What Is Hierarchy of GAAP?
The Hierarchy of Generally Accepted Accounting Principles (GAAP) is a structured framework that dictates the authoritative order of accounting guidance for companies in the United States. It provides a roadmap for accountants to determine which accounting principles and rules should be applied in specific circumstances when preparing financial statements. This hierarchy is a fundamental component of financial accounting, ensuring consistency, comparability, and transparency in financial reporting. The Hierarchy of GAAP guides preparers through the complex landscape of accounting pronouncements, from broad conceptual statements to specific industry-level guidance, aiming to provide a clear basis for reporting financial information.
History and Origin
The establishment of a structured accounting framework in the United States, including the foundation for what would become the Hierarchy of GAAP, was largely catalyzed by the financial instability of the early 20th century. Following the stock market crash of 1929 and the subsequent Great Depression, there was a recognized need for standardized and reliable financial information to restore public confidence and protect investors. To address this, federal legislation such as the Securities Act of 1933 and the Securities Exchange Act of 1934 were enacted, leading to the creation of the Securities and Exchange Commission (SEC)12,11.
Initially, the SEC supported the private sector in establishing accounting standards10. Over time, various private bodies contributed to the development of Generally Accepted Accounting Principles (GAAP). In 1973, the Financial Accounting Standards Board (FASB) was established as the primary private-sector body for setting accounting standards in the U.S.. The FASB’s pronouncements became a significant part of GAAP.
Before 2009, the GAAP hierarchy was explicitly defined within FASB Statement No. 162, The Hierarchy of Generally Accepted Accounting Principles. However, with the introduction of the Accounting Standards Codification (ASC) in September 2009, the formal hierarchy was integrated into the Codification itself. The ASC became the single source of authoritative GAAP for nongovernmental entities, simplifying how users identify and apply accounting standards,. 9All prior accounting standards documents were superseded, and any accounting literature not included in the Codification is considered non-authoritative. This evolution aimed to reduce the time and effort required to research accounting issues and mitigate the risk of non-compliance.
Key Takeaways
- The Hierarchy of GAAP establishes the authoritative order of accounting guidance, ensuring consistent application of principles in U.S. financial reporting.
- The Accounting Standards Codification (ASC), maintained by the FASB, is now the single authoritative source of GAAP for nongovernmental entities.
- Compliance with GAAP and its hierarchy is mandatory for publicly traded companies in the U.S.
- The hierarchy helps preparers of financial statements prioritize guidance when multiple sources might apply to a transaction.
- The Securities and Exchange Commission (SEC) has the authority to oversee and enforce GAAP compliance.
Interpreting the Hierarchy of GAAP
Interpreting the Hierarchy of GAAP primarily involves navigating the FASB Accounting Standards Codification®. The Codification organizes thousands of U.S. GAAP pronouncements into approximately 90 accounting topics, presented in a consistent structure. This structure is designed to be user-friendly, allowing accountants and financial professionals to easily locate and apply relevant guidance.
When a company faces an accounting issue, it must refer to the ASC to identify the most relevant and authoritative guidance. The Codification includes guidance from the Financial Accounting Standards Board (FASB) as well as relevant Securities and Exchange Commission (SEC) guidance in separate sections within the same topical structure. If specific guidance for a transaction or event is not found within the ASC, companies may then look to other non-authoritative sources for analogy or background information, such as FASB Concept Statements, industry practices, or generally accepted accounting textbooks. The ultimate goal of following the Hierarchy of GAAP is to ensure that financial statements fairly present a company's financial position, results of operations, and cash flows.
Hypothetical Example
Imagine "GreenTech Innovations Inc.," a publicly traded company developing sustainable energy solutions. GreenTech recently entered into a complex arrangement involving the sale of carbon credits, a transaction for which there isn't explicit, standalone guidance within their prior accounting policies.
To properly account for this, GreenTech's accounting team consults the Hierarchy of GAAP via the Accounting Standards Codification. They begin by searching the ASC for topics related to revenue recognition and specific guidance on environmental credits. They find broad principles for contract recognition and measurement (e.g., Topic 606, Revenue from Contracts with Customers) and specific sections discussing similar types of intangible assets.
