Understanding the principles of accounting is important when working with financial data that will be used to prepare a company's financial statements. As a business owner or an accountant, you are expected to have a strong understanding of accounting principles when working with financial information. Complying with standards allows you to ensure that all reporting is accurate and that you have the information you need when preparing for tax season.
The U.S. complies with its set of generally accepted accounting principles (GAAP) developed by the financial accounting standards board (FASB). Outside of the U.S., the international financial reporting standards (IFRS) are recognized by most companies and countries. IFRS is overseen by the international accounting standards board (IASB).
What Are the Accounting Principles Under GAAP?
GAAP must be used for financial reporting purposes by U.S. public companies. The aim of U.S. GAAP is to improve the comparability, consistency, and clarity of accounting information used for financial reporting purposes. There are ultimately 10 key principles that must be followed under GAAP.
Principle of Regularity
The principle of regularity is used to dictate accountants to use the approved accounting standards in the U.S. All standards must be adopted. The bookkeeper or accountant do not have the ability to choose which standards they comply with and which ones they don't.
Principle of Consistency
Under the principle of consistency, accountants must use the same accounting standards in every reporting period. If any changes are made to the accounting standards from one period to another, those changes must be noted clearly in their footnotes.
The principle of consistency ensures that uniform accounting practices from different accounting periods have reasonable comparability.
Principle of Sincerity
Under the principle of sincerity, accountants must do their best to present a precise and sincere picture of a business's financial circumstances. Accountants should not be overly partial to a business. This allows them to create accurate statements.
Principle of Permanence of Methods
Under the principle of permanence of methods, accounting standards shouldn't change. Once implemented, accounting methods remain the same unless a new standard or guideline is issued under authority from FASB.
However, some industries require different accounting standards than others. This can cause issues if someone tries to compare financial statements for companies from different industries.
Principle of Non-Compensation
Certified public accountants must show the positive and negative aspects of financial records to present a clear picture of a company's worth. Thus, they can't hide details. They aren't able to receive debt compensation from a company. Debt compensation includes stock or an ownership stake in a business.
Principle of Prudence
The principle of prudence must be based on fact and not conjecture. Thus, there must be a complete picture of a company's worth presented under financial reporting standards. There may be no pro forma accounting processes or reporting put into place.
Principle of Continuity
Under the principle of continuity, accountants must value assets based on the assumption that the company will stay in business. Assets should be valued at their historical value (original price), rather than their disposable value (the amount the asset can be used for).
Principle of Periodicity
The principle of periodicity requires that businesses use the accrual method of accounting rather than the cash-basis method of accounting. Cash-basis accounting recognizes revenue when it is received, while under the accrual basis of accounting revenue recognition occurs when it is earned. This is referred to as the matching principle.
Principle of Materiality / Good Faith
The principle of materiality gives accountants the ability to disobey GAAP rules when the amount under consideration is immaterial in nature.
As an example, you may purchase a $50 desk that you expect to use for 5 years. While it should be depreciated each year, you decide to expense it entirely at the time of purchase. Since the value of the desk is immaterial to the financial statements, the GAAP rule for depreciation may be ignored.
Principle of Utmost Good Faith
Under the principle of good faith, all parties involved in a transaction must be straightforward in their business dealings.
Should All U.S. Companies Comply with GAAP?
Only publicly-traded U.S. companies are required to comply with GAAP. Under the rules established by the Securities and Exchange Commission (SEC), companies that are publicly traded must have financial statements that are approved by a certified public accounting (CPA) firm.
While GAAP accounting is not required for non-publicly traded companies, GAAP is viewed favorably by lenders and creditors. Most banks that offer business loans will require client companies to have GAAP-approved financial statements.
If financial statements are not prepared using GAAP, investors should do their homework before making an investment. Comparing financial statements among companies that do not use GAAP may be impossible, even if they are working in similar industries.
What Are the Accounting Principles of IFRS?
Similar to GAAP, IFRS has its own set of accounting principles. IFRS accounting standards have been adopted by over 100 countries, including Canada, Australia, and countries within the European Union. IFRS standards and principles are set by the IASB.
The objectives of IASB are to develop public interest and enforce global accounting standards that require high quality of transparent and comparable information in financial reports.
