What are the accounting principles?
Accounting principles are the rules and guidelines that companies must follow when reporting financial data. The Financial Accounting Standards Board (FASB) publishes a standard set of accounting principles in the United States, called generally accepted accounting principles (GAAP).
Key points to remember
- Accounting standards are implemented to improve the quality of financial information published by companies.
- In the United States, the Financial Accounting Standards Board (FASB) publishes generally accepted accounting principles (GAAP).
- GAAP is required for all publicly traded companies in the United States; it is also regularly implemented by unlisted companies.
- Internationally, the International Accounting Standards Board (IASB) publishes International Financial Reporting Standards (IFRS).
- The FASB and the IASB sometimes collaborate to publish common standards on hot topics, but the United States does not intend to switch to IFRS in the foreseeable future.
Understand accounting principles
The ultimate goal of any set of accounting principles is to ensure that a company’s financial statements are complete, consistent and comparable. This makes it easier for investors to analyze and extract useful information from the company’s financial statements, including trend data over a specific time period. It also facilitates the comparison of financial information between different companies. Accounting principles also help mitigate accounting fraud by increasing transparency and identifying red flags.
Generally accepted accounting principles (GAAP)
Companies publicly traded in the United States are required to regularly file generally accepted accounting principles or financial statements in accordance with GAAP in order to remain publicly traded. The officers of listed companies and their independent auditors must certify that the financial statements and accompanying notes have been prepared in accordance with GAAP.
Some of the most fundamental accounting principles are as follows:
- Principle of accumulation
- Principle of conservatism
- Principle of consistency
- Cost principle
- Principle of economic entity
- Principle of full disclosure
- Principle of going concern
- Principle of reconciliation
- Principle of materiality
- Principle of monetary unit
- Principle of reliability
- Principle of revenue recognition
- Principle of the period
Accounting principles help to govern the world of accounting according to general rules and guidelines. GAAP attempts to standardize and regulate the definitions, assumptions and methods used in accounting. There are a number of principles, but some of the most notable include the principle of revenue recognition, the principle of correspondence, the principle of materiality and the principle of consistency. The ultimate goal of standard accounting principles is to enable users of financial statements to view a company’s financial statements with confidence that the information disclosed in the report is complete, consistent and comparable.
Completeness is guaranteed by the principle of materiality, as all significant transactions must be recognized in the financial statements. Consistency refers to a company’s use of accounting principles over time. When accounting principles allow a choice between more than one method, an enterprise should apply the same accounting policy over time or disclose its change in accounting policy in the footnotes of financial statements.
Comparability is the ability for users of financial statements to examine the financial statements of multiple companies side by side with the assurance that the accounting principles have been followed under the same set of standards. Accounting information is neither absolute nor concrete, and standards such as GAAP are developed to minimize the negative effects of inconsistent data. Without GAAP, it would be extremely difficult to compare the financial statements of companies, even within the same industry, which would complicate the comparison between apples and apples. Inconsistencies and errors would also be more difficult to spot.
Private companies and not-for-profit organizations may also be required by lenders or investors to file GAAP-compliant financial statements. For example, annual audited GAAP financial statements are a common loan clause required by most banking institutions. Therefore, most companies and organizations in the United States comply with GAAP, although this is not necessarily a requirement.
International Financial Reporting Standards (IFRS)
Accounting principles differ from country to country. The International Accounting Standards Board (IASB) publishes International Financial Reporting Standards (IFRS). These standards are used in more than 120 countries, including those of the European Union (EU).The Securities and Exchange Commission (SEC), the U.S. government agency responsible for protecting investors and policing securities markets, has said the United States will not transition to IFRS for the foreseeable future. However, the FASB and the IASB continue to work together to issue similar regulations on certain topics as accounting issues arise.For example, in 2014, the FASB and the IASB jointly announced new revenue recognition standards.
Since accounting principles differ across the world, investors should exercise caution when comparing financial statements of companies from different countries. The issue of different accounting principles is less of a concern in more mature markets. Nevertheless, caution should be exercised as there is still some leeway for distortion of numbers in many sets of accounting principles.
Frequently Asked Questions
Who sets the accounting principles and standards?
Various organizations issue accounting standards. In the United States, GAAP is regulated by the Financial Accounting Standards Board (FASB). In Europe and elsewhere, IFRS are defined by the International Accounting Standards Board (IASB).
How are IFRSs different from GAAP?
IFRS is a standards-based approach that is used internationally, while GAAP is a rules-based system used primarily in the United States. IFRS is viewed as a more dynamic platform that is regularly revised in response to an ever-changing financial environment, while GAAP is more static. Although the majority of the world uses IFRS, it is still not part of the world of US financial accounting. The SEC continues to review the transition to IFRS, but has not yet done so.
Several methodological differences exist between the two systems. For example, GAAP allows companies to use either first in, first out (FIFO) or last in, first out (LIFO) as the inventory cost method. LIFO, however, is prohibited under IFRS.
When were the accounting principles first established?
Standardized accounting principles date back to the advent of double-entry bookkeeping in the 15th and 16th centuries, which introduced a T-ledger with matched entries for assets and liabilities. Some scholars have argued that the advent of double-entry accounting practices during this era provided a springboard for the rise of commerce and capitalism. The American Institute of Accountants, which is now known as the American Institute of Certified Public Accountants, and the New York Stock Exchange attempted to launch the first accounting standards used by companies in the United States in the years 1930.
What are the criticisms of accounting principles?
Critics of principles-based accounting systems say they can give companies too much freedom and don’t mandate transparency. They believe that because companies do not have to follow specific rules that have been set, their reports can provide an inaccurate picture of their financial health. In the case of rules-based methods such as GAAP, complex rules can cause unnecessary complications in the preparation of financial statements. And having strict rules means that accountants can try to make their businesses more profitable than they actually are because of accountability to their shareholders.