Corporations, non-profits and government organizations must prepare their financial statements in accordance with generally accepted accounting principles (GAAP) set by the Financial Accounting Standards Board (FASB) and the American Institute of Certified Public Accountants (AICPA). Accounting principles are important because they establish a consistency that allows for more accurate and efficient viewing of company statements and reports.
The generally accepted accounting principles represent a complex, important set of accounting definitions, methods and assumptions that create a standard method of reporting the financial details of a business. With the GAAP, a hierarchy exists that dictates which standard should be used and when. FASB statements, accounting research bulletins and Accounting Principle Board opinions from the AICPA must be consulted first, followed by guides from the FASB and AICPA. If a standard is not found in the statements or guides, the questions and answers in FASB and AICPA implementation guides and industry standards must be used. When all companies follow a standard reporting method, greater financial transparency exists because investors know exactly what an "asset" is or that "inflation is ignored." Individual companies may not make their own rules.
Potential investors who want to direct funds to a certain type of industry without a particular company in mind will find accounting principles an important tool as individual businesses are reviewed. Standards allow the investor to compare and contrast companies across a singular industry or multiple industries quickly through balance sheet, income statement and annual report reviews. Lessons in each company's reporting practices are not required when every business uses GAAP.
Even though the principles have become more complex in recent years, the complexity relates to augmenting the principles to include new, complex situations versus heavily altering existing definitions and methods on an annual basis. Because of the long-term consistency in key accounting definitions and methods, standard company performance measures listed on financial statements and annual reports provide a realistic view of the company's growth or lack of growth over a period of years.
Considerations Not Covered by GAAP
While the generally accepted accounting principles serve an important purpose, a potential investor may want to use GAAP-covered financial reportings as only a portion of his overall picture of a company and also consult non-GAAP financial measures such as pro forma earnings and free cash flow. These items can be viewed as both a non-GAAP and a comparable GAAP financial measure. U.S. Securities and Exchange Commission Regulation G requires public companies disclosing non-GAAP financial measures to simultaneously present and reconcile the GAAP measure most comparable.