Definition: Accounting principles are the logical and formal set of rules and guidelines that companies must follow when reporting financial data. Accounting principles are based on how companies handle assets and liabilities, income statements, income tax returns, and balance sheets. These standards allow the public to see how profitable a company is in comparison to its peers.
They are based upon standards established by various organizations like the International Accounting Standards Board (IASB). These are the standards laid out for an organization to follow when creating or updating its internal accounting practices. Accounting principles are fundamental to understand because they help us understand how everything works behind the scenes and how much work goes into preparing and maintaining financial records for an organization.
GAAP is the acronym for Generally Accepted Accounting Principles. These serve as a common set of rules and guidelines to help companies produce financial statements according to some specific standardization.
In accounting, generally accepted accounting principles (GAAP) are principles used to prepare financial statements, reports, and other documentation used by investors, creditors, companies, and anyone else who requires financial information. GAAP goals are to provide a reliable and consistent method of preparing financial statements that consistently communicate the amount of cash generated, spent, and owed by a company in a given period. It supports financial reporting by providing appropriate standards for interpreting and reporting non-cash items such as inventory, property, plant, equipment, and inventory replacement.
Importance of Accounting Principles
- Accounting is essential because any mismanagement can cause financial trouble for a company. That trouble can affect its ability to perform its primary duty, managing its cash, borrowing, and investments.
- Accounting principles help explain how companies account for changes in their assets, liabilities, revenue, expenses, assets/liabilities, and other elements that make up the financial statements.
- An accounting principle is a statistical concept that helps determine what should be included in a company’s statements. Accounting principles are designed to help maintain consistency within a company’s financial statements by providing guidelines for how variables should be recorded to make comparisons across different periods.
- An effective accounting principle allows an organization to identify either positive or negative trends in its business operation. When these trends are identified, corrective action can be taken to minimize or eliminate the issues
- Accounting principles are used to prevent financial fraud, but it can be challenging to check or audit your financial statements. Accounting principles are designed to help with those checks and audits. These principles are found in numerous ranges of accounting textbooks, supplemental materials, and technical documents. These are simple rules designed to reduce errors in data and increase financial literacy among analysts, actuaries, and auditors.
The 10 general principles used in GAAP are
- Principle of Regularity- GAAP generally accepted accounting principles are guidelines that companies are required to follow to ensure the information they present is truthful and accurate.
- Principle of Consistency- Accountants are held to the principle of consistency. They should apply the same accounting standards throughout the reporting period and explain them in the footnotes.
- Principle of Sincerity- To the accountant, it’s a duty to ensure that a company’s financial situation is presented in a non-misleading manner.
- Principle of Permanence of Methods- Accounting procedures must be uniform so that it is possible to make meaningful comparisons between the financial statements of one time period with those of another.
- Principle of Non-Compensation- All transactions should be reported in a balanced, objective way. Full reporting, including both gains and losses, must be presented to ensure financial transactions are completely valid.
- Principle of Prudence- Businesses need to be able to report on their financial position accurately. The principle of prudence ensures that accounting policies are clear enough for decision-making and sound sufficient to measure the present position of the business.
- Principle of Continuity- Assets should be recorded at their fair value, assuming that the business will continue to operate until liquidation.
- Principle of Periodicity- The periodicity principle requires that all accounting entries are appropriately classified and recorded in the correct accounting period.
- Principle of Materiality- As a professional practice, accountants are expected to give a complete and accurate picture of a company’s financial position.
- Principle of Utmost Good Faith- Principle of Utmost Good Faith dictates that partners in the insurance industry deal honestly and that all facts about a particular transaction be properly disclosed.
Basic Accounting Principles
Accounting principles are the bedrock of any proper economic analysis and management. They establish the basis of basic accounting principles for the entire financial operation of a company or any other organization. The basic principles are meant to develop the behavior of a financial accounting system, regardless of the particular locale, industry, or institution in which financial statements are prepared.
Some of the most basic accounting principles are:
1. Accrual principle
It is a fundamental principle of accounting that income and expenses should be recognized in the period in which they occur.
2. Conservatism principle
Conservatism is the proper concept of accounting. Every company should account for both its income and its expenses. Still, when they calculate revenues and expenses, companies sometimes think they must only allocate income when certain that the company will make money in the future.
3. Consistency principle
Consistency accounting principle deals with how you can adopt a better accounting principle or system if your prior practice wasn’t doing it right. It requires you to examine yourself first to determine if the principle or system that you signed up for meets your individual goals. If it didn’t, then you shouldn’t be using it. Consistency accounting principle is a bit like the golden rule in business. If you treat others well, treat yourself well and treat your customers with respect, you will reap the rewards.
4. Cost principle
The cost accounting principle states that a business should only include costs when it actually spends money on goods or services. This principle makes it easier for businesses to hold steady costs as technology changes, which is good for businesses.
5. Economic entity principle
Economic entity principle is based on the notion that a company’s total assets, revenues, and profits should be taken into account in the allocation and use of resources and economic activity in a community.
6. Full disclosure principle
Full Disclosure principle refers to a principle that financial institutions must embrace and all readers of financial statements should be aware of. The purpose of this principle is not to force lenders to give preferential treatment to certain businesses but to ensure that all banks provide transparent, consistent, and honest information at all times.
7. Going concern principle
Going concern principle is a simple concept. It is the concept of an entity that operates continuously with sufficient funds to pay off its debts in full and within a certain time period.
8. Matching principle
Matching principle is the cornerstone of accounting. It ensures that we capture all of the income and expenses necessary to meet our basic financial needs and account for them properly. Yet, many people don’t know what the matching principle is or what it means. In simple terms, the matching principle states that your daily recorded revenue should also include day-to-day costs that are indirectly related to your primary source of revenue.
