Making Your Accounting Principles Acceptable

It would be very easy for an employee to expect fair treatment from professionals within the company s/he’s employed with. To expect them to act within the precepts of the Golden Rule: “Do Unto Others as You Would Have Them do Unto You” which, if company management were to engage in such honorable behavior, workers would have little or nothing to worry about. But that’s not the case and therefore principles and systems must be employed.

If everyone involved in the process of accounting followed their own system, or no system at all, there would be no way to truly tell whether a company was profitable or not. Most companies follow what is commonly referred to as GAAP (Generally Accepted Accounting Principles), and there are huge tomes in libraries and bookstores devoted to just this one topic.

Unless a company states otherwise, anyone reading a financial statement can make the assumption that company has used GAAP. If GAAP is not the set of principles used for preparing financial statements, then a business needs to make clear which other form of accounting they have used and are bound to avoid using titles in its financial statements that could mislead the person examining it.

GAAP is the gold standard for preparing financial statements and/or a financial report. Not disclosing that it has used principles other than GAAP makes a company legally liable for any misleading or misunderstood data. These principles have been fine-tuned over decades and have effectively governed accounting methods and the financial reporting systems of businesses.

Different principles have been established for different types of business entities, such as for-profit and NFP (Not For Profit) companies/organizations, governments and other enterprises. GAAP is not cut and dried, however. They’re guidelines and, as such, are often open to interpretation. Estimates have to be made at times, and they require good faith efforts towards accuracy.

You have probably heard the phrase “creative accounting,” which is when a company pushes the envelope a little (or a lot) too far to make their business look more profitable than it might actually be. This is also known as massaging the numbers, a practice that can spiral out of control and quickly turn into accounting fraud (or cooking the books). The results of these practices can be devastating and ruinous to hundreds and thousands of lives, as in the cases of Enron, Rite Aid and others.

Can Financial Window Dressing Help Your Business?

Financial managers can do certain things to increase or decrease net income that’s recorded in the year. This is called profit smoothing, income smoothing or just plain old window dressing. This isn’t the same as fraud, or cooking the books, though, just in case that thought had crossed your mind.

Most profit smoothing involves pushing some amount of revenue and/or expenses into other years than they would normally be recorded. A common technique for profit smoothing is to delay normal maintenance and repairs. This is referred to as deferred maintenance. Many routine and recurring maintenance costs required for autos, trucks, machines, equipment and buildings can be delayed, or deferred until later.

A business that spends a significant amount of money for employee training and development may delay these programs until the next year so the expense in the current year is lower. A company can also cut back on its current year’s outlays for market research and product development.

Some businesses might ease up on their rules regarding when slow-paying customers are written off to expense as bad debts or uncollectible accounts receivable. These businesses can put off recording some of their bad debts expense until the next reporting year.

A fixed asset that is not being actively used may have very little current or future value to a business. Instead of writing off the un-depreciated cost of the impaired asset as a loss in the current year, the business might delay the write-off until the next year.

You can see how manipulating the timing of certain expenses can make an impact on net income. This isn’t illegal although companies can go too far in massaging the numbers so that its financial statements are misleading. For the most part though, profit smoothing isn’t much more than robbing Peter to pay Paul.

Accountants refer to these as compensatory effects. The effects next year offset and cancel out the effects in the current year. Less expense this year is balanced by more expense the next year. The important thing is knowing how far to push the envelope in these kinds of maneuvers and keep yourself and your company out of trouble with the IRS, ’cause that kind of a problem you just don’t need.

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Is Disclosure Mandated to Complete Financial Reports?

Financial statements are the backbone of a complete financial report. In fact, a financial report is not complete if the three primary financial statements are not included. but a financial report is much more than just those statements. A financial report requires disclosures. This term refers to additional information provided in a financial report.

Therefore, any comprehensive and ethical financial report must include not only the primary financial statements, but disclosures as well.

The chief executive of a business (usually the CEO in a publicly held corporation) has the primary responsibility to make sure that the financial statements have been prepared according to generally accepted accounting principles (GAAP) and the financial report provides adequate disclosures. He or she works with the chief financial officer or controller of the business to make sure that the financial report meets the standard of adequate disclosures.

Some common methods of disclosures include:

  • Footnotes that provide information about the basic figures. Nearly all financial statements require footnotes to provide additional information for several of the account balances in the financial statements.
  • Supplementary financial schedules and tables that provide more details than can be included in the body of the financial statements.
  • Other information may be required if the business is a public corporation subject to federal regulations regarding financial reporting to its stockholders. Other information is voluntary and not strictly required legally or according to GAAP.

Some disclosures are required by various governing boards and agencies. These include:

  • The financial Accounting Standards Board (FASB) has designated many standards. Its dictate regarding disclosure of the effects of stock options is one such standard.
  • The Securities and Exchange Commission (SEC) mandates disclosure of a broad range of information for publicly held companies.
  • International businesses have to abide by disclosure standards adopted by the International Accounting Standards Board.