What are accounting principles?
Accounting principles are the rules and guidelines that companies and others must follow when reporting financial information. These rules make it easier to audit financial data by standardizing the terms and methods accountants must use.
TheInternational Financial Reporting Standards (IFRS)is the most widely used set of accounting principles, having been adopted in 167 jurisdictions. The United States uses a separate set of accounting standards known asgenerally accepted accounting principles (GAAP).
The central theses
- Accounting standards are being introduced 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 US; It is also routinely implemented by unlisted companies.
- Internationally, the International Accounting Standards Board (IASB) issues the International Financial Reporting Standards (IFRS).
- The FASB and IASB sometimes work together to issue joint standards on hot topic issues, but there are no plans for the US to move to IFRS anytime soon.
The purpose of the accounting principles
The ultimate goal of all accounting principles is to ensure that a company's financial statements are complete, consistent and comparable.
This makes it easier for investors to analyze and extract useful information from the company's financial statements, including trending 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 enabling red flags to be identified.
The ultimate goal of standardized accounting principles is to enable users of financial statements to examine an entity's financial information with confidence that the information disclosed in the report is complete, consistent and comparable.
Comparability is the ability for users of financial statements to examine the financials of multiple companies side-by-side, with assurance that accounting principles have been followed to the same standards.
Accounting information is not absolute or concrete, and standards are developed to minimize the negative impact of inconsistent data. Without these rules, comparing financial statements between companies, even within the same industry, would be extremely difficult. Inconsistencies and errors would also be harder to spot.
What are the basic accounting principles?
Some of the most basic accounting principles include the following:
- delimitation principle
- conservative principle
- consistency principle
- cost principle
- principle of economic unity
- Full Disclosure Principle
- Appropriate principle
- materiality principle
- Principle of monetary unit
- reliability principle
- Principle of revenue recognition
- period principle
Among the most notable principles are theRevenue RecognitionPrinciple, Matching Principle, Materiality Principle and Consistency Principle. Completeness is ensured by the principle of materiality, since all significant business transactions are to be taken into account in the annual financial statements. Consistency refers to a company's application of accounting principles over time.
When accounting policies allow for a choice between multiple policies, an entity should apply the same accounting policy or change its accounting policy over timeNotes to the financial statements.
Generally Accepted Accounting Principles (GAAP)
Generally Accepted Accounting Principles (GAAP) are uniform accounting principles for private companies and non-profit organizations in the United States. These principles are largely supported by theFinancial Accounting Standards Board (FASB), an independent non-profit organization whose members are elected by theFinancial Accounting Foundation.
A similar organization thatGovernment Accounting Standards Board (DRSB), is responsible for establishing GAAP standards for local and state governments.And a third body, the Federal Accounting Standards Advisory Board (FASAB), publishes accounting standards for federal agencies.
Although private companies are not required to comply with GAAP, public companies must file in accordance with GAAPfinancial statementsbe listed on a stock exchange. Chief officers of public companies and their independent auditors are required to certify that the financial statements and related notes have been prepared in accordance with GAAP.
Private companies and non-profit organizations may also be required by lenders or investors to file GAAP-compliant financial statements. For example, audited GAAP financial statements are a common loanBundrequired by most banking institutions. Therefore, most companies and organizations in the US adhere to GAAP, although it is not a legal requirement.
Accounting standards differ around the world, which means that it is not always easy to compare the financial statements of companies from different countries.
International Financial Reporting Standards (IFRS)
The International Accounting Standards Board (IASB) issues the International Financial Reporting Standards (IFRS). These standards are used in more than 120 countries, including the European Union (EU).
TheSecurities and Exchange Commission (SEC), the US government agency responsible for protecting investors and maintaining order in the United StatessecuritiesMarkets, has expressed an interest in moving to IFRS. However, given the differences between the two standards, the US is unlikely to switch any time soon.
However, the FASB and IASB continue to work together to issue similar guidance on specific issues when accounting issues arise.For example, in 2014 the FASB and IASB jointly announced new revenue recognition standards.
Because accounting standards differ around the world, investors should exercise caution when comparing the financial statements of companies from different countries. The issue of different accounting standards is less problematic in more mature markets. However, caution should be exercised as there is still room for bias in many accounting standards.
Who sets accounting policies and standards?
Various committees are responsible for setting accounting standards. In the United States, generally accepted accounting principles (GAAP) are regulated by the Financial Accounting Standards Board (FASB). In Europe and elsewhere, International Financial Reporting Standards (IFRS) are set by the International Accounting Standards Board (IASB).
How do IFRS differ from GAAP?
IFRS is a standards-based approach used internationally, while GAAP is a rules-based system used primarily in the United States. IFRS is viewed as a more dynamic platform that is regularly revised in response to an ever-changing financial environment, while GAAP is more static.
There are several methodological differences between the two systems. For example, GAAP allows companies to use either a first in, first out (FIFO) or last in, first out (LIFO) inventory cost method. However, LIFO isprohibited under IFRS.
When were accounting principles first established?
Standardized accounting principles date back to the advent ofdouble entry bookkeepingin the 15th and 16th centuries, which introduced a T-ledger with matching entries for assets and liabilities.Some scholars have argued that the advent of double-entry bookkeeping practices during this period provided a springboard for the rise of commerce and capitalism. In the 1930s, what would later become the American Institute of Certified Public Accountants (AICPA) and the New York Stock Exchange (NYSE) attempted to establish the first accounting standards to be used by firms in the United States.
What are some criticisms of accounting standards?
Critics of principles-based accounting systems say they can give companies far too much freedom and not mandate transparency. They believe their reporting can give an inaccurate picture of their financial health because companies don't have to follow specific rules that have been set. With rules-based methods like GAAP, complex rules can create unnecessary complications in the preparation of financial statements. These critics claim that strict rules mean companies have to expend an unfair share of their resources to comply with industry standards.
The final result
Accounting principles are rules and guidelines that companies must follow when reporting financial data. Whether it is GAAP in the US or IFRS elsewhere, the overarching goal of these principles is to increase transparency and generally make it easier for investors to compare the financial statements of different companies.
Without these rules and standards, public companies would likely present their financial information in a way that inflates their numbers and makes their trading performance look better than it actually was. If companies could choose what information to disclose and how, it would be a nightmare for investors.