The goal of GAAP is to ensure that information in financial statements is:
Relevant, representative, and reflective of the economic pictureComparable with that of other organizationsVerifiable and auditable by a third partyComprehensible to users of the information
As a result, GAAP compels companies to report their financial results accurately. For investors, the main advantages of GAAP are that it helps bring consistency and transparency to financial statements so that they can make more informed investment choices. That, in turn, may help bolster confidence in capital markets.
How GAAP Works
All public companies are required to issue frequent reports about their finances, which generally include details on revenues, ongoing and one-time expenditures, taxes, profits, and more. They do so not only for the benefit of lenders, donors, and taxpayers but also for investors. If you’re an investor, it is important to have a clear understanding of a company’s revenues, expenses, and operations. You also must trust that whatever information you have about a company is accurate. If every company used different methods to report the information in their financial statements, not only would different companies have no uniform convention by which to report these financials, but investors couldn’t make accurate comparisons about the financial positions of different companies. If a company adheres to GAAP for its financial reporting, you can be assured its financial statements are accurate because they follow the basic guidelines below:
Recognition: GAAP offers guidance on what should be included in financial statements, such as revenues, assets, liabilities, and expenses. Measurements: The accounting standards also outline the amounts of each component that should be included in financial statements. Presentation: GAAP explains which line items, subtotals, and totals should appear and be aggregated within financial statements. Disclosure: GAAP also identifies what is most important to investors in the financial statement and provides context for the information in the statements.
For example, if Company A and B both prepare their income statements according to GAAP, the earnings or profit on the bottom line of each should represent net income. As such, an investor considering buying the stock of one of these companies can do an apples-to-apples comparison of the profitability of Company A and B.
History of GAAP
For as long as money has changed hands, there has been some form of accounting. The practices familiar to us now emerged around the 15th century with the codification of double-entry bookkeeping, in which credits and debits were logged in distinct columns. Although internal audits at companies were common during the Industrial Revolution, poor financial reporting procedures were partially blamed for the economic problems that led to the Great Depression. One of the reforms spurred by the Depression was the establishment of the U.S. Securities and Exchange Commission (SEC), which was given the power in 1934 to supervise accounting methods. Today, the SEC relies on the Financial Accounting Foundation (FAF), an independent professional accounting group, to develop standards. The Financial Accounting Standards Board (FASB) and the Governmental Accounting Standards Board (GASB), two standards-setting organizations within the FAF, developed GAAP, and work to oversee and improve it.
Alternatives to GAAP
Even companies that generally adhere to GAAP may still put out other, non-GAAP-compliant financial statements. These are known as “pro forma” statements. With non-GAAP financial reporting, the company presents historical or projected financial results through measures that exclude amounts in comparable GAAP measures. For example, adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) is a common non-GAAP measure. Supporters of non-GAAP argue that pro-forma statements allow financials to be reported with more nuance and present a clearer picture for investors. The SEC, however, has expressed concern that such statements can potentially obscure results and deceive investors. In addition, non-U.S. companies often do not follow GAAP standards. Companies in more than 100 countries (and more than two-thirds of G20 nations) follow standards set by the International Financial Reporting Standards (IFRS) Foundation, which are broadly similar to GAAP. Other companies report financials using a combination of GAAP and non-GAAP methods, although non-GAAP financials are more likely to appear in press releases or investor presentations than the audited documents sent to the SEC. Some have argued that a combination of the two frameworks is more advantageous than either convention on its own. For example, FASB members have noted that using non-GAAP information to supplement official GAAP statements can be useful, with some arguing that the non-GAAP information offers insights into how management sees a firm’s performance. McKinsey & Company, a global business consultancy, published a report arguing that income statements from companies that use GAAP reporting are hard to interpret. In fact, McKinsey noted that many companies already have reported some earnings differently in an effort to provide more clarity to investors.
