Lesson 2: The World According to GAAP

Michael Sack Elmaleh, C.P.A., C.V.A.

This article describes the meaning of GAAP (Generally Accepted Accounting Principles)

Financial accounting consists of the rules and procedures used to measure the economic performance and condition of a business firm. The most widely used rules are Generally Accepted Accounting Principles (GAAP). Generally Accepted Accounting Principles (GAAP) were not handed down to the accounting profession from God through some Old Testament prophet. Rather, the accounting profession has delegated to a series of committees the responsibility for promulgating specific rules. Currently, the responsibility falls to the Financial Accounting Standards Board (FASB).

The Securities and Exchange Commission (SEC) is a regulatory agency of the federal government that can also set accounting principles for companies whose shares trade on various stock exchanges. Historically, the SEC has not intervened in setting accounting rules, but has left the task largely to the FASB. Occasionally, even the Congress has attempted to intervene in setting accounting rules.

Who Enforces GAAP?

Any company that is listed on a stock exchange has to prepare its financial statements in conformity with GAAP. Independent Certified Public Accountants (CPAs) must be hired to audit these accounting records and financial statements to insure that these statements have been prepared in conformity with GAAP. GAAP acquires its leverage through these auditing requirements. Failure to provide financial statements in accordance with GAAP would jeopardize the credibility of a firm’s financial statements and adversely affect the price of company stock.

Generally, non-publicly traded private businesses have no legal obligation to follow GAAP in preparing financial accounting reports. Non-publicly traded companies sometimes are required to use GAAP by banks or other lenders who require access to periodic financial reports. Sometimes these lenders require that CPAs audit these financial statements. Small firms often use GAAP rules for generating financial statements on a voluntary basis because these rules provide the best framework for developing useful information about economic performance and condition. 

Go to Lesson 3:The Fundamental Accounting Equation

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