Accounting Principles

What are Accounting Principles?

Definition: Accounting principles are the building blocks for GAAP. All of the concepts and standards in GAAP can be traced back to the underlying accounting principles. Some accounting principles come from long-used accounting practices where as others come from ruling making bodies like the FASB.

It’s important to have a basic understanding of these main accounting principles as you learn accounting. This isn’t just memorizing some accounting information for a test and then forgetting it two days later. These principles show up all over the place in the study of accounting. Trust me. After you know the basic accounting principles, most accounting topics will make more sense. You will be able to reference these principles and reason your way through revenue, expense, and any other combination of problems later on in the study course.

List of 10 Basic Accounting Principles

Here’s a list of more than 5 basic accounting principles that make up GAAP in the United States. I wrote a short description for each as well as an explanation on how they relate to financial accounting.

  • Historical Cost Principle
  • Revenue Recognition Principle
  • Matching Principle
  • Full Disclosure Principle
  • Cost Benefit Principle
  • Conservatism Principle
  • Consistency Principle
  • Objectivity Principle
  • Accrual Principle
  • Economic Entity Principle

Historical Cost Principle

Historical Cost Principle – requires companies to record the purchase of goods, services, or capital assets at the price they paid for them. Assets are then remain on the balance sheet at their historical without being adjusted for fluctuations in market value.

Revenue Recognition Principle

Revenue Recognition Principle – requires companies to record revenue when it is earned instead of when it is collected. This accrual basis of accounting gives a more accurate picture of financial events during the period.

Matching Principle

Matching Principle – states that all expenses must be matched and recorded with their respective revenues in the period that they were incurred instead of when they are paid. This principle works with the revenue recognition principle ensuring all revenue and expenses are recorded on the accrual basis.

Full Disclosure Principle

Full Disclosure Principle – requires that any knowledge that would materially affect a financial statement user’s decision about the company must be disclosed in the footnotes of the financial statements. This prevents companies from hiding material facts about accounting practices or known contingencies in the future.

Cost Benefit Principle

Cost Benefit Principle – limits the required amount of research and time to record or report financial information if the cost outweighs the benefit. Thus, if recording an immaterial event would cost the company a material amount of money, it should be forgone.

Conservatism Principle

Conservatism Principle – accountants should always error on the most conservative side possible in any situation. This prevents accountants from over estimating future revenues and underestimated future expenses that could mislead financial statement users.

Objectivity Principle

Objectivity Principle – financial statements, accounting records, and financial information as a whole should be independent and free from bias. The financial statements are meant to convey the financial position of the company and not to persuade end users to take certain actions.

Consistency Principle

Consistency Principle – all accounting principles and assumptions should be applied consistently from one period to the next. This ensures that financial statements are comparable between periods and throughout the company’s history.

List of Key Accounting Assumptions

Here is a list of the key accounting assumptions that make up generally accepted accounting principles:

  • Monetary Unit Assumption
  • Periodicity Assumption

Monetary Unit Assumption

Monetary Unit Assumption – assumes that all financial transactions are recorded in a stable currency. This is essential for the usefulness of a financial report. Companies that record their financial activities in currencies experiencing hyper-inflation will distort the true financial picture of the company.

Periodicity Assumption

Periodicity Assumption – simply states that companies should be able to record their financial activities during a certain period of time. The standard time periods usually include a full year or quarter year.

Fundamental Accounting Concepts and Constraints

Here is a list of the four basic accounting concepts and constraints that make up the GAAP framework in the US.

  • Business Entity Concept
  • Going Concern Concept
  • Materiality Concept
  • Industry Practices Constraint

Business Entity Concept

Business Entity Concept – is the idea that the business and the owner of the business are separate entities and should be accounted for separately. This concept also applies to different businesses. Each business should account for its own transactions separately.

Going Concern Concept

Going Concern Concept – states that companies need to be treated as if they are going to continue to exist. This means that we must assume the company isn’t going to be dissolved or declare bankruptcy unless we have evidence to the contrary. Thus, we should assume that there will be another accounting period in the future.

Materiality Concept

Materiality Concept – anything that would change a financial statement user’s mind or decision about the company should be recorded or noted in the financial statements. If a business event occurred that is so insignificant that an investor or creditor wouldn’t care about it, the event need not be recorded.

Industry Practices Constraint

Industry Practices Constraint – some industries have unique aspects about their business operation that don’t conform to traditional accounting standards. Thus, companies in these industries are allowed to depart from GAAP for specific business events or transactions.

Why Are Accounting Principles Important?

Generally Accepted Accounting Principles are important because they set the rules for reporting and bookkeeping. These rules, often called the GAAP framework, maintain consistency in financial reporting from company to company across all industries.

Remember, the entire point of financial accounting is to provide useful information to financial statement users. If everyone reported their financial information differently, it would be difficult to compare companies. Accounting principles set the rules for reporting financial information, so all companies can be compared uniformly.

What is the Purpose of Accounting Principles?

The purpose of accounting principles is to establish the framework for how financial accounting is recorded and reported on financial statements. When every company follows the same framework and rules, investors, creditors, and other financial statement users will have an easier time understanding the reports and making decisions based on them.