GAAP, which stands for generally accepted accounting principles, is the set of accounting standards followed by most U.S. businesses, not-for-profit organizations, and state and local governments, as well as non-U.S. companies that list their stock on U.S. stock exchanges. GAAP guidelines standardize how and what organizations report so that interested parties such as investors, lenders, or potential donors can better understand and utilize an organization's financial statements, and so taxpayers and citizens can hold governments accountable.

Let's take a closer look at why GAAP exists, who sets GAAP standards, the key parts of GAAP, and how GAAP can help you as an investor.

Printed financial statement with a pencil and calculator.

Image source: Getty Images.

The history of GAAP accounting

Accounting standards in one form or another aren't a new innovation. But for most of human history, there was little need to create broad standards and then require organizations to follow them. That changed in the 20th century, when the industrial age led to the birth of a large middle class looking to invest and increase its newly found wealth.

The reality that U.S. capital markets needed oversight came to a head in 1929, when the market crash destroyed the wealth of millions of Americans and set the stage for the Great Depression. This led to the creation of the U.S. Securities and Exchange Commission -- the SEC -- to regulate Wall Street and the 1939 establishment of the Committee on Accounting Procedure (CAP) by the American Institute of Certified Public Accountants, or AICPA.

The CAP was the first attempt at standardizing accounting for U.S. capital markets and was the precursor to GAAP. It was replaced by the Accounting Principles Board in 1959 in an attempt to incorporate more research into the development of accounting standards. But like the CAP before it, the board started without either a framework of accounting principles or much independence, which limited its success.

Eventually, it became apparent that a more independent body to establish accounting standards was needed. Following the publication of the so-called Wheat Report, a 1972 study on the establishment of accounting principles conducted by the AICPA and chaired by Francis Wheat, the Financial Accounting Foundation was established. The FAF is still in existence today, and this independent, private organization is responsible for oversight of the two standards boards that set GAAP for the private and public sectors: FASB and GASB.

What are FASB and GASB?

FASB, or the Financial Accounting Standards Board, was established in 1973 and is responsible for establishing and improving financial accounting and reporting standards -- that's GAAP -- for public and private companies and not-for-profit organizations. GASB, the Governmental Accounting Standards Board, was established in 1984 and serves the same role for state and local governments as FASB does for businesses and nonprofits.

GAAP was established to standardize what items must be recognized and how they are measured, presented, and disclosed in an organization's financial statements. This ensures a minimum level of consistency in financial reporting while also making reasonable comparisons between different entities and periods of time possible.

Moreover, GAAP's oversight by FASB and GASB allows for GAAP's evolution as business and industry changes necessitate, while their independence from the business community and government allows them to better serve the interests of their key constituents: consumers of financial reporting, including investors, lenders, and taxpayers.

How GAAP benefits public companies

GAAP oversight for publicly traded companies belongs to the Financial Accounting Standards Board as described above. Moreover, it is recognized by the SEC as the designated accounting standard setter for public companies.

The FASB's standards are also recognized by the AICPA and State Boards of Accountancy. The combination of broad acceptance of the FASB's GAAP standards and their enforcement by the SEC as the "law of the land" makes GAAP a powerful tool. It enables investors and financiers to have more trust in America's capital markets and helps those markets function more efficiently.

What are the main GAAP principles?

There are multiple answers to this, depending on what link you click in a web search. Let's start with the 10 general principles GAAP-certified accounting professionals are expected to adhere to:

  1. Principle of regularity: Adherence to GAAP rules as the standard.
  2. Principle of consistency: Applying the same standards throughout reporting; if standards change or are updated, fully disclose and explain the changes.
  3. Principle of sincerity: Produce accurate and impartial financial reports.
  4. Principle of permanence of methods: Use consistent procedures in preparing all financial reports.
  5. Principle of noncompensation: Fully report all aspects of an organization's performance, whether positive or negative, with no prospect of debt compensation.
  6. Principle of prudence: Report fact-based findings, not speculation.
  7. Principle of continuity: Reporting will assume that the organization will remain a going interest.
  8. Principle of periodicity: Financial reporting should be distributed across appropriate and commonly accepted -- such as quarterly or annual fiscal -- periods of time.
  9. Principle of materiality: Financial reporting should clearly disclose an organization's monetary position.
  10. Principle of utmost good faith: Anyone involved in the organization's financial reporting is expected to be acting honestly and in good faith.

