GAAP – What Exactly Is It?

Sep. 06, 2013 11:38 AM ET
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Michael C. Thomsett is a widely published options author. His "Getting Started in Options" (Wiley, 9th edition) has sold over 300,000 copies. He also is author of "Options Trading for the Conservative Investor" and "The Options Trading Body of Knowledge" (both FT Press); and "Options for Risk-Free Portfolios" and "Options for Swing Trading" (both Palgrave Macmillan). Thomsett also writes for and the Top Advisor Corner 

Anyone who has studied audited financial statements probably has run into the term "GAAP." This is an abbreviation for Generally Accepted Accounting Principles. This is the standard rules of operation and accounting standards used in the U.S.

Although GAAP is the prevailing force in accounting and auditing today, it is gradually being phased out and will eventually be replaced by International Financial Reporting Standards (IFRS). This will make U.S. financial reporting uniform with international standards. However, this change is likely to take many years. For now, any financial statements you read for U.S.-based companies were prepared and audited under GAAP rules.

There is no central organization called GAAP or any one body of managers or directors. It is the collective set of standards established through several different organizations and practices. Among these are requirements by the Securities and Exchange Commission (SEC) that all corporations report financial statements using the same rules, reporting procedures, and formats.

The methods for how transactions are booked and reported are complex and a lot of room for interpretation makes financial reporting difficult to understand. Even matters like when income should be recognized (reported) or when expenses are placed on the books, can become complex when accounting standards can be set up using different methods.

The rules come mostly from decisions made by two organizations. First is the Financial Accounting Standards Board (FASB), a non-profit organization created by the accounting industry; and by the American Institute of Certified Public Accountants (AICPA), the licensing and controlling association for professional accountants.

Under GAAP, several key principles are at work. These include regularity, the same treatment by everyone of well-defined rules of accounting practice. Another is consistency, which requires businesses to set and stay with one accounting method. Besides these two basic principles, several additional ones are part of the entire GAAP structure (full disclosure and good faith, for example).

This system is more than just the collection of rules and pronouncements of the two major organizations, the FASB and AICPA. The GAAP system also includes accounting books, magazine articles, and even speeches by accounting professionals. So the system is far-reaching and applies the discipline of accounting in many ways. For the non-accountant reading a balance sheet, income statement, and footnotes, the hope is that all of the decisions that went into those statements were fair, reasonable and consistent.

Although recent history demonstrates that accounting is far from an exact science, the accounting profession is working to improve the rules by which it requires companies to record transactions, and for auditors to interpret, verify, and analyze those decisions. No one should depend completely on the reported outcome; but by using wise financial analysis, anyone can decide whether a company is financial healthy or suffering. Accounting rules and auditing standards are important factors, but they are only part of the picture of what every investor needs to do to pick companies wisely.

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