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CORPORATE FINANCE & ACCOUNTING FINANCIAL STATEMENTS
GUIDE TO ACCOUNTING
Accounting Principles
By ALICIA TUOVILA Updated September 06, 2021
Reviewed by ANDY SMITH
Fact checked by KATRINA MUNICHIELLO
What Are Accounting Principles?
Accounting principles are the rules and guidelines that companies and other
bodies must follow when reporting financial data. These rules make it easier to
examine financial data by standardizing the terms and methods that
accountants must use.
The International Financial Reporting Standards is the most widely-used set of
accounting principles, with adoption in 166 jurisdictions. The United States
uses a separate set of accounting principles, known as the Generally Accepted
Accounting Principles (GAAP).
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KEY TAKEAWAYS
Accounting standards are implemented to improve the quality of
financial information reported by companies.
In the United States, the Financial Accounting Standards Board (FASB)
issues Generally Accepted Accounting Principles (GAAP).
GAAP is required for all publicly traded companies in the U.S.; it is also
routinely implemented by non-publicly traded companies as well.
Internationally, the International Accounting Standards Board (IASB)
issues International Financial Reporting Standards (IFRS).
The FASB and IASB sometimes work together to issue joint standards
on hot-topic issues, but there is no intention for the U.S. to switch to
IFRS in the foreseeable future.
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Accounting Principles
Understanding Accounting Principles
The ultimate goal of any set of accounting principles is to ensure that a
company's financial statements are complete, consistent, and comparable. This
makes it easier for investors to analyze and extract useful information from the
company's financial statements, including trend data over a period of time. It
also facilitates the comparison of financial information across different
companies. Accounting principles also help mitigate accounting fraud by
increasing transparency and allowing red flags to be identified.
Generally Accepted Accounting Principles (GAAP)
In the United States, the Generally Accepted Accounting Principles are largely
set by the Financial Accounting Standards Board, a nonprofit organization
whose members are chosen by the Financial Accounting Foundation. [1]
Although privately-held companies are not required to abide by GAAP, publicly
traded companies must file GAAP-compliant financial statements in order to be
listed on a stock exchange. Chief officers of publicly traded companies and their
independent auditors must certify that the financial statements and related
notes were prepared in accordance with GAAP. [2]
Some of the most fundamental accounting principles include the following:
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Accrual principle
Conservatism principle
Consistency principle
Cost principle
Economic entity principle
Full disclosure principle
Going concern principle
Matching principle
Materiality principle
Monetary unit principle
Reliability principle
Revenue recognition principle
Time period principle
There are a number of principles, but some of the most notable include the
revenue recognition principle, matching principle, materiality principle, and
consistency principle. The ultimate goal of standardized accounting principles
is to allow financial statement users to view a company's financials with
certainty that the information disclosed in the report is complete, consistent,
and comparable.
Important: The rules for U.S. GAAP are set by the Financial
Accounting Standards Board (FASB), an industry organization that
establishes uniform accounting principles for private companies and
nonprofits. A similar organization, the Governmental Accounting
Standards Board (GASB), is responsible for setting the GAAP
standards for local and state governments. [3] A third body, the
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Federal Accounting Standards Advisory Board (FASAB), publishes the
accounting principles for federal agencies. [4]
Completeness is ensured by the materiality principle, as all material
transactions should be accounted for in the financial statements. Consistency
refers to a company's use of accounting principles over time. When accounting
principles allow a choice between multiple methods, a company should apply
the same accounting method over time or disclose its change in accounting
method in the footnotes to the financial statements.
Comparability is the ability for financial statement users to review multiple
companies' financials side by side with the guarantee that accounting
principles have been followed to the same set of standards. Accounting
information is not absolute or concrete, and standards such as GAAP are
developed to minimize the negative effects of inconsistent data. Without GAAP,
comparing financial statements between companies would be extremely
difficult, even within the same industry. Inconsistencies and errors would also
be harder to spot.
