Generally accepted accounting principles (GAAP) are standards and rules used in financial preparation to ensure a clear and consistent understanding of a company’s financial health. GAAP includes options for accountants, making it important to codify them for easy reference. The Financial Accounting Standards Board (FASB) issues statements of principles for non-governmental organizations, while the Securities and Exchange Commission (SEC) requires their use by all publicly traded companies. Auditing by a certified public accountant (CPA) is critical to ensure compliance with GAAP.
Accounting principles are generally accepted standards and rules used in the preparation of financial journals, ledgers, and statements. Its use enables business owners, investors, and other interested parties to arrive at a clear and consistent understanding of a company’s financial health based on reading its audited financial statements. Having generally accepted accounting principles is a lot like having accepted rules for language, such as word definitions and grammar standards. Without generally accepted standards in language, meaning is lost; Without generally accepted accounting principles, statements presented to illustrate a company’s financial position will be interpreted in a variety of ways, leading to confusion and misunderstanding.
Certain accounting principles, such as double-entry bookkeeping and the segregation of company funds from those of its owner, are generally accepted around the world, while others are more specific to different regions or nations. Others are a matter of choice, and when preparing a company return, that choice must be noted on the return. For example, when determining the value of an inventory of purchased goods, a company might use the current market value of the inventory, or it might use the actual amount it paid for the inventory. Another choice a business must make is whether to use the cash or accrual basis for its accounting. The cash basis, favored by individuals and small businesses, involves recording expenses and income as they occur; Larger organizations almost universally use the accrual basis, recording these items as they are incurred.
The different options available to accountants, and the complexity of adhering to GAAP, actually make it important to codify them so they can be easily referenced. In the United States, the government does not require accounting standards, leaving that task to the free market. GAAP is developed by professional bodies composed primarily of accountants. Only one organization, the Financial Accounting Standards Board (FASB), actually issues statements of these principles for non-governmental organizations. Another organization, the Government Accounting Standards Board (GASB), addresses government accounting. While the government doesn’t set the standards, the Securities and Exchange Commission (SEC) requires their use by all publicly traded companies.
The FASB has issued more than 150 Financial Accounting Statements of Principles covering topics as diverse as how to account for different types of income, how to report wages paid, and how to report the purchase of another company. FASB statements are exceptionally detailed because they attempt to address every possible combination of factors that accountants may encounter. Despite this, some accountants manage to evade their purpose of presenting an honest and straightforward picture of an organization’s financial state, twisting and manipulating the data to present a distorted and misleading financial statement. That’s why it’s critical that companies have their books routinely audited by a disinterested third party, a certified public accountant (CPA), whose purpose is to certify that their books and records are maintained in accordance with GAAP.
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