Defining Accounting Principles and Concepts

Accounting principles and concepts are the established rules that companies follow when recording and summarizing their financial activities. This system creates a standardized language for business, ensuring that the information presented in financial statements is consistent and comparable between different organizations. Adhering to these shared conventions allows investors, creditors, and management to make informed decisions based on reliable data, building trust in the financial markets.

The Governing Frameworks of Accounting

In the United States, companies adhere to Generally Accepted Accounting Principles (GAAP). GAAP provides a detailed set of standards for financial reporting, sometimes offering industry-specific guidance to address unique business environments.

Outside of the U.S., more than 140 jurisdictions require the use of International Financial Reporting Standards (IFRS) for publicly listed companies. IFRS is a more principles-based system that aims to create a single set of global accounting standards, often requiring more professional judgment to apply its broader guidelines.

The Financial Accounting Standards Board (FASB) manages GAAP, with a mission to establish standards that provide useful information to investors. For IFRS, the International Accounting Standards Board (IASB) works to bring transparency and efficiency to global financial markets. The boards now primarily operate on separate agendas, and differences between GAAP and IFRS have emerged.

Foundational Accounting Assumptions

Economic Entity Assumption

The economic entity assumption states that a business’s financial activities must be kept separate from the personal finances of its owners. This separation is necessary to accurately assess the business’s performance, free from the owner’s personal wealth. For example, if an owner uses a company credit card for personal groceries, this is a personal expense. It must be recorded as a “draw” from owner’s equity, not a business expense. Maintaining separate bank accounts is a practical way to uphold this distinction.

Going Concern Assumption

The going concern assumption presumes a business will continue to operate for the foreseeable future. This assumption justifies recording assets like buildings at their original cost and depreciating them over their useful lives. Without this assumption, all assets would need to be valued at their immediate liquidation value, resulting in a completely different picture of the company’s financial health. Auditors must disclose if there is substantial doubt about a company’s viability, which can be challenged by factors like recurring losses or pending legal proceedings.

Monetary Unit Assumption

The monetary unit assumption requires a business to record its financial transactions in a specific, stable currency, such as the U.S. dollar. All economic events are measured in monetary terms. A key consequence is that this assumption disregards the effects of inflation. An asset purchased for $10,000 ten years ago remains on the books at $10,000, even though its purchasing power has changed.

Time Period Assumption

The time period assumption allows a company to divide its ongoing activities into artificial time intervals for reporting purposes. These reporting periods are typically a month, a quarter, or a year. This practice makes it possible to prepare financial statements like the income statement, which shows performance over a specific interval and allows for comparison of results from one period to the next.

Core Principles of Measurement and Recognition

Accrual Basis of Accounting

The accrual basis of accounting requires transactions to be recorded in the period they occur, regardless of when cash is exchanged. Under this method, revenues are recorded when earned and expenses are recorded when incurred. This method connects revenues with the expenses it took to generate them in the same period, offering a more accurate representation of a company’s operational results. This provides a more accurate picture of performance than the cash basis, which only recognizes transactions when cash is received or paid.

Revenue Recognition Principle

The revenue recognition principle dictates when a company should record revenue. Under the standard ASC 606, revenue is recognized when a company transfers promised goods or services to a customer in an amount it expects to receive. This process involves identifying the contract and its performance obligations, determining the transaction price, and allocating it to the obligations. Revenue is then recognized as each obligation is satisfied. For example, a company selling a one-year software subscription for $1,200 must recognize $100 of revenue each month as it provides the service, not the full amount upfront.

Matching Principle (Expense Recognition)

The matching principle mandates that expenses be recorded in the same accounting period as the revenues they helped to generate. For instance, if a company pays its sales staff a commission on products sold in December, that commission expense must be recorded in December’s financial statements. This holds true even if the actual cash payment of the commission to the salesperson does not happen until January. This principle also applies to assets that benefit multiple periods, like a machine. Instead of expensing the full cost at purchase, it is allocated as depreciation expense over the machine’s useful life, matching the cost against the revenues it helps generate each period.

Cost Principle (Historical Cost)

The cost principle, or historical cost principle, requires that assets be recorded on the balance sheet at their original purchase price. This cost includes all expenditures necessary to get the asset ready for use, such as shipping and installation. Once recorded, the asset’s value remains at its historical cost, reduced by accumulated depreciation. The principle prohibits increasing the recorded value of an asset, so a parcel of land purchased for $50,000 must remain on the books at that price, even if its current appraised value is $1 million.

Full Disclosure Principle

The full disclosure principle requires a company’s financial statements to include all information that could influence the judgment of an informed user. This additional context is typically presented in the footnotes that accompany the financial statements. Disclosures may cover topics like the accounting methods used, pending litigation, commitments under long-term contracts, or significant events that occurred after the balance sheet date.

Modifying Principles and Constraints

Materiality

Materiality allows companies to disregard other accounting principles for items that are insignificant. An item is material if its omission or misstatement could influence the decisions of financial statement users. This concept introduces professional judgment, as there is no single, universal threshold for what constitutes a material amount. For example, a large corporation can expense a $50 trash can immediately rather than capitalizing and depreciating it, as the cost is immaterial to its overall financial position.

Conservatism

The principle of conservatism guides accountants in situations of uncertainty. When faced with two acceptable alternatives, the chosen option should be the one that results in a less favorable outcome. This approach is often summarized as “anticipate no profit, but provide for all possible losses.” For instance, a company would record a liability for a potential lawsuit loss as soon as it is probable, but would not record a potential gain until the funds are actually received.