Basic Accounting Principles and Guidelines
Introduction to Accounting Principles
There are general rules and concepts that govern the
field of accounting. These general rules–referred to as basic accounting
principles and guidelines–form the groundwork on which more detailed,
complicated, and legalistic accounting rules are based. For example, the
Financial Accounting Standards Board (FASB) uses the basic accounting
principles and guidelines as a basis for their own detailed and comprehensive
set of accounting rules and standards.
The phrase "generally accepted accounting
principles" (or "GAAP") consists of three important sets of
rules: (1) the basic accounting principles and guidelines, (2) the detailed
rules and standards issued by FASB and its predecessor the Accounting
Principles Board (APB), and (3) the generally accepted industry practices.
If a company distributes its financial statements to the
public, it is required to follow generally accepted accounting principles in
the preparation of those statements. Further, if a company's stock is publicly
traded, federal law requires the company's financial statements be audited by
independent public accountants. Both the company's management and the
independent accountants must certify that the financial statements and the
related notes to the financial statements have been prepared in accordance with
GAAP.
GAAP is exceedingly useful because it attempts to
standardize and regulate accounting definitions, assumptions, and methods.
Because of generally accepted accounting principles we are able to assume that
there is consistency from year to year in the methods used to prepare a
company's financial statements. And although variations may exist, we can make
reasonably confident conclusions when comparing one company to another, or
comparing one company's financial statistics to the statistics for its
industry. Over the years the generally accepted accounting principles have
become more complex because financial transactions have become more complex.
Basic Accounting Principles and Guidelines
Since GAAP is founded on the basic accounting principles
and guidelines, we can better understand GAAP if we understand those accounting
principles. The following is a list of the ten main accounting principles and
guidelines together with a highly condensed explanation of each.
1. Economic Entity Assumption
The accountant keeps all of the business transactions of
a sole proprietorship separate from the business owner's personal transactions.
For legal purposes, a sole proprietorship and its owner are considered to be
one entity, but for accounting purposes they are considered to be two separate
entities.
2. Monetary Unit Assumption
Economic activity is measured in U.S. dollars, and only
transactions that can be expressed in U.S. dollars are recorded.
Because of this basic accounting principle, it is assumed
that the dollar's purchasing power has not changed over time. As a result
accountants ignore the effect of inflation on recorded amounts. For example,
dollars from a 1960 transaction are combined (or shown) with dollars from a
2018 transaction.
3. Time Period Assumption
This accounting principle assumes that it is possible to
report the complex and ongoing activities of a business in relatively short,
distinct time intervals such as the five months ended May 31, 2018, or the 5
weeks ended May 1, 2018. The shorter the time interval, the more likely the
need for the accountant to estimate amounts relevant to that period. For
example, the property tax bill is received on December 15 of each year. On the
income statement for the year ended December 31, 2017, the amount is known; but
for the income statement for the three months ended March 31, 2018, the amount
was not known and an estimate had to be used.
It is imperative that the time interval (or period of
time) be shown in the heading of each income statement, statement of
stockholders' equity, and statement of cash flows. Labeling one of these
financial statements with "December 31" is not good enough–the reader
needs to know if the statement covers the one week ended December 31, 2018 the
month ended December 31, 2018 the three months ended December 31, 2018 or the
year ended December 31, 2018.
4. Cost Principle
From an accountant's point of view, the term
"cost" refers to the amount spent (cash or the cash equivalent) when
an item was originally obtained, whether that purchase happened last year or
thirty years ago. For this reason, the amounts shown on financial statements
are referred to as historical cost amounts.
Because of this accounting principle asset amounts are
not adjusted upward for inflation. In fact, as a general rule, asset amounts
are not adjusted to reflect any type of increase in value. Hence, an asset
amount does not reflect the amount of money a company would receive if it were
to sell the asset at today's market value. (An exception is certain investments
in stocks and bonds that are actively traded on a stock exchange.) If you want
to know the current value of a company's long-term assets, you will not get
this information from a company's financial statements–you need to look
elsewhere, perhaps to a third-party appraiser.