The FAF also describes four GAAP principles that lead to financial reporting that consumers can more easily use:

  • Recognition -- what items should be recognized in the financial statements (for example: assets, liabilities, revenues, and expenses)
  • Measurement -- what amounts should be reported for each of the elements included in financial statements
  • Presentation -- what line items, subtotals, and totals should be displayed in the financial statements and how those items might be aggregated within the financial statements
  • Disclosure -- what specific information is most important to the users of the financial statements. Disclosures both supplement and explain amounts in the statements.

Examples of how GAAP works

Let's take a closer look at GAAP in action, with an example from each of the four previous principles.

Recognition

In short, recognition is how revenues, expenses, assets, and liabilities are acknowledged and accounted for in a company's financial reports.

Let's use net revenue (sometimes used interchangeably with net sales) from Nucor Corporation (NYSE:NUE) in Nucor's first quarter of fiscal 2019 as our example. The table below shows the revenue Nucor reported in the first quarter of both 2019 and 2018:

Metric Q1 2019 Q1 2018
Net sales $6.1 billion $5.6 billion

Source: Nucor Q1 2019 10-Q filing.

So what exactly does this number mean, and how did Nucor arrive at it? The short answer is, by delivering goods and services to customers during the reported period (January 1 to March 30, 2019) according to mutually agreed-upon requirements.

In other words, if a Nucor customer orders $10 million in steel products and Nucor delivered those products satisfactorily to the customer during the quarter, it would be able to recognize $10 million in revenue related to that order. This is a very simplified version, and it can get more complex. For instance, let's say a Nucor customer has a contract to buy $100 million in steel during the full year and received $50 million during the first quarter. If its agreement with the customer allowed for partial billing and recognition, Nucor would be able to recognize $50 million in revenue during the first quarter.

Here's the part that investors should pay close attention to: Revenue does not equal cash flows. In the examples above, it's likely that most of Nucor's customers don't actually pay for their steel shipments when they get them, and it could be weeks or even months before the company gets paid.

To take it a little further, Nucor would also recognize any expenses related to the revenue it recognized in the quarter, including material costs, employee salaries, utility payments to run its steel mills, and payments to shippers, just to name a few. And just as with the revenue it recognized but may not have yet received cash for, it's likely that Nucor would not have paid out the cash to cover all of the expenses related to the revenue it recognized. This is due to something called the matching principle, which requires a company to "match" expenses to the revenue it generated when that revenue is earned.

Why recognize revenue before getting paid or expenses before paying for them? Because GAAP follows the accrual method of accounting, which says that a company recognizes revenues and related expenses when sales are realized and earned, not when payment is received, which is called cash accounting.

Why does GAAP follow accrual accounting and not cash accounting? In short, because accrual accounting and the matching principle tie revenue and related expenses together. The resulting financial reporting measures a company's results based on its sales, the costs to make the products or complete the services sold, and other expenses to operate the business during a reported period.

Under cash accounting, cash expenses in one period aren't necessarily related to cash inflows during that same period. That can make it far more difficult to measure a company's financial performance, compare it to prior periods, or compare it to competitors. Hence, accrual accounting is the standard for GAAP accounting.

That's not to say cash flows don't matter or that they're not important. To the contrary, GAAP requires the inclusion of cash flows in a company's financial reporting. This can be found in the consolidated statements of cash flows in the annual and quarterly earnings report.

Measurement

This principle guides how a company determines what amounts it reports for each of the various items included in its financial statements. Let's use Nucor's first-quarter earnings once again as an example.

  March 30, 2019 March 31, 2018

Net sales

6,096,624 5,568,419

Costs, expenses, and other:

   

Cost of products sold

5,200,732 4,842,013

Marketing, administrative, and other expenses

180,739 182,960

Equity in earnings of unconsolidated affiliates

(2,906) (9,580)

Interest expense, net

28,443 37,114
  5,407,008 5,052,507

Earnings before income taxes and noncontrolling interests

689,616 515,912

Provision for income taxes

158,823 135,800

Net earnings

530,793 380,112

Earnings attributable to noncontrolling interests

28,987 25,933

Net earnings attributable to Nucor stockholders

501,806 354,179

Amounts in thousands of US dollars. Source: Nucor first quarter 2019 10-Q filing.