If the ASC provided a direct, clear answer for carbon credits, that would be the authoritative guidance. If not, they would then consider how the existing principles for similar transactions (like other intangible asset sales or service contracts) within the Codification apply by analogy. This systematic approach, guided by the Hierarchy of GAAP embedded in the ASC, ensures that GreenTech's treatment of the carbon credit sale is consistent with established accounting standards, even for a novel transaction.
Practical Applications
The Hierarchy of GAAP is fundamental to various aspects of finance and accounting, primarily serving to standardize financial reporting across U.S. entities. One of its main applications is in the preparation of financial statements, where it ensures that all publicly traded companies follow a consistent set of rules for items like revenue recognition, asset valuation, and disclosure requirements. This consistency allows investors and creditors to compare the financial performance of different companies effectively.
Furthermore, the hierarchy is crucial for auditors, who rely on it to determine whether a company's financial statements are presented fairly and in accordance with GAAP. The Securities and Exchange Commission (SEC) leverages the Hierarchy of GAAP as a primary tool for its enforcement actions against companies that fail to comply with accounting standards, ensuring market integrity and investor protection. F8or instance, the SEC has the authority to both set and enforce accounting standards for public companies in the U.S., often issuing guidance and interpretations on GAAP and SEC regulations. T7he framework also underpins financial analysis, enabling analysts to dissect company reports with a common understanding of the underlying accounting methodologies.
Limitations and Criticisms
Despite its crucial role in ensuring consistency and transparency, the Hierarchy of GAAP, particularly the extensive body of standards it governs, faces several criticisms. One significant challenge is the sheer complexity of the standards themselves. C6ritics argue that the vast and detailed nature of GAAP can make it difficult for companies, especially smaller ones, to fully understand and comply with all applicable rules,. 5T4his complexity can sometimes lead to inconsistencies in financial reporting due to differing interpretations of the guidelines.
3Another point of contention is the rules-based nature of U.S. GAAP, which some argue can lead to financial engineering rather than a clear portrayal of a company's underlying economics. This contrasts with more principles-based accounting systems like International Financial Reporting Standards (IFRS). The need for constant updates to address emerging transactions and industries also contributes to the perceived complexity and the ongoing effort required for compliance, including maintaining robust internal controls. W2hile the Accounting Standards Codification aimed to simplify access to authoritative guidance, the underlying intricacy of the rules remains a point of critique.
Hierarchy of GAAP vs. International Financial Reporting Standards (IFRS)
The Hierarchy of GAAP and International Financial Reporting Standards (IFRS) represent two prominent sets of accounting standards used globally. The primary distinction lies in their approach: U.S. GAAP is generally considered more "rules-based," while IFRS is often described as "principles-based." This means U.S. GAAP provides detailed rules for specific transactions, offering less room for interpretation, whereas IFRS provides broader guidelines and principles, requiring more judgment in their application.
While the Hierarchy of GAAP provides a clear authoritative structure within the U.S. financial reporting landscape, IFRS focuses on general principles for recognizing, measuring, and disclosing financial information. This difference in approach can lead to variations in how similar transactions are reported under each framework, impacting financial statements and their comparability across borders. For example, specific guidance on revenue recognition or materiality may differ in the granular details between the two sets of standards, even if the overarching objective of fair presentation is shared. Many countries outside the U.S. use IFRS, making it an alternative set of rules for global businesses.
1## FAQs
What is the purpose of the Hierarchy of GAAP?
The purpose of the Hierarchy of GAAP is to provide a clear and authoritative structure for accounting guidance, ensuring that financial statements are prepared consistently and comparably across different entities in the United States. It helps accountants determine which accounting standards apply to specific transactions.
How has the Hierarchy of GAAP changed over time?
Historically, the Hierarchy of GAAP was explicitly defined in FASB pronouncements, outlining various levels of authority. However, since September 2009, the Accounting Standards Codification (ASC) became the single authoritative source for U.S. GAAP for nongovernmental entities. The formal hierarchy is now embedded within the structure of the ASC itself.
Who enforces the Hierarchy of GAAP?
The Securities and Exchange Commission (SEC) is responsible for enforcing compliance with GAAP among publicly traded companies in the U.S. The Financial Accounting Standards Board (FASB) establishes and maintains the accounting standards that constitute GAAP.