Importance of Accounting Principles The Motley Fool

For example, how should an accountant report the cost of equipment expected to last five years? Reporting the entire expense during the year of purchase might make the company seem unprofitable that year and unreasonably profitable in subsequent years. Once the time period has been established, accountants use GAAP to record and report that accounting period’s transactions. Financial statements normally provide information about a company’s past performance. However, pending lawsuits, incomplete transactions, or other conditions may have imminent and significant effects on the company’s financial status. The full disclosure principle requires that financial statements include disclosure of such information. Footnotes supplement financial statements to convey this information and to describe the policies the company uses to record and report business transactions.

Accountants complying with GAAP assume that the business for which they are tabulating financial information will remain operational for the foreseeable future. Explain the three steps of financial analysis at the organizational level. Explain the role of the Financial Manager in developing and working with the 6 principles of Finance in the corporation. Explain how off-balance-sheet financing items should be treated for financial analysis purposes. Explain the relevance of Responsible Stewardship and Integrity in the context of financial management.

Objectives of Financial Statements

By applying similar standards in the reporting process, accountants can avoid errors or discrepancies. The objectivity principle is one of the most important constraints under generally accepted accounting principles.

• For example, potential lawsuits may be regarded as losses and are reported but potential gains from other sources are not.
• This principle refers to the standardization of time periods for financial reporting—such as annually, quarterly, or monthly.
• If not for GAAP, investors would be more reluctant to trust the information presented to them by companies because they would have less confidence in its integrity.
• However, due to the many different standards affiliated with GAAP, GAAP rules may be subject to various interpretations and potential manipulation.
• Since all public companies are required to abide by these standards when compiling their financial statements, GAAP is something that every accountant needs to be familiar with.

With the ability to portray a company’s fiscal standing in a favorable light, investors could be easily misled. GAAP incorporates a general guideline known as the prudence concept which states that a company should be conservative when recording its profits while undervaluing when recording expenses and losses. Under this concept of accounting, the final accounts of a business must show caution where income and expenses are impacted. Financial reporting should include any notes and descriptions needed to completely explain financial information contained in reports. Financial statements should report financial results following GAAP standards. The business and accounting staff apply GAAP rules as standard practice. Some assets — such as property, equipment and facilities — are accounted for using original purchase costs rather than current market values.

Diverse Types of Companies

Without the right accounting standards, publicly traded companies would be free to present their financial information in whatever format that casts the company’s position in the best possible light. In fact, such faulty and deceiving reporting practices are considered to be one of the primary factors that ultimately led to the Great Depression in 1929. These principles were eventually written into law and enforced by the Securities Act of 1933 and the Securities Exchange Act of 1934 along with a number of other laws issued by the Securities and Exchange Commission . Anyone exploring a degree in accounting or finance is bound to encounter Generally Accepted Accounting Principles somewhere along their educational path. These important principles play a vital role in ensuring that accountants abide by the ethics, regulations, and best practices set forth by the Financial Accounting Standards Board .

GAAP also helps companies gain key insights into their own practices and performance. Furthermore, GAAP minimizes the risk of erroneous financial reporting by having numerous checks and safeguards in place. The information provided in GAAP-compliant financial statements can therefore generally be regarded as reliable and accurate. Without GAAP, companies would be free to decide for themselves what financial information to report what is gaap and how to report it, making things quite difficult for investors and creditors who have a stake in that company. In order to be useful and helpful to users, GAAP requires information on financial statements to be relevant, reliable, comparable and consistent. This requires accountants to use the same financial reporting methods across all financial statements for easier comparisons of one financial statement to another.

GAAP: Understanding It and the 10 Key Principles

Thus, accountants lose “apples to apples” comparisons and may find it hard to create financial reports, evaluate the current financial status, and establish uniform plans. GAAP allows uniformity, ease of identifying financial statements, and the creation of a basis for comparison. Because all businesses using GAAP have utilized similar rules, financial reports are easier to understand and collate. For example, there is a general assumption that financial statements must be based on the premise that a company will continue in existence unless there is substantial evidence to the contrary. While the standards set by FASB and its predecessors account for the majority of GAAP, other rules can be found in statements from the Financial Reporting Executive Committee of the AICPA.

• With the ability to portray a company’s fiscal standing in a favorable light, investors could be easily misled.
• The business is considered a separate entity, so the activities of a business must be kept separate from the financial activities of its business owners.
• Some decisions are mundane and have only short-term consequences.
• Taxes, for example, are reported based on statutory rates, not on what the company actually paid.
• It’s important to note that accountants ignore the effects of inflation on the recorded dollar amounts.