Privately held companies and nonprofit organizations may also be required by
lenders or investors to file GAAP-compliant financial statements. For example,
annual audited GAAP financial statements are a common loan covenant
required by most banking institutions. Therefore, most companies and
organizations in the United States comply with GAAP, even though it is not a
legal requirement.
International Financial Reporting Standards (IFRS)
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Accounting principles differ from country to country. The International
Accounting Standards Board (IASB) issues International Financial Reporting
Standards (IFRS). These standards are used in over 120 countries, including
those in the European Union (EU). [5]
The Securities and Exchange Commission (SEC), the U.S. government agency
responsible for protecting investors and maintaining order in
the securities markets, has expressed interest in transitioning to IFRS. However,
because of the differences between the two standards, the U.S. is unlikely to
switch in the foreseeable future. [2]
However, the FASB and the IASB continue to work together to issue similar
regulations on certain topics as accounting issues arise. [6] For example, in 2014
the FASB and the IASB jointly announced new revenue recognition standards.
[7]
Since accounting principles differ across the world, investors should take
caution when comparing the financial statements of companies from different
countries. The issue of differing accounting principles is less of a concern in
more mature markets. Still, caution should be used as there is still leeway for
number distortion under many sets of accounting principles.
Who Sets Accounting Principles and Standards?
Various bodies are responsible for setting accounting standards. In the United
States, GAAP is regulated by the Financial Accounting Standards Board (FASB).
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In Europe and elsewhere, the IFRS are established by the International
Accounting Standards Board (IASB).
How Does IFRS Differ from GAAP?
IFRS is a standards-based approach that is used internationally, while GAAP is a
rules-based system used primarily in the U.S. The IFRS is seen as a more
dynamic platform that is regularly being revised in response to an ever-
changing financial environment, while GAAP is more static.
Several methodological differences exist between the two systems. For
instance, GAAP allows companies to use either the First in, First out (FIFO) or
Last in, First out (LIFO) as an inventory cost method. LIFO, however, is banned
under IFRS. [8]
When Were Accounting Principles First Set Forth?
Standardized accounting principles date all the way back to the advent of
double-entry bookkeeping in the 15th and 16th centuries which introduced a T-
ledger with matched entries for assets and liabilities. [9] Some scholars have
argued that the advent of double-entry accounting practices during that time
provided a springboard for the rise of commerce and capitalism. The American
Institute of Certified Public Accountants and the New York Stock Exchange
attempted to launch the first accounting standards to be used by firms in the
United States in the 1930s. [10]
What Are Some Critiques of Accounting Principles?
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Critics of principles-based accounting systems say they can give companies far
too much freedom and do not prescribe transparency. They believe because
companies do not have to follow specific rules that have been set out, their
reporting may provide an inaccurate picture of their financial health. In the case
of rules-based methods like GAAP, complex rules can cause unnecessary
complications in the preparation of financial statements. These critics claim
having strict rules means that companies must spend an unfair amount of their
resources in order to comply with industry standards.
Correction—June 15, 2022. This article has been edited to include the different
organizations that publish GAAP standards for government bodies.
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Related Terms
International Accounting Standards (IAS)
International Accounting Standards are an older set of standards that were replaced by
International Financial Reporting Standards (IFRS) in 2001. more
Generally Accepted Accounting Principles (GAAP)
GAAP is a common set of generally accepted accounting principles, standards, and
procedures that public companies in the U.S. must follow when they compile their
financial statements. more
Revenue Recognition As an Accounting Principle
Revenue recognition is a generally accepted accounting principle (GAAP) that identifies
the specific conditions in which revenue is recognized. more
International Financial Reporting Standards (IFRS)
International Financial Reporting Standards (IFRS) are a set of accounting rules currently
used by public companies in 166 jurisdictions. more
What Is an Accounting Standard?
An accounting standard is a common set of principles, standards, and procedures that
define the basis of financial accounting policies and practices. more
What Is Inflation Accounting?
Inflation accounting is a special technique used during periods of high inflation whereby
statements are adjusted according to price indexes. more
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