Accountants in the U.S. (and worldwide) must abide by a set of rules and guidelines when reporting their client’s financial data to facilitate a straightforward and transparent transfer of financial information understandable to any interested party.
Today’s Generally Accepted Accounting Principles (GAAP) that most U.S. companies must or choose to follow are based on the basic accounting principles drafted by the American Institute of Accountants (AIA) after the 1929 Wall Street Crash.
The reasoning is: if companies follow consistent methods, the increased transparency will reduce the number of accounting mistakes and instances of fraud.
So, what are the basic accounting principles? Let’s find out!
While complying with the official GAAP requirements is mandatory, the following fundamental accounting guidelines are used in good faith. Note that the list only includes the 10 most important principles while leaving out a few less relevant ones.
First and foremost, any business entity and its transactions should be treated separately from its owners, stakeholders, and their other business dealings.
This distinction is crucial for ensuring that the transactions of specific businesses are accurately recorded and that the liabilities and assets of different entities do not intermingle, making it much easier to check and audit the books.
By distinguishing personal and business transactions, the Economic Entity Principle facilitates a more organized and transparent view of a company's financial health.
Because of that, stakeholders can make informed decisions based on a clear understanding of the company's performance, unclouded by unrelated transactions.
Consider a small business owner who purchases a new laptop for personal use but also uses it during work. Under the Economic Entity Principle, this expense is recorded as a personal purchase, ensuring the company's finances remain intact.
Per this concept, businesses should only use currency units to record their transactions, typically the company’s local currency, in this case, the U.S. dollar.
By doing so, businesses can easily record the exact price and value of their sales and purchases without overestimating or underestimating their value.
When applying the Monetary Unit Principle, companies must use a stable currency to register their transactions. That way, accountants will be prevented from estimating the company’s liabilities and assets.
The principle’s main limitation is that it disregards the effects of inflation and currency fluctuations, which may distort the true value of the assets and liabilities.
Businesses should also report their financial activities in pre-defined and distinct time periods, ranging from weeks to months and years (calendar or fiscal).
Moreover, the time frame should be clearly stated on the company’s financial statements so investors and outside auditors can easily comb through and compare the data.
Regular and uniform reporting periods ensure reliable comparisons across time, thus enhancing the transparency and credibility of the financial data.
Standard reporting periods include weekly, biweekly (every other week), semimonthly (twice per month), monthly, quarterly (four times per year), semi-yearly, and annually (or fiscally), with each serving distinct purposes in financial analysis and reporting.
According to the Cost Principle, all assets, liabilities, and equity investments should be recorded with their original value from when they were initially transacted instead of adjusting their worth based on their condition or market inflation.
Historical cost refers to the original acquisition cost of an asset, which can be used to keep the financial statements unbiased and prevent the overvaluation or undervaluation of assets based on current market conditions.
Although the Cost Principle emphasizes historical cost, it acknowledges that adjustments may still be necessary when inflation significantly impacts the asset’s value.
Under such circumstances, accountants may use the Consumer Price Index (CPI) to adjust the asset’s cost, thus reflecting its current market value.
This principle is the cause of the many footnotes attached to financial statements—it compels businesses to disclose every piece of information relevant to the business, as it may prove vital to lenders, investors, stakeholders, and other interested parties.
Making proper and informed resolutions is only possible if decision-makers have up-to-date, relevant, accurate, and comprehensive financial data.
Investors looking for a sure return on investments, lenders approving huge loan applications, and auditors inspecting the company’s compliance with the applicable regulations all need access to every piece of information to put their decision into context.
Typically, the information is presented in the relevant statements below the on-page summaries. The footnotes include all additional details and explanations regarding specific entries in the financial statements.
Accountants must always support their accounting records with reliable evidence, such as bank statements, appraisal reports, purchase receipts, invoices, checks, and other financial documents supplied by customers, vendors, and other entities.
Then, if and when this proof is requested for whatever purpose, the business should be able to present it promptly and correctly—as long as the documents are verifiable, objective, and dependable, no further investigation will be necessary.
Verifiability implies that multiple accounting professionals, given the same information, would arrive at similar conclusions, thus confirming the data's credibility.
Objectivity requires that accounting records and financial statements remain unbiased, using factual data and disregarding personal opinions and feelings—this impartiality further strengthens the reliability of the financial data.
Based on the accrual accounting system most businesses use, this concept involves recording the revenue and all related expenses simultaneously.
In essence, this principle implies that accountants use the double-entry accounting method, which recognizes two entries for each transaction: debit entries in one account offset by credit entries of the same amount in another.
A company that takes out a bank loan for $50,000 will debit its assets account by $50,000 and credit its loan liability account for the same amount, thus staying true to the Matching Principle with the double-entry method.
Unlike the accrual accounting method, the cash basis one recognizes revenues and expenses only when cash is exchanged. Therefore, businesses using cash basis accounting do not necessarily abide by the Matching Principle.
Adding onto the previous principle, Revenue Recognition refers to recording income as soon as it is earned instead of after it is received at a later date. As such, this guideline is another facet of the accrual accounting system described above.
Revenue should be recognized when: (a) the seller has performed their obligations, (b) the amount can be measured reliably, (c) the economic benefits are likely to flow to the entity, and (d) the costs can be measured reliably.
Accountants that follow the Conservatism Principle record potential expenses and liabilities as soon as possible but only register definite revenues and assets.
By doing so, the projected profits of any business will slant conservatively as less net income will be recorded in any given accounting period.
The main benefit of expecting fewer profits is that businesses start exercising caution in their dealings to increase their earnings. Moreover, no expectations lead to more positive surprises, which typically drive the prices of shares when they happen.
Conservative accounting is open to manipulation by profiteers as they will have an easier time hiding unexpected revenue. On top of that, revenue shifting is a common occurrence in such circumstances—delayed transactions are reported in the next period, resulting in one statement being understated and the next being overstated.
Last but not least, we should cover the Consistency Principle: accountants must utilize the same accounting methods and principles with every task they undertake.
As a result, they will deliver clear and thorough financial reports that can be understood easily once other parties grasp the accounting rules that are being employed.
Companies abiding by the Consistency Principle keep implementing the same accounting methods across all their divisions until better and tested methods can be implemented safely without disrupting routine accounting procedures.
The benefits are clear: third parties can easily audit businesses as every financial statement is clear and comparable; the time to check the books is shortened since external reviewers do not have to learn new accounting methods for different statements; business owners can quickly track the patterns and trends of their finances.
Any set of accounting principles has one main goal: to ensure accurate, complete, consistent, and comparable financial statements across all businesses and industries. This regulation allows both inside and outside investors and regulators to quickly analyze any company’s performance and compare it to others of its kind. Plus, the risk of fraud is greatly reduced since accounting red flags are identified rapidly.
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