Accounting principles are a set of recommendations, guidelines and rules that companies are required to follow while preparing financial statements and financial reports. Accounting principles make sure that the company prepares its financial statements in a consistent and complete manner, with total clarity and transparency in its financial operations.
Since all companies in the country are mandated to prepare their financial statements in the same format and manner, there will be uniformity in the statements. This will make it possible to compare the financial statements of different companies in the same industry to assess performance and set benchmarks.
It also helps to promote comparison between companies. Read on to find out more.
What are accounting principles?
Using accounting principles makes it easier for the stakeholders to gather useful information from them. It also helps investors analyze them better and helps in better decision-making regarding investments.
One of the biggest impacts of following accounting principles is fraud mitigation. Since accounting principles follow the audit trail and encourage total transparency, every dollar is accounted for. This helps identify red flags and areas of possible fraud, thereby protecting the company’s finances.
In the United States, a standard set of accounting principles known as GAAP or generally accepted accounting principles has been given by the Financial Accounting Standards Board for companies in the country to follow.
Only publicly held companies in the United States are required to mandatorily follow GAAP. Private companies need not follow these principles but in many cases, they have to, especially if they want help from investors and lenders. For example, if a company wants to apply for a business loan, it must submit financial statements that have been prepared and audited according to the mandates of GAAP.
The same applies to companies when they seek investments. Investors are more likely to offer funds when GAAP-compliant statements are made available to them. Therefore, most companies in the country prepare their financial statements according to GAAP compliance mandates.
Who sets accounting principles and standards?
Since different parts of the world use different accounting principles, there are various bodies that set accounting standards. In the United States, the Financial Accounting Standards Board (FASB) regulates GAAP. In Europe and other countries, the International Accounting Standards Board (IASB) determines and sets the International Financial Reporting Standards (IFRS).
What are the generally accepted accounting principles?
The generally accepted accounting principles or GAAP are they are more commonly known are a set of accounting principles that public companies in the U.S. are expected to follow while preparing their financial statements. It is a mandatory requirement for publicly traded companies in the country to remain publicly listed on stock exchanges. It is the responsibility of the chief executives and the independent auditors of the company to ensure that the financial statements and their accompanying notes are prepared according to GAAP requirements.
Fundamental accounting principles of GAAP
Here is a list of some of the fundamental accounting principles as prescribed by GAAP:
- Principle of accrual
- Principle of consistency
- Principle of cost
- Principle of conservatism
- Principle of full disclosure
- Principle of matching
- Principle of going concern
- Principle of economic identity
- Principle of monetary unit
- Principle of revenue recognition
- Principle of materiality
- Principle of time period
- Principle of reliability
By standardizing the assumptions, methods and definitions that are to be used for accounting purposes throughout the country, GAAP ensures governance and oversight in accounting. As mentioned above, there are a lot of principles that are part of GAAP. But some of the most important ones are the matching principle, the consistency principle, the principle of revenue recognition and the materiality principle.
The main aim of GAAP standardizing accounting principles is to ensure that users who depend on financial statements to make crucial decisions have financial information that is complete, consistent and comparable with that of other companies.
Let’s look at these three factors in detail:
- Completeness: Completeness is tied to the principle of materiality. All transactions that are material in nature must be recorded in the company’s books and financial statements.
- Consistency: A company must follow the same accounting practices and methods year after year. If the accounting principles give the company a choice to choose accounting techniques, it must choose one and stick with it. If it changes accounting practices, the company must disclose this change in the footnotes contained in the financial statements.
- Comparability: Comparability refers to the ability to compare the financial statements of one company with those of another company in the same industry. This helps users compare the performances and financial cash flows of various companies simultaneously.
Without GAAP oversight, it would be impossible for companies to maintain consistency and complete transparency in their financial statements. GAAP ensures that the data and information contained in the financial statements of public companies are collated and reported consistently year after year, assuring stakeholders full transparency and accuracy of facts.
International financial reporting standards (IFRS)
Accounting principles are not the same in every country. Each country or region has its own set of accounting principles according to which resident companies prepare their financial statements. The IASB or International Accounting Standards Board compiles and issues the International Financial Reporting Standards (IFRS) that are used in over 120 countries today including countries in the European Union (EU).
While the United States currently does not follow IFRS, the FASB and IASB work together to regulate and maintain uniformity in accounting matters that are common to both.
An investor should be careful while comparing the financial statements of companies from various parts of the world. Since accounting principles are not the same world over, certain parts of the financial statements may seem confusing.
What is the difference between IFRS and GAAP?
GAAP is predominantly used in the United States and is a system based on rules. On the other hand, IFRS is used internationally in many countries and uses an approach based on standards rather than rules. GAAP is considered to be a rigid and static system whereas IFRS is a dynamic system that is more suited to the constantly changing financial markets globally.
