Mastering GAAP principles for accountants

For any organization, accurately tracking and presenting financial information is crucial. This is why standardized accounting practices are essential to ensure that financial reports are transparent, consistent, and comparable. This is where the Generally Accepted Accounting Principles (GAAP) come into play.

The foundation of GAAP can be traced back to the aftermath of the 1929 Stock Market Crash and the Great Depression. Widespread suspicion that misleading financial reporting by public companies contributed to the economic turmoil prompted the federal government to collaborate with the accounting industry to establish standardized best practices.

This collaboration led to landmark legislation such as the Securities Act of 1933 and the Securities Exchange Act of 1934, which cemented the establishment of GAAP. Today, GAAP is the mandatory standard for financial reporting for for-profit businesses, non-profit organizations, and government entities across the United States.

What are the generally accepted accounting principles?

Established and overseen by the Financial Accounting Standards Board (FASB) for the private sector and the Governmental Accounting Standards Board (GASB) for state and local governments, GAAP consists of a standardized set of rules and requirements that dictate how financial statements are prepared and presented.

The primary goal of GAAP is to ensure a high level of clarity and consistency in financial statements. This standardization makes it easier for stakeholders to understand the information presented and to effectively compare the financial health of one organization against another. As mandated by U.S. securities law, any entity that issues public financial statements must adhere to GAAP.

The objectives of GAAP vary slightly depending on the type of organization. For for-profit companies and non-profits, the main purpose is to provide useful financial information to stakeholders, lenders, and other interested parties who provide resources to the entity.

For state and local governments, there's an added layer of purpose. Beyond providing financial transparency, GAAP aims to empower taxpayers and other users of governmental financial statements to hold these public bodies accountable for their use of public funds.

The 10 fundamental tenets of the GAAP framework

The GAAP framework is built upon 10 core principles that serve as the foundation for transparent and reliable financial reporting. These principles ensure that financial information is presented in a standardized and ethical manner.

The 10 key principles are as follows:

1. Principle of Regularity: Accountants must strictly adhere to all GAAP rules and regulations without deviation.
2. Principle of Consistency: The same accounting practices must be applied across all reporting periods to ensure comparability.
3. Principle of Sincerity: Accountants are obligated to provide an accurate and impartial depiction of the company’s financial situation.
4. Principle of Permanence of Methods: Consistent accounting procedures should be used in the preparation of all financial reports.
5. Principle of Non-Compensation: All aspects of an organization’s performance, whether positive or negative, must be fully reported without the expectation of offsetting debt.
6. Principle of Prudence: Financial reporting must be based on factual data, avoiding any speculation to ensure entries are realistic.
7. Principle of Continuity: It is assumed that the business will continue its operations in the foreseeable future.
8. Principle of Periodicity: Financial reporting is divided into distinct and consistent time periods, such as fiscal quarters or years.
9. Principle of Materiality: All financial reports must fully disclose the company’s monetary position, with assets valued at cost.
10. Principle of Utmost Good Faith: All individuals involved in the accounting process are presumed to be acting honestly and truthfully.

Distinguishing between GAAP and IFRS

While GAAP is the standard in the United States, another major set of accounting standards, the International Financial Reporting Standards (IFRS), is used by most other countries. Though they share some similarities, several key differences exist between them. IFRS is developed by the International Accounting Standards Board (IASB).

Pilar Garcia, CPA and Tax and Accounting Executive Editor for Thomson Reuters, highlights a fundamental distinction:

The primary difference between the two sets of standards is the underlying methodology. Historically, U.S. GAAP is rules-based, whereas the underlying methodology for IFRS is principles-based. A principles-based standard allows more flexibility in how an accounting standard is interpreted and applied to certain transactions.

This core difference leads to several major variations in accounting treatment:

• Inventory Accounting: Under GAAP, companies are permitted to use the Last In First Out (LIFO) method for inventory valuation. IFRS, however, explicitly prohibits the use of the LIFO method.
• Research & Development (R&D): GAAP requires that nearly all R&D costs be expensed as they are incurred. In contrast, IFRS allows for the capitalization and subsequent amortization of some R&D costs, provided the company can demonstrate the commercial viability of the project.
• Lessee Accounting: Under GAAP, a lessee must classify leases as either finance or operating leases, which affects how they are reported. Under IFRS, all leases are treated as finance leases, leading to different subsequent measurement and reporting outcomes.

Navigating the GAAP rules for cost capitalization

A core principle of GAAP is that costs can be capitalized if they are expected to provide future economic benefits to the organization over a long-term period. This means the cost is recorded as an asset rather than an expense.

However, the application of this rule isn't always straightforward. In many situations, GAAP is not explicit, requiring accountants to use their professional judgment and diligently document the reasoning behind their accounting conclusions.

As Pilar Garcia notes:

In some cases, the GAAP is straight forward, such as the accounting for fixed assets. In other cases, the GAAP is highly technical, such as the accounting for costs related to internal-use software or the accounting for certain transactions in connection with a business combination.

Making these critical judgments requires having all relevant financial data at your fingertips. Properly categorizing an expense versus a capitalized cost often starts with the initial document, like an invoice or receipt. Tools like Zenceipt can streamline this process by automatically monitoring a connected email inbox for such documents, ensuring that nothing gets missed and that accountants have a complete, organized set of records to base their decisions on.

When faced with ambiguity, it is crucial for management to exercise careful judgment and maintain thorough documentation to support the chosen accounting policy.

Understanding consolidation models in GAAP

Under U.S. GAAP, there are two main models for determining whether a company must consolidate another entity due to a controlling financial interest: the variable interest entity (VIE) model and the voting interest entity model.

A reporting entity must first assess if the VIE model applies to its situation. If it does not, the entity then defaults to using the voting interest entity model. This is a required order of operations; an entity cannot choose which model to apply.

The VIE model is particularly complex. A party is considered to have a controlling financial interest in a VIE if it possesses both: (a) the power to direct the activities that most significantly impact the VIE’s economic performance, and (b) the obligation to absorb losses or the right to receive benefits from the VIE that could be significant. While multiple parties can have a variable interest in a VIE, only one can be the primary beneficiary—the party that must consolidate the entity. It is worth noting that private companies may be eligible to elect not to apply the VIE guidance if they meet certain conditions.

Under the more straightforward voting interest entity model, a party is generally considered to have a controlling financial interest if it owns more than 50% of the outstanding voting shares of the entity.

How to handle outstanding checks under GAAP

When dealing with outstanding checks, the authoritative guidance comes from the U.S. GAAP rules in FASB ASC 210. This section addresses the composition of "cash available for current operations" and rules around offsetting asset and liability balances.

Because outstanding checks represent obligations the company still owes at the reporting date, the common practice is to report them as liabilities on the balance sheet.

However, there is some potentially conflicting, non-authoritative guidance. According to Pilar Garcia, "AICPA Q&A Section 1100.08 seemingly conflicts with this practice because it indicates that outstanding checks should be reported as a reduction of cash."

Garcia emphasizes that the AICPA's Q&A document is non-authoritative. Therefore, accountants must prioritize the official U.S. GAAP rules detailed in FASB ASC 210 to ensure proper reporting. This authoritative guidance should always be the primary source for determining the correct treatment of outstanding checks on financial statements.