Accounting principles are defined as the general rules, regulations, and guidelines that are used for governing the field of accounting. The purpose of accounting principles is to convey financial information and financial reporting in an acceptable and understandable language from one business to another.
Publicly traded companies that disclose financial information for the public eye have to follow these principles while preparing their statements. Accounting principles are implemented to improve the quality of the financial information that various companies report.
Understanding Generally Accepted Accounting Principles
These general and mandatory guidelines may differ depending upon the nature and origin of the company, but the latter needs to ensure due care and diligence all the same. Accounting principles aid in identifying potential red flags in a company and also to maintain transparency.
These principles are set forth by various bodies. In the United States, accounting principles are regulated by the Financial Accounting Standards Board (FASB). In India, the institute that guides and enforces accounting principles is the Institute of Chartered Accountants of India (ICAI).
In most of Europe, these principles are mandated and enforced by the International Accounting Standards Board (IASB). Since these principles can vary from region to region, and their enforcement agency also varies, it would be prudent for investors to be cautious when comparing financial statements of different companies from cross tits to be disclosed in the financial statements.
It indicates that only those transactions or the company’s financial statements that can be verified should be recorded. The hierarchy of GAAP is designed for improving financial reporting. It incorporates a framework to select the principles that public accountants should utilize while preparing financial statements as per U.S. GAAP. The hierarchy includes-
- Statements by the Financial Accounting Standards Board (FASB) along with Accounting Research Bulletins and Accounting Principles Board opinions by the American Institute of Certified Public Accountants (AICPA)
- FASB Technical Bulletins alongside AICPA Industry Audit and Accounting Guides and Statements of Position
- AICPA Accounting Standards Executive Committee Practice Bulletins along with positions of the FASB Emerging Issues Task Force (EITF) and topics discussed in Appendix D of EITF Abstracts
- FASB implementation guides, AICPA Industry Audit and Accounting Guides, AICPA Accounting Interpretations along with Statements of Position not cleared by the FASB and accounting practices that are widely accepted and followed
Let us now delve into different types of principles of accounting-
13 Basic Accounting Principles
There have been several popular accounting principles throughout the world. They are as follows:
1. Revenue Recognition Principle
This concept posits that the business should only acknowledge the revenue when it has completed a significant part of the process of earning said revenue. Many firms have been known to exploit this principle and commit reporting frauds.
2. Accrual Principle
This principle posits that all financial transactions should be recorded when they occur and not when the cash flow occurs. This principle helps prevent the delayed or accelerated transactions that occur when cash flow is associated, which presents a more accurate picture of the firm’s financial condition.
3. Consistency Principle
This principle states that once a firm decides on an accounting principle to be used, it needs to stick with it and follow it throughout the other accounting periods. Having inconsistency in accounting principles can deter potential investors as well.
4. Cost Principle
This principle suggests that a business record all their liabilities and assets and equity at the original cost at which they were sold or purchased. The original value of the asset/equity or liability may fluctuate over time, although this is not reflected in the financial statements.
5. Economic Entity Principle
This principle suggests that the owner of the business and the business itself should be kept separate from each other. The transactions, assets, and liabilities of one should not affect the other.
6. Full Disclosure Principle
If there is any crucial information in the firm that may impact the decision of those reading the statements, it must mandatorily be disclosed, without fail.
7. Going Concern Principle
This concept assumes that a business will exist and continue to operate for as long as the foreseeable future. This allows the owner to defer assets or liabilities to the future instead of acknowledging them instantaneously.
8. Matching Principle
This principle states that each source of income should be related to all the relevant expenditures within the same accounting period. It also states that every credit effect should have a debit effect and vice versa.
9. Monetary Unit Principle
Businesses should refrain from including transactions that cannot be expressed monetarily in a stable unit of currency.
10. Reliability Principle
This principle acts as a barometer for determining what financial information should be presented in the business’s financial statements.
11. Time Period Principle
The transactions incurred by the business during a specific accounting period should be expressed within that period itself. It should not be published in a later year but at the appropriate time.
12. Materiality Principle
If an item in the business can change the outlook of the business in the minds of those reading the financial statements, it must mandatorily be recorded or disclosed in the books of accounts.
13. Conservatism Principle
In those circumstances in which there are two acceptable solutions for reporting an item, the accountants should choose the less favorable outcome or less net income or less asset amount. This concept lets accountants anticipate future losses instead of future gains.
On the concluding note, it is clear that these principles are integral parts of a wide variety of accounting frameworks, as they are inevitable in governing the treatment and reporting of business transactions.
What are your thoughts about the importance of these accounting principles in managing financial transactions and accounting activities?