Accounting principles are rules and guidelines that aim to standardize accounting and improve the quality of the financial information companies report every year.
The Basic Accounting Principles and Assumptions:
Basic Accounting Principles:
1. Economic entity assumption.
The principle states that the activities of a business must be kept separate from those of its owner and other economic entities. Even different business divisions within the same company must keep separate records. This is to ensure that when someone reviews a company's financial records they can assume the records accurately reflect only the information pertaining to that particular company's transactions and other related activities.
Economic entity assumption example:
Susan owns a small video production company. The following transactions appear in her records:
- A camera.
- Editing software.
- A projector.
- Two desktop computers.
- Payments made to a construction company for a pool.
- A desk.
- Two airplane tickets to Spain for a family holiday.
Only the expenses relating directly to the company should be in the company's financial records. All else, the pool payments and airplane tickets, should be removed. They belong in Susan's financials, not the company's.
2. Monetary unit assumption.
The Monetary Unit Assumption concept states that if transactions and other activities can be measured and expressed in monetary terms they can be recorded on the balance sheet. It doesn't matter what currency is being used, it need only be stable and dependable.
Monetary unit assumption examples:
- A design company has within it a visionary art director that is undoubtedly the company's biggest asset, but the art director cannot be expressed objectively in terms of monetary units. So, this is not an asset the company can report in its accounting records.
Note on monetary unit assumption:
In the U.S., the Monetary Unit Assumption does not make allowances for inflation. So, commercial property bought in 1965 for $500,000 will still, twenty years later, be recorded on the balance sheet as being worth $500,000.
3. Time period assumption.
Also known as the periodicity assumption, the time period assumption allows the ongoing activities of a business to be broken up into periods of a quarter, six months, and a year. These periods are known as accounting periods.
Different financial statements are created in relation to different accounting periods.
Time period assumption example:
- An income statement prepared for the accounting period 2018 - 2019 will reflect how profitable a company was for that year.
4. Cost principle.
The cost principle states that anything acquired by a company through a transaction must be recorded in financial records at its original cash value. The asset's recorded value will not fluctuate along with inflation or changes in market value.
Only assets acquired through transactions may appear on a company's balance sheet.
Cost principle example:
- A company buys a delivery vehicle for $5,000 in 2015. In 2020, the vehicle is valued at $1,000. Instead of changing the entries in the financial records, the difference in market value is represented over the asset's lifetime. So, for the five years in which the vehicle was in use, the company expenses an annual amount to a depreciation account and leaves the value of the asset unchanged in the balance sheet.
Accounting for appreciation and depreciation in the cost principle:
Appreciation is treated as a gain. While the original value of the asset goes unchanged in the balance sheet, the difference between the original value and the increased value is recorded as "revaluation surplus."
Depreciation is treated as a loss. While the original value of an asset on the balance sheet goes unchanged, the difference between the original value and the lower market value is expensed every year over the course of the asset's life.
Pros and cons of cost principle:
- More straightforward to record assets at historical value.
- Original purchase price of an asset is easily confirmed.
- Accountants need less time to verify the value of assets.
- Increasingly seen as inaccurate.
- Doesn't allow some valuable assets to be recorded on the balance sheet.
5. Full disclosure principle.
The Full Disclosure Principle is there to make companies report and share all necessary and relevant information transparently. Essentially, any information that could impact important business decisions relating to the company and its activities must be reported openly in its financial statements.
Full disclosure principle examples:
Potential investors should be told the company is facing a lawsuit.
Any changes in accounting policies must be reported.
Inventory losses must be recorded in financial statements.
Significant business relationships must be defined and explained.
6. Going concern principle.
The going concern principle assumes a company will stay in business in the future as long as there is no evidence to the contrary. This allows companies to accrue expenses in the belief that they will still be in operation when it is time to meet financial obligations.
If there is evidence a business will soon be liquidated, then it can no longer be considered a going concern. There are a number of reasons for this with a company's inability to pay back financial obligations chief among them.
Going concern principle example:
- A company makes pesticides. Suddenly, pesticides are no longer legal. Seeing as pesticides are all the company makes, it can not be considered a going concern for it will soon be out of business.
