What Are Accounting Principles?
Accounting principles are the established rules and guidelines that companies and other organizations must adhere to when reporting financial data. These principles standardize accounting methods and terminology, making financial data easier to interpret and compare. The most widely used set of accounting principles globally is the International Financial Reporting Standards (IFRS), adopted by 168 jurisdictions. In contrast, the United States uses Generally Accepted Accounting Principles (GAAP).
Key Takeaways:
- Accounting standards improve the quality of financial information reported by companies.
- The Financial Accounting Standards Board (FASB) issues GAAP in the U.S.
- GAAP is mandatory for publicly traded companies in the U.S. and often used by non-publicly traded companies.
- Internationally, the International Accounting Standards Board (IASB) issues IFRS.
- The FASB and IASB sometimes collaborate on joint standards, but the U.S. does not plan to switch to IFRS.
Understanding Accounting Principles
The primary objective of any set of accounting principles is to ensure financial statements are complete, consistent, and comparable. This facilitates investors’ ability to analyze and extract useful information, including trend data over time and comparisons across different companies. Standardized accounting principles also help prevent accounting fraud by increasing transparency.
Comparability
Comparability allows users to review multiple companies’ financial statements side by side, ensuring that consistent accounting principles have been applied. Without standardized rules, comparing financial statements among companies, even within the same industry, would be challenging, and inconsistencies and errors would be more difficult to detect.
Basic Accounting Principles
Some of the fundamental accounting principles include:
- Accrual principle
- Conservatism principle
- Consistency principle
- Cost principle
- Economic entity principle
- Full disclosure principle
- Going concern principle
- Matching principle
- Materiality principle
- Monetary unit principle
- Reliability principle
- Revenue recognition principle
- Time period principle
Notably, the revenue recognition principle, matching principle, materiality principle, and consistency principle are critical. The materiality principle ensures completeness, while consistency refers to using the same accounting methods over time.
Generally Accepted Accounting Principles (GAAP)
GAAP is a set of uniform accounting principles for private companies and nonprofits in the U.S., primarily set by the FASB. The Governmental Accounting Standards Board (GASB) sets GAAP standards for local and state governments, and the Federal Accounting Standards Advisory Board (FASAB) sets principles for federal agencies.
Publicly traded companies must file GAAP-compliant financial statements to be listed on a stock exchange. While not legally required for privately held companies and nonprofits, many comply with GAAP due to lender or investor requirements. For example, annual audited GAAP financial statements are commonly required by banks.
International Financial Reporting Standards (IFRS)
The IASB issues IFRS, used in approximately 168 jurisdictions, including the European Union. While the U.S. SEC has shown interest in transitioning to IFRS, significant differences between the two standards make this unlikely in the near future. However, the FASB and IASB continue to collaborate on joint regulations for specific accounting issues.
Who Sets Accounting Principles and Standards?
In the U.S., the FASB regulates GAAP, while the IASB sets IFRS for Europe and other regions. These bodies establish and update accounting standards to reflect the changing financial environment.
Differences Between IFRS and GAAP
IFRS, a standards-based approach, is used internationally, while GAAP is a rules-based system used primarily in the U.S. IFRS is more dynamic and regularly updated, whereas GAAP is more static. Methodological differences include inventory cost methods, with GAAP allowing FIFO or LIFO, while IFRS bans LIFO.
History of Accounting Principles
Standardized accounting principles date back to double-entry bookkeeping in the 15th and 16th centuries, which introduced a T-ledger with matched entries for assets and liabilities. The AICPA and the NYSE attempted to launch the first U.S. accounting standards in the 1930s.
Critiques of Accounting Principles
Critics of principles-based systems argue they allow too much freedom and may lack transparency. Conversely, rules-based systems like GAAP can be overly complex and resource-intensive for companies to comply with.
The Bottom Line
Accounting principles are essential for companies to follow when reporting financial data. Whether using GAAP in the U.S. or IFRS internationally, the goal is to enhance transparency and make it easier for investors to compare financial statements across companies. Without these standards, companies might present inflated financial information, misleading investors.
Note: Investors should be cautious when comparing financial statements from companies in different countries due to differing accounting principles. While mature markets present less concern, potential number distortion remains under various accounting standards.
For more detailed guidance on accounting principles and how they affect your financial reporting, contact BOA & Co. Financial Group at 1300 952 286 or email us at info@boanco.com.au. Visit our website at www.boanco.com.au for more information.