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 in the United States a standardized set of accounting principles called generally accepted accounting principles (GAAP). Some of the most basic accounting principles are:
- Accumulation principle
- Principle of conservatism
- Principle of consistency
- Cost principle
- Principle of the economic entity
- Principle of full disclosure
- Principle of continuity
- Principle of reconciliation
- Principle of materiality
- Principle of the monetary unit
- Principle of reliability
- Income recognition principle
- Principle of the period
Key points to remember
- Accounting standards are implemented to improve the quality of financial information communicated by companies.
- In the United States, the Financial Accounting Standards Board (FASB) issues generally accepted accounting principles (GAAP).
- GAAP is required for all publicly traded companies in the United States; it is also regularly implemented by companies not listed on the stock exchange.
- 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 current affairs, but the United States does not intend to switch to IFRS in the foreseeable future.
Understanding accounting principles
Generally accepted accounting principles
Companies listed on the United States stock exchange are required to regularly file GAAP financial statements in order to remain listed on the stock exchange. The chief executive officers of listed companies and their independent auditors must certify that the financial statements and accompanying notes have been prepared in accordance with GAAP.
Private companies and not-for-profit organizations may also be required by lenders or investors to file GAAP financial statements. For example, annual financial statements audited under GAAP are a common restrictive clause required by most banking institutions. As a result, most businesses and organizations in the United States comply with GAAP, although this is not necessarily a requirement.
Accounting principles help to govern the world of accounting in accordance with 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 more notable ones include the income recognition principle, the matching principle, the materiality principle and the consistency principle. The ultimate goal of standard accounting principles is to allow users of financial statements to view a company’s financial statements with the certainty that the information disclosed in the report is complete, consistent and comparable.
Completeness is ensured by the principle of materiality, since all major transactions must be recorded in the financial statements. Consistency refers to the use by a company of accounting principles over time. When accounting principles allow you to choose between several methods, a company must apply the same accounting method over time or disclose its change in accounting method in the footnotes of the financial statements.
Comparability is the ability of financial statement users to review the financial statements of multiple companies side by side with the assurance that accounting principles have been followed according to 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 in the same industry, which would make comparison between apples difficult. Inconsistencies and errors would also be more difficult to spot.
International financial reporting standards
Accounting principles differ from country to country. The International Accounting Standards Board (IASB) publishes International Financial Reporting Standards (IFRS). These standards are used in over 120 countries, including those of the European Union (EU). The Securities and Exchange Commission (SEC), the US government agency responsible for protecting investors and policing the securities markets, has said that 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 matters as accounting issues arise. For example, in 2020, the FASB and the IASB jointly announced new revenue recognition standards.
Because accounting principles differ around the world, investors should exercise caution when comparing the financial statements of companies from different countries. The issue of different accounting principles is less of a concern in more mature markets. However, caution should be exercised as there is still room for distortion of the numbers in many sets of accounting principles.