What Are Accounting Principles?
You need to know that accounting principles are the guidelines you must follow when recording and reporting your company's accounting transactions. They create uniformity in financial statements, which makes it tougher for firms to hide information or inflate their numbers. These principles also simplify understanding a business’s health and comparing financials across companies or periods. In the U.S., you follow generally accepted accounting principles (GAAP). In many other countries, it's international financial reporting standards (IFRS).
Key Takeaways
Remember, accounting principles are the rules public companies must use for preparing and disclosing financial statements. They're based on core practices; for instance, the matching principle requires recording revenue and expenses at the same time. External auditors check if a company follows these principles. Since different boards have preferences, multiple standards exist, like GAAP and IFRS.
Understanding Accounting Principles
These principles explain how you should report transactions such as sales, purchases, and payments. Before they existed, companies could record and report data however they wanted, making statements hard to compare and easy to skew positively. For investors and regulators, that was a real problem.
The origins go back to the 1929 Stock Market Crash and the Great Depression. Companies had free rein then, often hiding losses and inflating profits with creative methods. After the crash, investigations revealed widespread manipulation that fueled speculation, leading Congress to pass the Securities Acts of 1933 and 1934 to protect investors.
Those laws created the Securities and Exchange Commission (SEC) and required standardized reporting for public companies. In the same decade, the American Institute of Certified Public Accountants (AICPA) collaborated with the SEC to develop the first formal standards. In other countries, IFRS from the International Accounting Standards Board (IASB) handles this.
The Core Principles
- Conservatism Principle: Recognize expenses and liabilities as soon as possible, even if uncertain, but only record revenues and assets when certain—to be open about losses and cautious about gains.
- Consistency Principle: Once you adopt a method, stick to it for easy comparisons over time.
- Cost Principle: Record assets, liabilities, or equity at original purchase cost.
- Economic Entity Principle: Keep company and owner transactions separate with distinct records and accounts.
- Full Disclosure Principle: Reveal all relevant material information in statements, like breakdowns of write-downs or depreciation.
- Going Concern Principle: Defer some expenses like depreciation assuming the company will continue operating.
- Matching Principle: Record expenses related to revenue in the same period as the revenue.
- Materiality Principle: Report in detail anything likely to impact investor decisions.
- Monetary Unit Principle: Only record items expressible in currency to avoid inflating with intangibles like employee quality.
- Objectivity Principle: Base accounting on facts and evidence, free from bias.
- Reliability Principle: Only record transactions with evidence like receipts or invoices.
- Revenue Recognition Principle: Recognize revenues when realized and earned, not just when cash is received.
- Time Period Principle: Report activities over standard periods like quarters or years.
Generally Accepted Accounting Principles (GAAP)
GAAP are the principles all regulated U.S. entities—public companies, government agencies, nonprofits—must follow. The Financial Accounting Standards Board, an independent nonprofit chosen by the Financial Accounting Foundation, sets and revises them. Compliance gets verified by external audits from certified public accountants.
Companies often include non-GAAP figures alongside compliant ones in statements. If it's non-GAAP, they must disclose it, and you as an investor should note that.
International Financial Reporting Standards (IFRS)
IFRS are used in 168 jurisdictions, including the EU, U.K., Canada, India, Russia, South Korea, South Africa, and Chile. The IASB, an independent body in London, issues and maintains them.
Their 17 standards cover topics from revenue recognition to insurance and leases, based on clarity, relevance, reliability, and comparability.
Enforcement varies by country; in the EU, all companies must comply, while elsewhere it might apply only to banks or large firms.
Warning
Be cautious when comparing statements from different countries, as not all principles are identical.
IFRS vs. GAAP
Both share the goal from 1930s reforms: protecting investors via transparency and consistency. IFRS is principles-based, allowing interpretation, while GAAP is rules-based, specifying exact preparations.
They differ in recording transactions, like balance sheet formats, interest treatment, asset revaluations, inventory, intangibles, R&D expenses, liabilities, and revenue. For example, GAAP allows last-in, first-out inventory but not reversals, while IFRS bans the method but permits reversals under conditions.
The Bottom Line
Accounting principles ensure your company's reporting is transparent, consistent, and objective, using uniform metrics and approaches. For you as an investor, this makes statements similar, easier to understand, analyze, and compare.
Principles vary by region but share fundamentals: be conservative on income estimates and forthcoming on expenses.
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