The field of accounting certainly isn’t an easy one to grasp; financial statements and related disclosures are confusing, acronyms like GAAP and FASB don’t make any sense, and the field liberally uses jargon and employs countless technical terms that laypeople find confusing. Accountants are generally thankful for these things because the aforementioned complexity provides them with job security, though it also muddles the waters of understanding that are already considerably murky. Hopefully, this article serves as a water filter for you, in a sense – it’s time to learn about generally accepted accounting principles.
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What Are Generally Accepted Accounting Principles, and What Does the Phrase Mean?
GAAP, pronounced identically to gap, is an acronym for generally accepted accounting principles. To appropriately explain the meaning of this concept and the need for such industry standards, let’s provide some context in terms of what financial accounting is.
Take a Step Back – What Is Accounting for?
Accounting, defined as “the system of recording and summarizing business and financial transactions and analyzing, verifying, and reporting the results” by the Merriam-Webster Dictionary, Although one could dissect enough specific types and uses of accounting to count all of the reader’s fingers and toes, the broadest classifications of the field are threefold.
Tax, Management, and Financial Accounting
Businesses, individuals, and married couples file tax returns to report income to the Internal Revenue Service – in the United States, the tax-collecting government agency is the IRS, though each country has their own such bureau – and pay taxes to be used for societal needs by the general public. This form of accounting is called tax accounting.
Companies, corporations, and businesses incur costs and generate revenue while operating. These entities are deeply concerned with quantifying all revenues and costs of revenues because they would otherwise be unable to determine levels of profit and loss. They also create budgets to evaluate performance and make decisions; this type of accounting is referred to in the industry as management accounting.
Financial accounting informs everyone concerned with the performance of a business how well that entity is doing by ultimately creating financial statements. Shareholders can’t make good decisions without knowing the finances of businesses they invest in. Creditors aren’t sure if they can profit from lending money to companies unless they look to their total assets under management, current liabilities, and ratios between various line items. Other parties like the government and the publishing company’s own management use financial statements, as well.
Here’s How the Concept Relates to Financial Accounting
People use financial statements to compare one company’s financial position to another or industry averages. By themselves, financial statements don’t mean anything – they’re simply boring disclosure forms with numbers littered across them. If financial statements and the field of accounting weren’t regulated, companies’ accountants would make up figures that don’t represent the facts of the businesses they’re supposed to represent.
However, since accounting is regulated, financial disclosures from companies can reliably be used to compare their suitability for investments, potential for growth, and more.
Accounting isn’t very complex in itself, though public companies’ financial statements and related disclosures are endlessly confusing. Thanks to industry standards, however, financial statements can reliably be used to compare companies.
