What are Accounting Principles?
Accounting Principles are the set of rules and guidelines that govern how companies record and report financial data. They are extremely important because they standardize the way companies present their financials. They standardize and regulate accounting definitions, assumptions, and methods. For example, these principles lay forth the exact criteria under which a company may record revenue. Any well-trained Analyst will understand what a company’s revenue represents because it’s clearly defined with a standardized set of criteria.
You can think of these principles as the grammar behind a language. Just like grammar governs how we use words, these principles govern how companies record financial data. Without grammar, there wouldn’t be a standardized way of constructing sentences and people’s words wouldn’t make any sense. Likewise, without Accounting Principles, companies wouldn’t have a standardized method of recording financials. Different companies’ financial statements would use different methodologies, which will be extremely confusing for Analysts. Companies would also have wide leeway to manipulate financials. That’s why governments all over the world require companies to follow Accounting Principles. It creates a uniform accounting methodology and reduces room for fraud.
Globally, there are three sets of accounting standards that most established companies follow. American companies and those that trade on the American stock exchanges follow the US GAAP, or Generally Accepted Accounting Principles. Chinese companies follow China GAAP. The rest of the world outside of the US and China follow the International Financial Reporting Standards (IFRS). Here’s a map of the countries that adopt IFRS.
American Accounting Principles
American companies follow the US GAAP (Generally Accepted Accounting Principles) when they record their financials. This helps companies across the country prepare financials using a consistent methodology.
In the US, the Securities and Exchange Commission (SEC) has the legal authority to set accounting standards for public companies. However, the SEC looks to a private non-government organization, Financial Accounting Standards Board (FASB), for their technical expertise. As a result, FASB often takes the leadership role in setting and improving the US GAAP.
While FASB has the power to set accounting rules, it does not have the power to enforce. That’s where the SEC comes in. SEC works closely with FASB on the accounting standards and makes sure all the major companies comply.
Small businesses don’t necessarily have to follow this set of rigorous accounting standards. They have leeway because they are usually privately-owned within families. However, large businesses with many investors, especially public companies, usually have to comply with US GAAP.
China Accounting Principles
The Chinese Accounting Standards (CAS), or “China GAAP”, govern accounting and bookkeeping practices in China. All Chinese public companies must follow China GAAP when preparing their financial statements.
Chinese accounting standards and presentation formats were historically very different from that of the western world. However, in April 2010, the Chinese Ministry of Finance issued “Roadmap for Continuing Convergence of Chinese Accounting Standards for Business Enterprises with International Financial Reporting Standards”. It indicated that it will revise and improve China GAAP to converge closer to IFRS that the rest of the world follow. Today, China GAAP is very similar to that of IFRS.
Rest of World Accounting Principles
Outside of the United States and China, most countries follow the IFRS (International Financial Reporting Standards). The IFRS is a set of rules governed by the IFRS Foundation and the International Accounting Standards Board (IASB).
Globally, over 150 countries follow IFRS as their accounting standard. These countries require domestic public companies to follow the IFRS when recording their financials. IFRS is widely popular is because it makes financial statements understandable and comparable across international boundaries. European investors can easily understand African companies and Latin American analysts can easily evaluate Middle Eastern companies. There is a global trend of growing international shareholding and trade. IFRS is progressively replacing many countries’ own national accounting standards to develop a uniform global set of accounting standards.
10 Important Accounting Principles
Across the world, there are a number of key accounting principles. They form the foundation upon which US GAAP, China GAAP and IFRS build their set of rules and guidelines. We lay out the 10 most important ones below.
Separate Entity Assumption
This principle states that accountants should record business transactions separately for each entity. First, this principle requires separation of business transactions and personal transactions. This prevents business owners’ personal transactions from mixing up measurements of business performance. Consequently, the financial statements will reflect purely the business results. Second, this principle requires accountants to avoid intermingling business transactions among different entities. Each business entity should have its own set of transactions.
Monetary Unit Principle
The Monetary Unit Principle states that only accounts measurable with monetary units can be recorded in the company’s financial statements. If a transaction is quantifiable with money, the accountant should record it. If a transaction is not quantifiable with money, then the accountant should not record it. This principle prevents accountants and management teams from recording transactions based on subjective opinions.