In large part, measurement is also guided by accrual accounting and the matching principle where applicable. For instance, Nucor reported $6.1 billion in revenue in the quarter and $5.2 billion in costs of goods sold. These were the costs it incurred to make the steel products it sold in the quarter, including operating its steel mills, paying mill workers, and buying the materials (such as iron) used to make the steel it sold.

Going a little further, Nucor incurred other expenses during the quarter as well that may not have related directly to revenue, but they were incurred and so must be recognized. For instance, interest expense in the quarter was $28.4 million, meaning that was the amount of interest Nucor owed its debtors during the first quarter, based on its lending agreements. Similarly, marketing and administrative and other expenses of $180.7 million in the quarter were not a direct cost of sales, but the company incurred those expenses, including administrative costs, employee wages, advertising, and others, during the quarter.

The result is a collection of financial data that was measured in a consistent way from one item to the next and also from one period and one company to the next following the same accounting standards.

Presentation

It's important for a company not only to recognize and measure its financial information in a consistent way but also to present it in such a manner that the consumers of that information can effectively utilize it.

The short version: Companies are given some flexibility in how much detail they choose to report, but they're required to report certain items in certain ways in their financial statements. Some examples of items you will find in every 10-K or 10-Q filed by a public company include the following:

  • The income statement, which lists a company's revenue, cost of goods, expenses, and income. This is the information most used by investors and is typically one of the first items found in a company's financial reporting.
  • The balance sheet lists the value of a company's assets such as property and inventory, as well as its liabilities, such as debt and accounts payable. Digging deeper into the balance sheet, you'll find "current" assets and liabilities. These are liabilities that must be resolved within one year and assets that are highly liquid, such as cash and inventory. This further paring down of the balance sheet helps investors determine how much potential liquidity -- current assets -- a company has, as well as potential liabilities it must deal with soon, such as debt to repay or refinance.
  • The statement of cash flows describes a company's cash flows based on three different criteria: operating activities, which are best described as the company's actual business; investing activities, such as capital expenditures, acquisitions, or divestitures; and financing activities, such as issuing or repurchasing stock, issuing or repaying debt, and cash dividends paid to shareholders. The cash flow statement must also include cash and equivalents at the beginning and end of the period, which, when used hand in hand with the breakdown by activity, helps explain where a company generated -- and spent -- its cash during the period.

These are only some examples of items GAAP provides guidance for aggregating and presenting in financial reporting. If you're interested in an exhaustive list, it sounds like you're an ideal candidate for some accounting courses. Joking aside, the key takeaway is that this is a critical principle in providing you with consistent-looking, easy-to-read financial reports.

Disclosure

In addition to the results of its operations, cash flows, and other activities, a business is obligated to disclose any additional information that could have material impact on a company. While that sounds like a very broad statement -- and indeed it is -- this principle is meant to ensure that management makes potential investors, lenders, or other stakeholders aware of things that could have serious implications for a company.

Here are some examples of things a company would disclose under this principle:

  • An ongoing investigation by a regulator that's likely to result in a materially significant fine or regulatory sanctions.
  • Ongoing litigation that's likely to result in a material financial loss or expense.
  • The nature of the organization's relationship with a related party (such as another business owned by an executive or large shareholder) the organization does substantial business with.

The list could go on, but there are guidelines to prevent a company from feeling the need to report every minor undisclosed item. In general, a company must only disclose items or events that are likely to have a material impact on the organization's financial position or results.

What is non-GAAP accounting?

The short definition is any financial reporting a company provides that doesn't meet GAAP. In general terms, this means excluding certain items from its financial or operating results, often in an attempt to explain the impact of a nonrecurring (one-time) item or event.

For instance, if a company does significant business in Florida and a hurricane caused it to close a large portion of its stores during a quarter, it would likely report non-GAAP (often called "adjusted" or "pro forma") financial information showing what its results would have been had the weather event not caused the shutdown.

Another example: A company makes a large acquisition and provides non-GAAP information excluding nonrecurring expenses related to the acquisition, such as legal fees and expenses related to moving or terminating employees or closing or combining certain operations.

