Accounting Principles That Are Essentials to Understand

If everyone involved in the accounting process follows their own system, or none at all, there is no way to really know whether a business is profitable or not. Most companies follow what are called Generally Accepted Accounting Principles, or GAAP, and in libraries and bookstores there are large volumes devoted to just this topic. Unless the company states otherwise, anyone who reads the financial statements can assume the company uses GAAP.

If GAAP is not the principle used to prepare financial statements, companies should clarify what other forms of accounting are used and should avoid using securities in their financial statements that could mislead those examining them.

GAAP is the gold standard for budgeting. Failure to disclose that you have used principles other than GAAP makes the company legally liable for misleading or misunderstood data. These principles have been refined over the decades and have effectively governed the accounting methods and financial reporting systems of companies. Different principles have been established for different types of business entities, such as for-profit and not-for-profit corporations, governments, and other businesses.

However, GAAP is not cut and dried. They are guidelines and therefore often open to interpretation. Estimates must be made intermittently and require good faith efforts towards accuracy. You’ve probably heard the phrase “creative accounting” and this is when companies push the boundaries a little (or a lot) to make their business appear more profitable than it really is. This is also called a massage number. This can spiral out of control and quickly turn into accounting fraud, which is also called cookbook. The results of these practices can destroy and destroy hundreds and thousands of lives, as in the case of Enron, Rite Aid, and others.

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