7. Matching principle.
The matching principle states that any expenses and the revenues they create should be recognized in the same period. The principle acknowledges that a cause and effect relationship exists between expense and revenue.
If there is no revenue caused by an expense, the expense is recorded when incurred.
- A secondhand videography gear store buys a camera for $4,000. It then sells the camera a few months later for $5,600. Seeing as the cost of the camera and the revenue it produced upon the sale can be matched, they should be recorded in the same accounting period.
8. Revenue recognition principle.
Relating to the accrual principle, the revenue recognition principle says that a company should record revenue when a sale has been made or service is done, not when the sale and service are paid for.
This regulates what can be considered as revenue and when it should be recorded.
Revenue recognition principle example:
- A design agency has delivered a logo to a company. The agency can recognize the revenue upon delivery of the logo, regardless of when it will be paid for the service.
9. Materiality principle.
The materiality principle states that other accounting principles do not necessarily have to be followed if the net impact of ignoring them is negligible. Materiality refers to the size of an amount and how it relates to the size of the company.
Determining whether or not an amount or transaction is immaterial requires professional judgement. But a good test is whether determining something as immaterial actually ends up misleading investors or decisionmakers.
Materiality principle example:
- The cost principle states that one should expense depreciation over the lifetime of an asset. If the depreciation is so small, one need not carry the expense over in smaller amounts across the asset's useful lifetime. Investors are not going to be misled by a $100 expense for a coffee machine not being broken up over five years to account for depreciation.
10. Conservatism principle.
The conservatism principle says that company accounts should be prepared with caution and some moderation, especially in times of uncertainty. So, in such times, liabilities should be recognized immediately upon discovery and revenues only when verified.
When faced with an accounting challenge, the accountant should take the least optimistic view of the situation.
Conservatism principle example:
- A company is being sued for $100 million. It is uncertain whether the company will lose the lawsuit or not, so the accountant, following the conservatism principle, taking the less optimistic view, would recognize the $100 million as a liability/expense.
11. Accrual principle.
The accrual principle states that transactions should be recorded when they happen and not when their resulting cashflow happens.
Accrual principle example:
- The recording of revenue the day you send an invoice to a client and not on the day a month later when the client actually pays.
12. Reliability principle.
Also known as the objectivity principle, the reliability principle is used as a guide for knowing what information is accurate, trustworthy, fair, and relevant. Only those transactions that can easily be verified with evidence should be recorded in accounts.
13. Consistency principle.
The consistency principle states that once a company has decided on an accounting principle it can't change it unless this change would lead to more accurate financial reporting.
Such a change in accounting principles must be documented. This is in accordance with the full disclosure principle.
Consistency principle example:
- If your company has used the accrual method for revenue and expenses, you can't suddenly switch to the cash method.
Generally Accepted Accounting Principles:
These principles form the foundation of the set of accounting principles issued annually by the Financial Accounting Standards Board (FASB) called the generally accepted accounting principles (GAAP), a national framework all publicly traded companies must follow.
What are the principles of GAAP?
- The principle of consistency.
- The principle of permanent methods.
- The principle of non-compensation.
- The principle of prudence.
- The principle of regularity.
- The principle of sincerity.
- The principle of good faith.
- The principle of materiality.
- The principle of continuity.
- The principle of periodicity.
When was GAAP established?
The term "generally accepted accounting principles" was first used in an American Institute of Accountants' publication in 1936.
What is the difference between GAAP and IFRS?
The International Financial Reporting Standards (IFRS) are used in 110 countries, whereas the Generally Accepted Accounting Principles are used only in the U.S. It has been argued that GAAP is more rules-based, and IFRS, principles-based.
Why is GAAP important?
- It standardizes accounting methodologies.
- It improves the accounting quality.
- Company financials can easily be evaluated.
- GAAP can be used to track financial performance.
Who uses GAAP?
Publicly traded companies and other regulated companies use GAAP. Smaller companies aren't forced to use GAAP unless they're in the process of obtaining credit or looking for investors. Government agencies have a different set of GAAP to follow, regulated by the Government Accounting Standard Board.
What are the 4 accounting conventions?
- Full disclosure.
How many GAAP rules are there?
There are ten GAAP principles.