GAAP stands for generally accepted accounting principles, the framework a US entity’s financial statements are prepared under. The phrase is a legal term rather than a description of consensus: a standard is generally accepted because a body the Securities and Exchange Commission has recognized issued it, not because practitioners agree with it.
That is the part most definitions leave out, and it is the part that answers every follow-on question about who sets GAAP and who has to follow it.
What Makes a Standard Generally Accepted
The test is statutory. Section 108 of the Sarbanes-Oxley Act of 2002 amended section 19 of the Securities Act of 1933 to establish criteria that must be met in order for the work product of an accounting standard-setting body to be recognized as generally accepted, and the new subsection 19(b) provides that the Commission may recognize as generally accepted, for purposes of the federal securities laws, any accounting principles established by a standard setting body that is organized as a private entity and that has, for administrative and operational purposes, a board of trustees serving in the public interest (SEC, Policy Statement, Release No. 33-8221).
The Commission then applied that test and said who passed. The Securities and Exchange Commission has determined that the Financial Accounting Standards Board and its parent organization, the Financial Accounting Foundation, satisfy the criteria in section 108 of the Sarbanes-Oxley Act of 2002 and, accordingly, FASB’s financial accounting and reporting standards are recognized as generally accepted for purposes of the federal securities laws (SEC, Policy Statement, Release No. 33-8221).
The arrangement predates the statute. At the time of the FASB’s formation in 1973 the Commission reexamined its policy and formally recognized pronouncements of the FASB that establish and amend accounting principles and standards as authoritative, in the absence of any contrary determination by the Commission (SEC, Policy Statement, Release No. 33-8221). Sarbanes-Oxley put criteria under a practice that had run for three decades on recognition alone.
Who Has to Follow It
For anything filed with the Commission, the rule is a presumption rather than a requirement, and the presumption is unforgiving. Financial statements filed with the Commission which are not prepared in accordance with generally accepted accounting principles will be presumed to be misleading or inaccurate, despite footnote or other disclosures, unless the Commission has otherwise provided (17 CFR 210.4-01(a)(1)).
Read the qualifiers rather than the headline. The presumption is not conclusive, it can be displaced where the Commission has otherwise provided, and disclosure does not cure it. That last clause is the one that surprises people: explaining a departure in the notes does not rescue the statements from the presumption.
Nothing in that provision reaches a company that files nothing with the Commission. A private company applies GAAP because an audit engagement, a lender’s covenant, a buyer’s diligence or an owner agreement calls for it, not because this rule reaches it. Which basis a smaller client is actually on, and what changes when it is not GAAP, is set out in modified cash basis accounting.
Where the Authoritative Text Sits
GAAP as a body of principles and the document that holds it are not the same thing, and the document is explicit about its own status. The FASB Accounting Standards Codification is the source of authoritative generally accepted accounting principles recognized by the FASB to be applied by nongovernmental entities, and an Accounting Standards Update is not authoritative; rather, it is a document that communicates how the Accounting Standards Codification is being amended (FASB, Accounting Standards Update No. 2015-11).
Two limits are worth reading off that sentence rather than skipping past. The recognition runs to nongovernmental entities, so it does not settle what a government reports under. And an Update is a communication about a change, not the rule itself, which is why a workpaper citing an ASU number for a live requirement is citing the wrong document.
How a Codification reference is structured, why every paragraph in it carries equal authority, and what it replaced are set out in ASC accounting.
What GAAP Is Not
It Is Not the Tax Rules
A return and a GAAP financial statement answer to different authorities and reach different numbers from the same facts. Inventory is the clearest case, where the reporting rule and the Internal Revenue Code both run on one stock of goods, worked through in inventory accounting. The difference between the reported charge and the return’s is the whole subject of deferred income tax.
It Is Not IFRS
They are different frameworks with different standard setters, and a US filing rule names both. A foreign private issuer may file under US generally accepted accounting principles or under International Financial Reporting Standards as issued by the International Accounting Standards Board (17 CFR 210.4-01(a)(2)). What the other framework is and who issues it is in IFRS, and which differences still move a number in a US firm’s workpapers is in GAAP vs IFRS.
It Is Not a Guarantee of Comparability
Two entities can apply the same framework and report different numbers, because the framework permits choices. Cost formulas are the standing example, and how one set of purchases produces two different figures is worked through in LIFO vs FIFO. GAAP constrains the range of acceptable answers rather than producing one answer.
Common Questions
The Financial Accounting Standards Board, for nongovernmental entities. The Commission determined that the FASB and the Financial Accounting Foundation satisfy the section 108 criteria, so FASB’s standards are recognized as generally accepted for purposes of the federal securities laws (SEC, Policy Statement, Release No. 33-8221). The Codification the Board maintains is the source of authoritative GAAP for those entities (FASB, Accounting Standards Update No. 2015-11).
For statements filed with the Commission, in effect yes, through a presumption: statements not prepared in accordance with generally accepted accounting principles are presumed misleading or inaccurate unless the Commission has otherwise provided (17 CFR 210.4-01(a)(1)). For a company that files nothing with the Commission, GAAP arrives through an agreement rather than through that rule.
That the statements were prepared under the framework, which for a nongovernmental entity means under the Codification (FASB, Accounting Standards Update No. 2015-11). It is a statement about the framework applied, not a statement that the numbers were audited, and not a claim that another entity applying the same framework would report the same figures.
Not by force of the Commission’s filing rule, which reaches statements filed with the Commission (17 CFR 210.4-01(a)(1)). In practice the requirement usually arrives from a lender, an investor, an audit engagement or an owner agreement.
Accountably places trained offshore accountants and tax preparers inside US CPA and EA firms, and a firm can put a real block of its own close and reporting work through a trial task before a client file depends on it.
