GAAP: Understanding It and the 10 Key Principles

The IFRS Foundation is responsible for overseeing, maintaining and updating the accounting standards in each of these countries. Conceptually, GAAP is more rules-based while IFRS is more guided by principles. The two standards treat inventories, investments, long-lived assets, extraordinary items, and discontinued operations, among others.

• GAAP (generally accepted accounting principles) is a collection of commonly followed accounting rules and standards for financial reporting.
• Lizzette began her career at Ernst & Young, where she audited a diverse set of companies, primarily in consumer products and media and entertainment.
• International Financial Reporting Standards (IFRS) are issued by the International Accounting Standards Board (IASB), and they specify exactly how accountants must maintain and report their accounts.
• These standards are used in more than 120 countries, including those in the European Union (EU).
• This standardization ostensibly creates a commonality in all financial reports.
• Under IFRS, a firm can choose its own policy for classifying interest based on what it considers to be appropriate.
• EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity.

The way a balance sheet
is formatted is different in the US than in other countries. Under GAAP, current assets are listed first, while a sheet prepared under IFRS begins with non-current assets. For financial analysts performing valuation work and financial modeling, it’s important to have a solid understanding of accounting principles. While this is important, financial models focus more on cash flow and economic value, which is not significantly impacted by accounting principles (other than for the calculation of cash taxes). GAAS are the auditing standards that help measure and ensure the quality of audits. Auditors review and report on the financial records of companies according to the generally accepted auditing standards.

What’s the International Standard?

International Financial Reporting Standards, or IFRS, is the accounting framework used in most other countries. IFRS focuses more on general principles than what is gaap, which makes the IFRS body of work much smaller, cleaner, and easier to understand than GAAP. Since IFRS is still being constructed, GAAP is considered to be the more comprehensive accounting framework. Public companies in the United States are required to use GAAP for financial reporting. However, these firms may also opt to use non-GAAP measures to show more accurate performance results. This is especially important to investors and analysts who want a clear picture of the health of an organization and its operations.

Companies are allowed to display their own accounting figures, as long as they are disclosed as non-GAAP and provide a reconciliation between the adjusted and regular results. GAAP prescribes that interest paid and interest received should be classified as operating activities, while international standards are a bit more flexible. Under IFRS, a firm can choose its own policy for classifying interest based on what it considers to be appropriate. Interest paid can be placed in either the operating or financing section of the cash flow statement, and interest received in the operating or investing sections.

What Is GAAP in Auditing?

The procedures used in financial reporting should be consistent, allowing a comparison of the company’s financial information. GAAP may be contrasted with pro forma accounting, which is a non-GAAP financial reporting method. Internationally, the equivalent to GAAP in the U.S. is referred to as International Financial Reporting Standards (IFRS). When a company holds investments such as shares, bonds, or derivatives on its balance sheet, it must account for them and their changes in value. Both GAAP and IFRS require investments to be segregated into discrete categories based on asset type. GAAP is derived from the pronouncements of a series of government-sponsored accounting entities, of which the Financial Accounting Standards Board (FASB) is the latest.

• These guidelines are important because they underscore appropriate actions and activities of auditors.
• However, any company that does a large amount of international business may need to use IFRS reporting on its financial disclosures in addition to GAAP.
• Instead, independent boards assume the responsibility of creating, maintaining, and updating accounting principles.
• Internationally, the equivalent to GAAP in the U.S. is referred to as International Financial Reporting Standards (IFRS).
• For instance, valuations for private companies can vary widely under the current GAAP rules.
• After the main groups of the NASB and AICPA, the GAAP standards are then created by sub-agencies such as FASB Technical Bulletins, AICPA Industry Audit, and Accounting Guides and Statements of Position.
• It is updated annually to incorporate pronouncements issued by FASAB through June 30 of each year.

There are some important differences in how accounting entries are treated in GAAP vs. IFRS. IFRS rules ban the use of last-in, first-out (LIFO) inventory accounting methods. Both systems allow for the first-in, first-out method (FIFO) and the weighted average-cost method.

Global impact

In practice, since much of the world uses the IFRS standard, a convergence to IFRS could have advantages for international corporations and investors alike. While valuing assets, it should be assumed the business will continue to operate. This refers to emphasizing fact-based financial data representation that is not clouded by speculation.

There is a stated intent to eventually merge GAAP into IFRS, but this has not yet occurred. Given recent differences of opinion arising during several joint projects, it is possible that the frameworks will never be merged. According to research conducted by Harvard accounting professors and MIT’s School of Management, non-GAAP adjustments to net income increased by 33% from 1998 to 2017. Of the companies in the S&P 500, 97% used non-GAAP adjustments in 2017, a 38% increase from 1996.

Thus, even if GAAP rules are not an absolute state requirement for accounting practices, it is required that you follow these principles in order to maintain consistency in professional business practices. After all, if a stakeholder is unable to apply guidance to a company’s financial statements, they are unlikely to work with them due to the higher exposure to risk. GAAP is the set of standards and regulations any publicly traded company in the U.S. is legally required to follow when preparing financial documents.

Updates to your application and enrollment status will be shown on your Dashboard. HBS Online does not use race, gender, ethnicity, or any protected class as criterion for admissions for any HBS Online program. No, all of our programs are 100 percent online, and available to participants regardless of their location. There are no live interactions during the course that requires the learner to speak English.

For instance, valuations for private companies can vary widely under the current GAAP rules. The rules might be applicable for well-established public companies, but new non-public firms are more difficult to quantify. This ambiguity causes difficulties for analysts who seek to find and distinguish comparable firms. One of the chief reasons to use the GAAP is that it is virtually required for all financial documentation.