GAAP stands for Generally Accepted Accounting Principles, which are the standard practices of financial accountants. Any rule or convention used by accountants when recording or presenting financial statements, including income, expenses, liabilities and assets, is part of GAAP. Thus, GAAP is not in itself a rule, but rather a collection of general accounting rules which accounting firms follow when preparing financial statements.
The reason GAAP exists is to create consistency within various regions. Because all accounting firms use the same general guidelines, their financial statements can be read easily by financial analysts, shareholders and so on. This consistency is vital to financial efficiency, as it is basically the “language” by which accountants and others communicate. Comparing net income between two companies becomes a meaningful task if both are determined with GAAP. Without GAAP, the time needed to decipher financial statements from various companies would be monumental.
There are currently over 150 separate rules that make up GAAP. These rules have become very complex over the years. They are related to a wide range of topics, from things like reporting regular income to determining stock options. Again, the most important part of GAAP as it relates to all of these topics is consistency, as the principles allow for effective communication and comparison of different financial statements.
The Financial Accounting Standards Board (FASB) creates the rules which make up GAAP. This non-profit organization also amends these principles on a regular basis, and these changes have a large impact across the accounting world. The FASB recently amended GAAP so that banks did not have to mark their assets to the lower of cost, which had dramatic effects regarding the net worth of the banks.
As you can see, GAAP has huge ramifications for accountants and others, and a large part of the study of accounting goes into learning the GAAP. In understanding the rules of GAAP and why the FASB creates them, accountants can learn to more effectively apply the principles to actual business events. On top of this, knowledge of GAAP and the FASB gives one the ability to understand a plethora of financial material that would otherwise be indiscernible.
With international businesses becoming more prevalent, GAAP is losing its power in favor of International Accounting Standards (IAS). Since GAAP applies to the United States only, it has a smaller scope than IAS. When reading the financial statements of a company based in the United States, for example, one might have trouble making comparisons to the same type of statements from an international business, assuming the latter uses IAS. If you do not know from which accounting standards a financial statement was prepared, you might assume a company has more or less money than is actually the case. Thus, the majority of large companies, even in the United States, have begun to conform to IAS over GAAP. It is generally assumed by those in the accounting world that IAS will take over as the sole collection of accounting rules used worldwide, replacing GAAP completely.