Accounting is a set of practices, not a science with immutable natural laws. Practices can change from accountant to accountant. Accountants might also be influenced by top managers to adopt practices that show a glowing picture of the company entrusted to their management.
While deliberate manipulation of accounts to portray a more favorable view of the performance and financial status of the company will come under the definition of fraud, varying practices from accountant to accountant can make the accounts quite undependable. The same thing can be accounted in different ways and an outside reviewer will have no way of knowing whether one company did better than another, or just adopted a different accounting practice.
For example, a company valuing its inventories at cost price might show a poorer performance compared to another company that changed its inventory valuation method this year to market value.
To prevent such varying (and undisclosed) practices, accounting bodies have been issuing guidelines on how to record business transactions and how to prepare financial statements. The accumulated body of such guidelines has come to be known as Generally Accepted Accounting Principles or GAAP.
Government Authorities Get into the Picture
Governments have supported standardization of accounting practices such as GAAP by making it necessary on the part of companies to disclose whether they have followed GAAP in preparing their published accounts. Auditors also have to report on this issue. Bodies such as Securities Exchange Commission insist that listed companies follow standard accounting practices and disclose a great deal of information.
What exactly is GAAP?
GAAP sets out certain principles, standards and procedures for recording business transactions and preparing company financial reports. The broad aim is to ensure that the published accounts present a fair view about the operating performance and financial status of the company, and also conform to a common set of rules for presenting the information. Consistency of presenting information among companies can make the accounts comparable, and make it possible to compare the performance of one company against another company in the same industry.
The principles can be either those that have become standard owing to long convention, or those specifically laid down by authoritative bodies after considering all aspects. The US GAAP has four each of three things: Assumptions, Principles and Constraints.
Four Assumptions
- Business Entity: A business is different from its owners and its accounts must be kept separate from owners’ personal accounts;
- Going Concern: Assumes that the business will continue for ever, and allows such practices as valuing fixed assets at costs minus accumulated depreciation, irrespective of their market values;
- Stable Monetary Unit: Allows valuation of assets at cost prices, instead of adjusting them for inflation;
- Time Period: Accounting reports are prepared for specific time periods such as a financial quarter or year
Four Principles
- Cost Principle: Assets are mostly valued based on acquisition costs and not at fair market value, thus removing the chance of subjectivity in the valuations. This principle is being challenged on the ground that it presents distorted picture in times of inflation;
- Revenue Principle: Revenue is reported in the period it is earned, and not in the period when cash is received
- Matching Principle: Expenses should relate to the revenue shown to the extent possible, as illustrated by Cost of Goods Sold. However, where an expense cannot be identified with revenue, as in the case of office salaries, it is accounted fully in the period it accrued;
- Disclosure Principle: Information presented through the main report, notes to accounts and as supplementary information should be adequate to make a judgment about the company’s performance and financial status
Four Constraints
- Objectivity: Only information supported by objective evidence should be included in the financial statements;
- Materiality: What is included and what is omitted are determined by whether the information is likely to affect the decisions of a reasonable person;
- Consistency: Follow the same method of accounting for similar items and follow the same accounting practices from year to year;
- Prudence: Choose the conservative option; avoid overstating assets or income; and understating liabilities or expense
Detailed guidelines have been published by the accounting bodies indicating how to account for specific transactions and how to report results. One source of detailed information, including analyses, is Unlimited Learning Resources - GAAP Page.