9. Materiality principle
Materiality, or accuracy, works by supposing that if you did not record a transaction, then it would influence the way someone else interpreted the statement. This leads to the general principle that you should write down everything if it could conceivably impact the decision-making process.
10. Monetary unit principle
The monetary Unit principle is an important concept in economics and business. In a free-market economy, said principle states that a business’s activities should consist only of transactions for a stable unit of currency. In this way, it prevents fluctuations of prices from changing the amount of money in circulation.
11. Reliability principle
The principle holds that only certain transactions on a credit card should be recorded, and those only because they can be proven to have occurred. There can be no question about who paid for anything; once the borrower has paid the bill for something, the debt for that purchase ends with that original buyer.
12. Revenue recognition principle
The revenue recognition principle (RRP) states that the revenue earned by a company should be recognized at the time of the transaction. This can be either a cash payment or a service rendered such as a speech or training.
13. Time period principle
A business should report its financial statements (income statement/balance sheet) appropriate to a specific time period. Unlike income statements that appear in a calendar year, balance sheets are executed on an annual basis.
Compliance with GAAP
GAAP stands for Generally accepted accounting principles. They are rules written by the U.S. Securities and Exchange Commission (SEC). The SEC requires publicly traded companies in the U.S. to follow GAAP (generally accepted accounting principles) in order to remain listed on an exchange such as the NYSE (New York Stock Exchange) or NASDAQ (National Association of Securities Dealers Automated Quotations).
It is not needed for non-publicly traded companies to follow GAAP, the Generally Accepted Accounting Principles of the United States. However, because most lenders and creditors in the United States follow GAAP, most companies do as well. To qualify for most bank loans, the company must prepare annual financial statements prepared following GAAP. Banks will generally not make loans to companies that do not have an established and consistent GAAP-compliant reporting system in place.
If a set of financial data has not been fairly and accurately prepared following Generally Accepted Accounting Principles, investors should be skeptical. Any non-GAAP measures provided by a company should be clearly defined, explained, and reconciled to its most directly comparable GAAP measure. GAAP requires that non-GAAP measures be identified in financial disclosures and public statements.
GAAP vs. IFRS
GAAP are state-set accounting standards used for financial reporting. GAAP standards are primarily focused on U.S. companies. Although commonly used in other countries, the International Financial Reporting Standards (IFRS) are becoming the international alternative to GAAP standards. Both of these standards are set by private organizations rather than governmental entities.
The IASB and the FASB are working since 2002 to reconcile GAAP financial reporting standards and IFRS. Recently, the SEC removed the requirement for non-U.S. companies registered in USA to reconcile their financial reports with GAAP if their accounts already complied with IFRS.
Few differences between the two are listed below:
- The International Financial Reporting Standards (IFRS) are the globally accepted accounting principles, whereas the Generally Accepted Accounting Principles (GAAP) are the generally accepted accounting principles used in the United States.
- GAAP (Generally Accepted Accounting Principles) are standards that are revised infrequently. On the other hand, IFRS (International Financial Reporting Standards) are revised more regularly to reflect changes in the financial environment.
- The Generally Accepted Accounting Principles (GAAP) allow companies to use either the First in, First out (FIFO) or Last in, First out (LIFO) method as an inventory cost method. However, LIFO is banned under IFRS.
- Under GAAP, research and development costs must be expensed as incurred. Under IFRS, certain costs can be capitalized over multiple periods if conditions are met.
- GAAP states that a company cannot reverse a write-down on their annual report, where IFRS can.
Where are generally accepted accounting principles (GAAP) used?
Generally accepted accounting principles (GAAP) are rules and standards used by government agencies, financial analysts, and investors to ensure that its financial statements provide accurate information about its performance. Investors use GAAP numbers to measure a company’s performance against previous periods. The SEC and other regulatory authorities also use GAAP numbers.
Why is GAAP important?
GAAP is important because it establishes a consistent standard of presentation within the financial markets. Investors have confidence in the validity and consistency of publicly-shared information because GAAP provides a uniform measure by which to express balance sheet and income statements, as well as other financial disclosures. The consistency of the GAAP rules assures investors have confidence in the information presented by companies.
What are non-GAAP measures?
Non-GAAP measures are any measurements that deviate from Generally Accepted Accounting Principles. GAAP are the rules that govern financial statement preparation and presentation. Companies sometimes use Non-GAAP to report a performance metric when they believe the GAAP rules are not flexible enough to capture certain aspects about their operation. Investors should always be wary of non-GAAP measures. Although there are legitimate uses for them, they can easily be used misleadingly.
Who sets accounting principles and standards?
Several organizations sets standards–in the U.S., GAAP is created by the Financial Accounting Standards Board (FASB). In other countries, IFRSs are regulated and maintained by the International Accounting Standards Board (IASB).
What are some critiques of accounting principles?
Some critics say that principles-based accounting systems are too flexible, potentially misleading some investors. They believe because companies do not have to follow specific rules that have been set out, their reporting may provide an inaccurate picture of their financial health.
While rules-based methods like GAAP have their uses, they have significant drawbacks. These disadvantages are most notable when these methods cause unnecessary complications during the preparation of financial statements. This situation is made worse when accountants use rules that encourage them to prepare accounting statements that over-or understate the performance of their companies because such statements are more likely to please stakeholders.
An accounting principle is the best representation of how proper financial analysis should be conducted. Accounting principles cover the various steps that make up the process of managing a company’s financial information.
Accounting principles help investigate any discrepancies or problems that arise between the accounts of different companies, as they provide a framework for the accountant to have visibility over every activity in the accounting process. These principles also help keep the financial statements organized and informative throughout their lifecycle.