GAAP stands for Generally Accepted Accounting Principles. The U.S. Securities and Exchange Commission (SEC) requires that GAAP be followed by all companies whose stock is publicly traded on the open market. GAAP currently governs how U.S. accountants keep their books. The Financial Accounting Standards Board (FASB) defines and amends GAAP.
GAAP runs for thousands of pages and spells out a lot of detailed rules. However, GAAP only provides guidelines. Companies take those guidelines and apply a logic that makes sense for their particular situations. However, once they pick how they are going to apply GAAP, they must be consistent and use it on an on-going basis. When a company wants to change how they apply GAAP, they must publicly disclose the change.
One example of the way GAAP can be applied concerns how to account for operating expenses. GAAP says that all operating expenses must be reflected on a company’s books; however, it does not say how to categorize them specifically. For example, the same expense might be accounted for differently by two different companies, and both companies might still be in perfect compliance with GAAP.
Here’s how that might work. Cost of goods sold or cost of services (also known as COGS and COS) is one category of business expenses. It includes all the costs directly involved in producing a product or delivering a service. Another category of operating expense is selling, general, and administrative expenses (SG&A). The accounting department has to make decisions about what to include in COGS or COS and what to put somewhere else.
Some of these decisions are easy: for example the wages of the people on the manufacturing line or the cost of materials used to make the product should definitely go in COGS or COS. Conversely, the cost of supplies used by the accounting department and the salary of the human resources manager are definitely in SG&A, not in COGS or COS.
But then there’s the gray area—and it’s enormous. For example, what about the salary of the person who manages the plant where the product is manufactured? What about the wages of the plant supervisors? You’d think GAAP would say, “The plant manager is out,” or “The supervisor is in.” No such luck; GAAP only provides guidelines. Companies take those guidelines and apply a logic that makes sense for their particular situations. The key to proper application of GAAP, as accountants like to say, is reasonableness and consistency. So long as a company’s logic is reasonable, and so long as that logic is applied consistently, whatever it wants to do in this instance is OK.
(Excerpts from Financial Intelligence, Chapter 8 – Costs and Expenses)
GAAP defines the standard for creating financial reports in the United States. It helps to ensure the statements’ validity and reliability, and allows for easy comparison between companies and across industries. But GAAP doesn’t spell out everything; it allows for plenty of discretion and judgment calls. This flexibility in applying GAAP is why financially intelligent managers need to understand the estimates, bias, and assumptions behind these judgment calls, and how they affect the financials.