5. Full Disclosure Principle
If certain information is important to an investor or
lender using the financial statements, that information should be disclosed
within the statement or in the notes to the statement. It is because of this
basic accounting principle that numerous pages of "footnotes" are
often attached to financial statements.
As an example, let's say a company is named in a lawsuit
that demands a significant amount of money. When the financial statements are
prepared it is not clear whether the company will be able to defend itself or
whether it might lose the lawsuit. As a result of these conditions and because
of the full disclosure principle the lawsuit will be described in the notes to
the financial statements.
A company usually lists its significant accounting
policies as the first note to its financial statements.
6. Going Concern Principle
This accounting principle assumes that a company will
continue to exist long enough to carry out its objectives and commitments and
will not liquidate in the foreseeable future. If the company's financial
situation is such that the accountant believes the company will not be able to
continue on, the accountant is required to disclose this assessment.
The going concern principle allows the company to defer
some of its prepaid expenses until future accounting periods.
7. Matching Principle
This accounting principle requires companies to use the
accrual basis of accounting. The matching principle requires that expenses be
matched with revenues. For example, sales commissions expense should be
reported in the period when the sales were made (and not reported in the period
when the commissions were paid). Wages to employees are reported as an expense
in the week when the employees worked and not in the week when the employees
are paid. If a company agrees to give its employees 1% of its 2018 revenues as
a bonus on January 15, 2019, the company should report the bonus as an expense
in 2018 and the amount unpaid at December 31, 2018 as a liability. (The expense
is occurring as the sales are occurring.)
Because we cannot measure the future economic benefit of
things such as advertisements (and thereby we cannot match the ad expense with
related future revenues), the accountant charges the ad amount to expense in
the period that the ad is run.
(To learn more about adjusting entries go to Explanation
of Adjusting Entries and Quiz for Adjusting Entries.)
8. Revenue Recognition Principle
Under the accrual basis of accounting (as opposed to the
cash basis of accounting), revenues are recognized as soon as a product has
been sold or a service has been performed, regardless of when the money is
actually received. Under this basic accounting principle, a company could earn
and report $20,000 of revenue in its first month of operation but receive $0 in
actual cash in that month.
For example, if ABC Consulting completes its service at
an agreed price of $1,000, ABC should recognize $1,000 of revenue as soon as
its work is done—it does not matter whether the client pays the $1,000
immediately or in 30 days. Do not confuse revenue with a cash receipt.
9. Materiality
Because of this basic accounting principle or guideline,
an accountant might be allowed to violate another accounting principle if an
amount is insignificant. Professional judgement is needed to decide whether an
amount is insignificant or immaterial.
An example of an obviously immaterial item is the
purchase of a $150 printer by a highly profitable multi-million dollar company.
Because the printer will be used for five years, the matching principle directs
the accountant to expense the cost over the five-year period. The materiality
guideline allows this company to violate the matching principle and to expense
the entire cost of $150 in the year it is purchased. The justification is that
no one would consider it misleading if $150 is expensed in the first year
instead of $30 being expensed in each of the five years that it is used.
Because of materiality, financial statements usually show
amounts rounded to the nearest dollar, to the nearest thousand, or to the
nearest million dollars depending on the size of the company.
10. Conservatism
If a situation arises where there are two acceptable
alternatives for reporting an item, conservatism directs the accountant to
choose the alternative that will result in less net income and/or less asset
amount. Conservatism helps the accountant to "break a tie." It does
not direct accountants to be conservative. Accountants are expected to be
unbiased and objective.
The basic accounting principle of conservatism leads
accountants to anticipate or disclose losses, but it does not allow a similar
action for gains. For example, potential losses from lawsuits will be reported
on the financial statements or in the notes, but potential gains will not be
reported. Also, an accountant may write inventory down to an amount that is
lower than the original cost, but will not write inventory up to an amount
higher than the original cost.
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