Time Period Principle
This principle says that businesses should report their performance for a specific time period. All financial statements must indicate the time period they are for in order to be meaningful. Without specifying time period or consistency, the numbers would be meaningless. Whereas the Income Statement and the Cash Flow Statement report financials over a period of time, the Balance Sheet report financials as of a specific point in time.
The Materiality Principle requires accountants to record information that are “material” (significant) when preparing financial statements. Most businesses have sophisticated control systems that record all their transactions. Therefore, the major implication of this principle isn’t about material transactions, but about immaterial (insignificant) transactions.
This principle allows accountants some liberty in how they treat immaterial transactions. A common usage of this principle is to expense immaterial costs rather than to capitalize them. For example, suppose a company purchased $100 of office supplies. If the $100 is immaterial, the accountant can record the $100 as part of the year’s SG&A expense. However, if the $100 is material, then the accountant will have to follow the standard procedure. They may have to capitalize the office supplies where the $100 adds to PP&E and depreciate over the supplies’ remaining lifespan.
Materiality is a vague concept without an exact definition. Hence, we often have to rely on accountants’ professional opinion. What is material to one business might be immaterial to another. For example, spending $100 buying office supplies might be material to a local store, but will be immaterial to Amazon.
Under the Accrual Principle, companies recognize revenue when they deliver the products and when the collection of payment is reasonably certain. Notice that revenue is not recognized based on when the company receives the cash payments from the sale. In other words, revenue is a measure of the value of products sold as opposed to cash received.
The Matching Principle requires companies to recognize expenses in the same period as the corresponding Revenue. Companies “match” revenue and related expenses together and record them in the same period. If an expense is directly attributed to revenue (i.e. cause and effect relationship), the company should record it in the same period as the corresponding Revenue. If an expense isn’t directly attributable to Revenue, the company should record the expense in the period that it was used.
The Cost Principle requires companies to record their Assets, Liabilities and Equity items on the Balance Sheet at their historical cost. The definition of historical cost is the value of money it pays or receives at the time of transaction (“cost basis”). This is an aspect of conservatism within financial accounting. For example, companies often sell their products at a higher price than their cost. However, accountants have to base product values on historical cost rather than what they can sell for. In other words, the value of inventory on the Balance Sheet is based on how much it cost the company to produce these inventory. It’s not based on the value these inventory can sell for.
Another example is real estate. Suppose a company purchased a building 30 years ago that’s worth 100 times as much today. However, despite the higher valuation, the company must record the value of the building at its historical cost. It has to record the value of the building according to how much it originally cost to acquire the building. Cost Principle injects an aspect of conservatism into financial statements.
Continuity Principle (aka “Going Concern Principle”)
The Continuity Principle allows accountants to assume that a company will continue to exist in the foreseeable future. This transaction underpins various line items on the financial statements, such as D&A, Prepaid Expenses, Deferred Expenses, etc. Without this assumption, companies have to record these expenses right away because the company will cease to exist.
The leading accounting standards generally require accountants to be conservative when preparing financial statements. This principle has two main implications.
First, it requires accountants to choose the more conservative methodology in situations where there are more than one acceptable methodologies. If there’s an accounting method that yields lower Diluted EPS, then accountants should opt for that method instead.
Second, it impacts various accounting rules on how companies record income vs. expenses, and assets vs. liabilities. For example, companies must record impairment expense when the fair market value is below the carrying value. However, the opposite is not true. They may not record gains when the fair market value is above the carrying value. Similarly, companies must disclose potential liabilities under Commitments & Contingencies. But the same rules don’t require them to disclose potential income streams.
The Consistency Principle requires companies to maintain the same accounting methodology from one period to the next. Companies may not fluctuate between altering methodologies from period to period whenever it suits them. They must stay consistent with their chosen methodology. Those who do change their methodology must fully disclose the change and its implications. The analyst community usually heavily scrutinize changes in methodologies.
These are the 10 main accounting principles. There are many other accounting principles, but the ones above are the most important. They form the foundation of the leading sets of accounting rules and guidelines.
How to Use These Accounting Principles
These accounting principles form the basis on which companies prepare their financial statements. Accountants use these rules as a guide when recording journal entries and preparing statements. Analysts need to keep these rules in mind when they analyze financial statements to understand the context behind the numbers.
In our Lumovest courses, we’ll build upon these principles and walk you through how to analyze financial statements step-by-step. You can watch how it’s done through lesson videos and then practice the analysis through our worksheets. Sign up today for just $30.