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 2014 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, 2014, or the 5 weeks ended May 1,
2014. 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, 2013, the amount is
known; but for the income statement for the three months ended March 31,
2014, 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, 2014 the month ended December 31, 2014 the three months ended December 31, 2014 or the year ended December 31, 2014.
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 2014 revenues as a bonus on January 15, 2015, the company should
report the bonus as an expense in 2014 and the amount unpaid at December
31, 2014 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.