GAAP, otherwise known as generally accepted accounting principles, are a set of accounting rules that provide guidelines for both business and corporate accounting. This makes navigating the complexities, details, and legalities of a comprehensive set of approved accounting methods more manageable.
It is fortunate for investors that there are standard accounting principles which allow for companies in good standing to display their high-quality attributes.
U.S and Canadian law states that publicly traded companies on indices and stock exchanges must follow GAAP guidelines. Of these guidelines, there are 10 core concepts:
- Principle of Consistency: Consistent standards are applied throughout the financial reporting process
- Principle of Regularity: GAAP-compliant accountants strictly adhere to established financial rules and regulations
- Principle of Permanence of Methods: Consistent procedures are used during preparation of all financial reports related to business activities
- Principle of Sincerity: GAAP-compliant accountants must remain committed to impartiality and accuracy at all times
- Principle of Prudence: Speculation must never influence the reporting of fiscal data
- Principle of Non-Compensation: Any and all aspects of an organization’s performance -whether positive or negative- are fully reported and without any prospect of debt compensation
- Principle of Continuity: All asset valuations are based on the assumption that the organization’s operations will continue
- Principle of Periodicity: Reporting of all revenues are divided by standard accounting time-periods without exception, such as fiscal quarters or years
- Principle of Materiality: Financial reports fully disclose the organization’s monetary situation
- Principle of Utmost Good Faith: All involved parties are believed to be acting in full accordance with law, regulation, and in utmost honesty
As noted, any company with a high-quality of earnings will have nothing to hide from investors. Hence, they will use these GAAP standards and regulations to their full effect.
The fundamentals behind GAAP standards are based on reliability and relevance in accounting. This is to say:
Reliability: The accounted metric in question is free of any error or bias whatsoever. It accurately represents a verifiable business transaction.
Relevance: The accounted metric has predictive power in that it is timely in nature. It can enhance understanding about prior predictions made. It also has value for making new predictions. This allows for confirmation or contradiction of previous biases also.