This video discusses Generally Accepted Accounting Principles (GAAP). GAAP refers to the common set of rules companies must follow when preparing financial reports for external parties (investors and creditors). Not all countries use the same GAAP. A country may adopt International Financial Reporting Standards or it may create its own local GAAP

GAAP is an abbreviation for “Generally Accepted Accounting Principles.”  GAAP refers to the set of rules and principles that companies must follow when preparing financial reports for investors, creditors, and other parties outside the company. Publicly-traded companies like Coca-Cola are required to issue quarterly and financial statements by law, and these statements must be prepared according to GAAP.  Coca-Cola can’t just say, “We don’t like GAAP and prefer to do our own thing” or they will be de-listed from stock exchanges and face other consequences.

If GAAP didn’t exist, as was the case for most of human history, then it would be very difficult for investors to evaluate companies’ financial health.  One company could choose to recognize revenue only when it ships a product while a competing company could choose to hire a monkey and recognize revenue whenever the monkey eats a banana.  Comparing the revenue of these two companies makes absolutely no sense because revenue is not computed according to a common set of rules.

GAAP solves the problem; if everyone has to follow GAAP, you can be reasonably sure that revenue isn’t based on banana-tossing (unless we’re talking about Enron). If you are a self-employed DJ who performs at weddings, you are probably not required to create financial reports.  You are not publicly-traded and are not compelled to create financial statements.  If you want to borrow money from a bank or pitch an investment to the people on Shark Tank, however, you will need to create some financial statements.  And those financial statements need to be prepared according to GAAP, not according to the whim of a monkey.

Unfortunately, not all countries use the same GAAP.  More than one hundred countries have adopted International Financial Reporting Standards (IFRS), so if you compare the financial statements from companies in any of those countries they will have been prepared according to the same rules.  Some countries, like the United States, prefer to create their own GAAP.  This makes it difficult to compare the financial statements of a U.S. company to a company that uses IFRS.  Hopefully that will change one day but it doesn’t look like it’s going to happen anytime soon.

Maybe one day the accounting gods will bless us with an accounting utopia in which financial statements from companies around the world are prepared according to the exact same rules.  This would help investors and creditors better allocate capital, but more importantly it would make things easier for the poor accounting students who have to learn multiple sets of accounting rules 🙂