What Are Accounting Principles?
Accounting principles are the rules and guidelines that companies must follow when reporting financial data. The Financial Accounting Standards Board (FASB) issues a standardized set of accounting principles in the U.S. referred to as generally accepted accounting principles (GAAP).
Key Points
>Accounting standards are implemented to improve the quality of financial information reported 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 U.S.; it is also routinely implemented by non-publicly traded companies as well.
>> Internationally, the International Accounting Standards Board (IASB) issues International Financial Reporting Standards (IFRS).
>> The FASB and IASB sometimes work together to issue joint standards on hot-topic issues, but there is no intention for the U.S. to switch to IFRS in the foreseeable future.
Understand the principles of accounting
The ultimate goal of any set of accounting principles is to ensure that the company’s financial statements are complete, consistent, and comparable. This makes it easier for investors to analyze and extract useful information from a company’s financial statements, including trend data over a period of time. It also makes it easier to compare financial information across different companies. Accounting principles also help mitigate accounting fraud by increasing transparency and allowing red flags to be identified.
Generally Accepted Accounting Principles (GAAP)
Publicly traded companies in the United States are required to file GAAP, or GAAP-compliant financial statements in order to remain publicly listed on stock exchanges. The heads of publicly traded companies and their independent auditors must certify that the financial statements and related notes have been prepared in accordance with generally accepted accounting principles.
Some of the basic accounting principles include:
<>Entitlement principle
<>Conservative principle
<>Consistency principle
<>Costing principles
<>The principle of economic entity
<>The principle of full disclosure
<>The principle of continuity
<>Matching principle
<>The principle of materiality
<>Monetary unit principle
<>Reliability principle
<>Revenue recognition principle
<>Time period principle
GAAP helps govern the world of accounting by standardizing and regulating the definitions, assumptions, and methods used by accountants across the country. There are a number of principles, but the most prominent among them are the revenue recognition principle, matching principle, materiality principle and consistency principle. The ultimate goal of Uniform Accounting Principles is to allow users of financial statements to view a company’s financial statements while ensuring that the information disclosed in the report is complete, consistent, and comparable.
Completeness is ensured by the principle of materiality, whereby all material transactions must be accounted for in the financial statements. Consistency refers to a company’s use of accounting principles over time. When accounting principles allow a choice between multiple methods, the company must apply the same accounting method over time or disclose its change in accounting method in the footnotes in the financial statements.
Comparability is the ability of users of financial statements to review the financial statements of several companies along with ensuring that accounting principles are followed by the same set of standards. Accounting information is not absolute or tangible, and standards such as GAAP are developed to minimize the negative effects of inconsistent statements. Without GAAP, comparing corporate financial statements would be very difficult, even within the same industry, which makes the “apples to apples” comparison difficult. It will also be difficult to spot inconsistencies and errors.
Privately owned businesses and nonprofit organizations may also be required by lenders or investors to submit GAAP-compliant financial statements. For example, GAAP Audited and Audited Annual Financial Statements is a common loan covenant required by most banking institutions. Therefore, most companies and organizations in the United States comply with GAAP, although it is not necessarily a requirement.
International Financial Reporting Standards (IFRS)
Accounting principles differ from state to state. The International Accounting Standards Board (IASB) issues International Financial Reporting Standards (IFRS). These standards are used in more than 120 countries, including those in the European Union (EU). The Securities and Exchange Commission (SEC), the US government agency responsible for protecting investors and maintaining order in stock markets, has stated that the US will not switch to IFRS for the foreseeable future. However, the Financial Accounting Standards Board and the International Accounting Standards Board continue to work together to issue similar regulations on certain topics when accounting issues arise. For example, in 2014, the Financial Accounting Standards Board and the International Accounting Standards Board jointly announced new revenue recognition standards.
Since accounting principles differ around the world, investors should exercise caution when comparing financial statements for companies from different countries. The issue of differing accounting principles is less relevant in more mature markets. However, caution should be exercised as there is still room for numerical distortion under many sets of accounting principles.
Who sets the principles and standards of accounting?
Various bodies are responsible for setting accounting standards. In the United States, GAAP is regulated by the Financial Accounting Standards Board (FASB). In Europe and elsewhere, IFRS are set by the International Accounting Standards Board (IASB).
How do IFRS differ from GAAP?
International Financial Reporting Standards (IFRS) is a standards-based approach that is used internationally, while GAAP is a rules-based system that is primarily used in the United States. GAAP is more stable.
There are many methodological differences between the two systems. For example, GAAP allows companies to use either first in, first out (FIFO) or last in, first out (LIFO) method as their inventory cost method. However, LIFO is banned under IFRS.
When were accounting principles first established?
Standardized accounting principles date back to the emergence of double-entry bookkeeping in the 15th and 16th centuries that introduced the T ledger with matching entries for assets and liabilities. Some scholars have argued that the emergence of double-entry accounting practices during that time was a springboard for the rise of commerce and capitalism. The American Institute of Certified Public Accountants and the New York Stock Exchange attempted to launch the first accounting standards to be used by companies in the United States in the 1930s.
What are some criticisms of accounting principles?
Critics of principle-based accounting systems say they can give companies too much freedom and not impose transparency. They believe that because companies do not have to follow specific rules that have been set in place, their reports may provide an inaccurate picture of their financial health. In the case of rule-based methods such as GAAP, complex rules can cause unnecessary complications in the preparation of financial statements. These critics claim that having strict rules means that companies must expend an unfair amount of their resources in order to comply with industry standards.