In the two examples above, the company's goal is to demonstrate what its results would (or should)look like during a more typical period or once an acquisition is integrated into the business.

These examples deal with nonrecurring items, but many companies provide non-GAAP results in their releases every quarter. So what gives? In many cases, the non-GAAP numbers are meant to provide additional detail.

For instance, adjusted EBITDA -- earnings before interest, taxes, depreciation, and amortization -- excludes a combination of cash- and noncash expenses, as well as other items management chooses to back out (this is the "adjusted" part), to give investors a clearer look at the core operating results of the business.

This can be handy information, but it shouldn't be used instead of GAAP. For instance, adjusted EBITDA results are typically far better than the GAAP financials (a big reason companies want you to see them) and are no promise of an improving financial situation for a company. To put it plainly, take the vast majority of non-GAAP financial data with a big grain of salt.

When is non-GAAP better?

In general cases, investors would do best to utilize both GAAP and non-GAAP reporting in concert to analyze a company, and never ignore GAAP results out of hand. However, there are some rare exceptions when a non-GAAP measure is a more useful metric.

The one that stands out most is in the case of real estate investment trusts, or REITs. Like other companies, REITs are required to depreciate their assets, which shows as an expense each quarter on the income statement.

In most instances, it makes sense for a company to depreciate and amortize its assets. A delivery vehicle, machinery at a factory, computer equipment, and most other assets lose economic value over time, so a company must take depreciation expense or amortize its value over the life of that asset.

Here's where asset depreciation under GAAP doesn't work so well for REITs. As a starting point, a REIT is generally made up primarily of real estate assets. To be a REIT, a company must hold at least 75% of its assets in a combination of real estate or investments, cash, or federal treasuries.

The catch here is that real estate is the rare asset companies can own that usually gains in value over time. So taking substantial -- and noncash -- depreciation expenses for real estate assets that make up the majority of its value makes the net income a REIT reports under GAAP generally much smaller than its true earnings capacity.

For this reason, funds from operations, or FFO, was developed. FFO is a simple formula, taking net income and then adding real estate-related depreciation back to it. The resulting number is called funds from operations, and it is widely considered a better proxy for earnings in this particular industry.

Some other industries use FFO and a similar metric, cash available for distribution, or CAFD, to report their financial results. In general, the industries that use these metrics own substantial real estate or long-lived assets that retain significant economic value while also paying large dividends.

With these notable exceptions, GAAP numbers should remain your go-to financial results, with the non-GAAP information companies provide offering additional context and taken with a grain of salt.

Is GAAP used outside the U.S.?

While foreign companies that list their stocks on U.S. exchanges must use GAAP in their financial reports filed with the SEC, more than 140 countries follow the International Financial Reporting Standards, or IFRS.

While there is some overlap in GAAP and IFRS, they differ in a number of key aspects that affect when and how an organization may recognize revenues and expenses, how it can treat inventory, and how it values both tangible and intangible assets, just to name a few.

In general, GAAP is more conservative in how companies can value and report items, while IFRS gives companies more leeway. This is best described as GAAP being rules based while IFRS is more principles based.

Looking at the future of global accounting standards, GAAP is more likely to be superseded by IFRS at some point than the other way around. Simply put, despite the size of U.S. capital markets, IFRS is used by most of the rest of the world already.

The SEC has indicated an interest in incorporating IFRS into U.S. financial reporting. In 2012, it released a report following a two-year study that found the differences in the two systems -- as well as perceived weaknesses with IFRS for certain industries -- were substantial enough that it wasn't feasible to quickly move U.S. reporters from GAAP to IFRS.

GAAP is an important tool for individual investors

For most individual investors, it's not necessary to be a subject matter expert on GAAP. But a basic understanding of the key principles, the accrual accounting method and matching principle, can go a long way toward helping you benefit from the information you find in a company's financial reporting.

But that's just the beginning. Understanding the basics of GAAP can also help you better understand the non-GAAP information companies report, making you less reliant on Wall Street analysts' buy and sell recommendations (which in aggregate are no better than flipping a coin) and more capable of reaching your own conclusions on a given investment.

It won't make you a perfect investor, but over time, increasing your understanding of the key accounting principles American companies follow in their financial reporting should help you become a better investor.