsement of GAAP began with legislation like the Securities Act of 1933 and the Securities Exchange Act of 1934, laws enforced by the U.S. Securities and Exchange Commission (SEC) that target public companies. Today, the Financial Accounting Standards Board (FASB), an independent authority, continually monitors and updates GAAP.
All 50 state governments prepare their financial reports according to GAAP. The Governmental Accounting Standards Board (GASB) estimates that about half of the states officially require local and county governments to adhere to GAAP.
Government institutions, including federal legislative and judicial branches, enforce compliance with GAAP guidelines. However, the government itself plays no role in developing or updating the associated accounting practices. Instead, that is left to private organizations and independent boards.
The FAF is responsible for appointing board members and ensuring that these boards operate fairly and transparently. Members of the public can attend FAF organization meetings in person or through live webcasts.
On the recommendation of the American Institute of CPAs (AICPA), the FASB was formed as an independent board in 1973 to take over GAAP determinations and updates. The board comprises seven full-time, impartial members, ensuring that it works for the public's best interest.
The 35-member Financial Accounting Standards Advisory Council monitors the FASB. FASB is responsible for the Accounting Standards Codification (ASC), a centralized resource where accountants can find all current GAAP.
The GASB was established in 1984 as a policy board charged with creating GAAP for state and local government organizations. Many groups rely on government financial statements, including constituents and lawmakers. GASB prioritizes fairness and transparency. The board's processes and communications are available for public review.
Also known as "pro forma" reporting, non-GAAP reporting describes financial statements, reporting standards, and disclosures that were not prepared using GAAP guidelines. They may be used by U.S. businesses and organizations not subject to GAAP requirements, or by certain international entities operating in U.S. capital markets.
Non-GAAP reporting is the subject of much debate among accountants and financial regulators in the United States. Proponents of non-GAAP reporting standards contend that many associated practices offer useful financial insights that cannot be generated solely by following GAAP guidelines. They also contend that as a matter of standard practice, organizations clearly label all documented financial information generated by non-GAAP measures.
The opposing viewpoint holds that GAAP practices create a transparent standard that facilitates direct comparisons and accurate analysis. Non-GAAP accounting techniques deviate from these standards by definition, leading some professionals and stakeholders to dispute or reject their use.
The SEC receives a large number of comments and complaints about the issue. In December 2022, the SEC updated the standards it uses when evaluating financial disclosures that contain pro forma reporting. However, as of June 2024, the underlying debate remains without a definitive resolution.
While GAAP accounting strives to alleviate incidents of inaccurate reporting, it is by no means comprehensive. Companies can still suffer from issues beyond the scope of GAAP depending on their size, business categorization, location, and global presence.
GAAP may seem to take a "one-size-fits-all" approach to financial reporting that does not adequately address issues faced by distinct industries. For example, state and local governments may struggle with implementing GAAP due to their unique environments. New GAAP hierarchy proposals may better accommodate these government entities.
Small businesses may also struggle with implementing GAAP. These standards may be too complex for their accounting needs, and hiring personnel to create GAAP-compliant reports can be expensive. As a result, the FASB works with the Private Company Council to update GAAP with private company exceptions and alternatives.
Due to the thorough standards-setting process of the GAAP policy boards, it can take months or even years to finalize a new standard. These wait times may not benefit companies complying with GAAP, as pending decisions can affect their reports.
GAAP is not the international accounting standard, which is a developing challenge as businesses become more globalized. The International Financial Reporting Standards (IFRS) is the most common set of principles outside the United States.
The IFRS system is widely used outside the United States. IFRS principles are issued and updated by the International Accounting Standards Board (IASB), an independent and private organization based in London. As of June 2024, IFRS guidelines are used in more than 100 countries, including most major economies in Europe, South America, and Asia.
Formal collaboration between the FASB and the IASB dates back to 2002, when the two entities formed a partnership known as the Norwalk Agreement. Under the agreement's terms, the FASB and the IASB established the joint objective of developing accounting standards with international cross-jurisdictional compatibility.
Despite some progress under the Norwalk Agreement, the FASB and the IASB continue to battle friction resulting from fundamental disagreements at the governance level. As of June 2024, the United States has not fully adopted IFRS principles, and domestic U.S. companies remain bound to GAAP reporting guidelines. However, the FASB and the IASB remain active collaborative partners and continue to work toward the formation of uniform international accounting standards.
Notably, IFRS standards do apply to some business entities operating in the United States. Foreign-based companies registered with the SEC use IFRS reporting guidelines in their U.S. disclosure filings. Some U.S. small and mid-size enterprises (SMEs) voluntarily use IFRS accounting procedures, which are neither expressly permitted nor prohibited under applicable U.S. laws.
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