Accounting principles will matter to you differently if you want to invest in a company or if you own a company.
If you decide to invest in a company, you will look at accounting principles to see whether the company followed the principles.
But if you own a company, you need to do a lot more. You need to report your financial data as per the accounting rules and guidelines.
First, let’s understand what are accounting principles.
Accounting Principles are the rules and guidelines followed by the different entities to record, to prepare and to present the financial statements of the company for presenting true and fair picture of those financial statements.
What are accounting principles?
As the name suggests, accounting principles are set of rules and guidelines by maintaining which a company should report its financial data. To understand this, we can talk about the most popular sets of accounting principles, i.e. generally accepted accounting principles (GAAP).
If you own a company in the United States and you are public listed company here’s what you need to do to remain in the most important and major stock exchanges –
- First, you need to learn the GAAP through and through.
- And then, you need to adhere to GAAP while reporting your financial statements.
If you don’t take the above steps, then you won’t be allowed to be listed on the major stock exchanges in the US.
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Now, let’s go into bit detail about what are accounting principles.
What is GAAP?
Understanding GAAP will help you adhere to the most common set of accounting principles. Let’s understand GAAP briefly –
- GAAP is a set of rules and guidelines that the companies need to follow while reporting its financial statements.
- GAAP is created to ensure that the financial reporting remains transparent and coherent throughout the process. And it also ensures that the financial reporting done in one organization remains consistent with the financial reporting done in another company.
- The fascinating thing about GAAP is it is not similar in all geographic locations. As per the region and the industries, GAAP is implemented and followed upon. In the United States, the Securities and Exchange Commission (SEC) ensures that the financial reporting done by the company is followed as per the generally accepted accounting principles (GAAP).
- The publicly traded companies in the United States must comply with both the SEC and the GAAP. Otherwise, it wouldn’t be possible for them to remain publicly traded.
What is IFRS?
GAAP is not being followed in many countries. That’s why we also need to talk about International Financial Reporting Standards (IFRS). Let’s talk about IFRS briefly as well.
- In the US, GAAP is being followed. In many countries other than the US, IFRS is being followed in the case of financial reporting.
- IFRS helps public companies prepare and report financial statements in all over the world.
- Since similar IFRS are set for the entire world, it becomes easy to implement. And for investors also, the comparison between companies becomes significantly easier.
- The auditors also get a global standard to adhere to whenever they verify the financial statements of companies prepared by following IFRS.
- IFRS is not like GAAP. IFRS doesn’t change as per the region. Rather IFRS has a general guideline for preparing financial statements but IFRS doesn’t have any industry-specific financial reporting.
List of Accounting Principles (Top 6)
Here is the list of basic accounting principles that company follow quite often. Let’s have a look at them –
#1 – Accrual principle:
This is one of the most common accounting principles. It says that company should record accounting transactions in the same period it happens, not when the cash flow was earned. For example, let’s say that a company has sold products on credit. As per the accrual principle, the sales should be recorded during the period, not when the money would be collected.
#2 – Consistency principle:
This is another accounting principle which is commonly followed by all organizations. As per this principle if a company follows an accounting principle, it should keep following the same principle until a better accounting principle is found out. If the consistency principle is not followed, then the company would jump around here and there and financial reporting would turn out to be messy. For investors also, it would be difficult to see where the company has been going and how the company is approaching its long term financial growth.
#3 – Conservatism principle:
As per the conservatism principle, accounting faces two alternatives – one, report a bigger amount or two, report a lesser amount. To understand this in detail, let’s take an example. Let’s say that Company A has reported that it has a machinery worth of $60,000 as its cost. Now, as the market changes, the selling value of this machinery comes down to $50,000. Now the accountant has to choose one from two choices – first ignore the loss the company may incur on selling the machinery before it’s actually sold; and second to report the loss on machinery immediately. As per the conservatism principle, the accountant should go with the former choice, i.e. to report the loss on machinery even before the loss would actually happen. Conservatism principle encourages the accountant to report greater liability amount, lesser asset amount, and also a lesser amount of net profits.
#4 – Going concern principle:
As per the going concern principle, it’s accepted that a company would go on operating for as long as it can in near or foreseeable future. By following the going concern principle, a company may defer its depreciation or similar expenses for the next period of time.
#5 – Matching principle:
Matching principle is the basis of the accrual principle we have seen before. As per the matching principle, it’s said that if a company recognizes and records revenue, it should also record all costs and expenses related to it. For example, if a company records its sales or revenues, it should also record the cost of goods sold and also other operating expenses.
#6 – Full disclosure accounting principle:
As per this accounting principle, a company should disclose all financial information to help the readers see the company transparently. Without the full disclosure principle, the investors may misread the financial statements because they may not have all the information available with them to make a sound judgment.
Accounting Principles Video
This was the guide to Accounting Policies and the list of top accounting policies. Here are the other articles in accounting that you may like –