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What is GAAP? It Sounds Like a Hazard on the Sidewalk…

What was your company’s net profit last year? It seems like a simple question, doesn’t it? In fact, we should add a joke here about it being harder to earn the profit than it is to measure it. The surprising truth is that your company’s profit is a subjective question.

Not only does the amount earned last year depend upon how it is measured, the method chosen to measure it may make the difference between a net profit and a net loss for the year. For example, if you only recognize income when you receive the cash for your sales, your net profit will be different for the year than if you recognize income based on both cash sales and your accounts receivable balance. This sort of ambiguity may be alright for a sole-proprietorship without debt, but for bankers, shareholders, and other users of financial statements, a uniform method of financial accounting is vital to evaluating future variables.

This is why GAAP, or Generally Accepted Accounting Principles, was created. GAAP is a standard framework of guidelines for financial accounting. Companies that use GAAP for their financial accounting have opted to report their financials in a standardized way.

GAAP includes principles on:

Recognition – what should be recognized and when
Measurement – what amounts should be accrued and what should not
Presentation – what line items should be displayed and what should be aggregated
Disclosure – what is of specific importance and should be separately called out

While a uniform system of financial measurement is a great idea, it is only required for certain entities. The Securities and Exchange Commission (SEC) requires publicly-traded companies and certain regulated companies to use GAAP. Some government entities also have to use it, but the government has its own implementation that differs from U.S. GAAP. Bankers evaluating companies for loans may require GAAP-prepared financial statements as well.

So who gets to make such exciting decisions as to what disclosures need to be added and what needs to be on the face of a balance sheet? In the United States, it’s the Financial Accounting Standards Board (FASB). Other countries have their own interpretations of GAAP, for instance:

Canada – Generally Accepted Accounting Principles
China – Chinese Accounting Standards
India– Generally Accepted Accounting Practice
United Kingdom – Generally Accepted Accounting Practice

Because the world is getting more globally-connected, it was noted that an internationally-recognized system would be best. It was this goal that established the International Accounting Standards Board (IASB), an organization made up of many different countries. The international system is known as International Financial Reporting Standards (IFRS). Although most countries are moving to incorporate their systems into an international standard, most of us in the United States are concerned primarily about our Yankee version as this is the requirement here.