What are accounting principles?
Accounting principles are guidelines that businesses and other entities follow when reporting financial data. Accounting principles make it easier for accountants to assess financial data by standardizing the methods they should use.
Basic accounting principles
There are a few basic accounting principles that companies must follow to maintain standard financial statements. They include:
- Accrual principle. According to the accrual principle, transactions must be recorded during the accounting period in which they occur and not when cash flow happens. With this type of accounting, financial records show what happened during the accounting period.
- Conservatism principle. The conservatism principle is when businesses record expenses as soon as they happen. Revenues and assets are recorded only when they are assured. With this principle, businesses may sometimes end up recording losses before they happen. This does not provide an accurate picture of the company’s financial situation.
- Consistency principle. According to the consistency principle, once a business follows one principle, it continues to follow the principle unless there is a compelling reason to change. Failure to do so can make it difficult for users of financial statements to understand and compare the company’s financial performance over time.
- Matching principle. The matching principle states that businesses should record revenues and related expenses at the same time. So, businesses record the cost of purchasing inventory along with the revenue the sold inventory items generated. This is the basis of accrual accounting.
Some of the other principles include cost principle, economic entity principle, full disclosure principle, going concern principle, materiality principle, monetary unit principle, reliability principle, revenue recognition principle, and time period principle.
Standard accounting principles
There are two main standards of accounting principles: International Financial Reporting Standards (IFRS) and generally accepted accounting principles (GAAP). The United States follows GAAP.
GAAP: GAAP is rules-based, and primarily in the U.S. Public companies and non-profit organizations must follow GAAP, and while privately held companies aren’t required to, some follow GAAP if they intend to get loans or other financing. This is because most lenders and investors require GAAP-compliant financial statements. Companies that want to trade publicly have to regularly file financial statements that are compliant with GAAP if they want to be registered on the stock market. Experts consider GAAP to be more static than IFRS.
These principles were set by the Financial Accounting Standards Board (FASB). The members of the FASB are chosen by the independent non-profit Financial Accounting Foundation (FAF).
The Governmental Accounting Standards Board (GASB) sets the GAAP standards for local and state governments, and the Federal Accounting Standards Advisory Board (FASAB), does the same for federal agencies.
IFRS: The International Accounting Standards Board (IASB) issues International Financial Reporting Standards (IFRS). More than 120 countries, including the European Union, use IFRS. It is more dynamic and standardized than GAAP because it goes through regular revisions.
Why are accounting principles important?
Accounting principles make it easier for accountants to read, record, analyze, and report on companies’ financial data. These principles make sure that reports are clear, consistent, and complete.
Since the information across all businesses follows similar principles, it is easier for investors to understand the company’s financial position, and in turn, if they should invest in the company in the first place. Accounting principles also mitigate and help prevent fraud.