Similar to GAAP, IFRS has a number of accounting principles. The principles of IFRS are indicated below:
Under the going concern standard, the business that is presenting its financial statements should be run for the foreseeable period of time. There is no intention to close the business.
Under the consistency period, once the owner chooses a method to run the business, that method may not be changed. Thus, if a particular method is chosen to record depreciation for an asset, it must remain the same.
Under the accrual concept, all expenses and revenue must be recognized when they are incurred, not when the exchange of cash takes place.
Under the business entity concept, the owner and the business are separate. Thus, if the owner used their own money to start the business as a loan, the business is responsible for paying the owner back.
The money measurement principle allows only transactions to be recorded in the books that can be measured in monetary terms. Thus, if a vendor makes arrangements to purchase a service from the company, then the revenue from the service must be recorded in the business's books.
However, if there is no arrangement or agreement to purchase a service, then no transaction may be recorded.
Under the accounting period principle, the business is run according to specific time periods. For example, a company may choose to show its accounting from January through December.
Once the accounting period is established, it should remain the same unless there is a specific reason to change it. If a change is made, comparable financials must be presented in accordance with IFRS standards.
This principle requires that complete and understandable information must be provided to employees, investors, and the government. This information should include all relevant financial statements, including the income statement, balance sheet, statement of shareholder's equity, and the statement of cash flows.
The materiality concept allows that other standards may be ignored if the transaction to be recorded is immaterial to the overall presentation of the financial statements.
Prudence or Conservatism
The prudence principle requires that all prospective losses must be taken into account, but the potential for possible income should be ignored. Thus, you cannot overstate income on general expectations. However, potential losses must be addressed and noted in the financial statements.
All fixed assets must be recorded at their historical costs. Thus, if you purchase a machine for $1,000,000 and the fair value of the machine decreases to $900,000 by the end of the year, you must still show the original value of the machine less any depreciation.
Any increases or decreases in the fair value of the equipment are not recognized until the machine is sold.
Under the matching concept, expenses incurred associated with revenue earned should be properly matched in the financial statements.
The dual aspect allows for every transaction to have a double entry, meaning there must be a debit to one account and a credit to another.
What Are the Differences Between GAAP and IFRS?
GAAP is focused on the accounting standards for publicly traded U.S. companies, while IFRS identifies the international accounting standards that have been adopted by most of the other countries of the world.
The IASB and FASB have been working on the convergence of IFRS and GAAP since 2002. In 2007, the SEC removed the requirement that non-U.S. companies registered in America reconcile their financial reports with GAAP if their accounts complied with IFRS. This led to a significant reduction in work and compliance requirements for those non-U.S. companies trading on U.S. exchanges.
There are a few key differences between both sets of standards. These include:
GAAP allows companies to use the Last In, First Out (LIFO) standard as an inventory cost method. However, it is not allowed by IFRS.
Research and Development Costs
Research and development costs are to be charged to expense as they are incurred under GAAP. Under IFRS, the costs can be capitalized and amortized over multiple periods if certain conditions are met.
GAAP specifies that the amount of write-down of an inventory or fixed asset cannot be reversed if the market value of the asset increases. Under IFRS, the write-down may be reversed.
Balance Sheet Presentation
The way a balance sheet is formatted is different under GAAP than in other countries. Under GAAP, current assets are listed first, while IFRS begins with non-current assets.
GAAP standards also require a balance sheet to list accounts in order of liquidity. Thus, accounts are listed in order from most liquid to least liquid. This includes listing current assets, non-current assets, current liabilities, non-current liabilities, and owners' equity.
Under IFRS, the order is the exact opposite.
Cash Flow Statement
The company's cash flow statement is prepared differently under GAAP and IFRS. This is most clear in the treatment of interest and dividends.
GAAP advises that interest paid and received should be classified as operating expenses, while IFRS allows for more flexibility. Under IFRS, a firm may choose its own policy for classifying interest based on what it considers to be appropriate. Thus, it may be considered as an operating or financing cost.
Under GAAP, dividends paid must be accounted for in the financing section, while dividends received are included in the operating section.
Under IFRS standards, companies may classify dividends paid in either operating or financing cash flows. Dividends received can be classified as operating or investing.
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