Introduction to Accounting Principles confident conclusions when comparing one

company to another, or comparing one company's

There are general rules and concepts that financial statistics to the statistics for its industry.
govern the field of accounting. These general Over the years the generally accepted accounting
rules–referred to as basic accounting principles principles have become more complex because
and guidelines–form the groundwork on which financial transactions have become more complex.
more detailed, complicated, and legalistic
accounting rules are based. For example, Basic Accounting Principles and Guidelines
the Financial Accounting Standards Board
(FASB) uses the basic accounting principles and 1. Economic Entity Assumption
guidelines as a basis for their own detailed and
comprehensive set of accounting rules and The accountant keeps all of
standards. the business transactions of a sole proprietorship
separate from the business
The phrase "generally accepted accounting owner's personal transactions. For legal purposes,
principles" (or "GAAP") consists of three important a sole proprietorship and its owner are considered
sets of rules: (1) the basic accounting principles and to be one entity, but for accounting purposes they
guidelines, (2) the detailed rules and standards are considered to be two separate entities.
issued by FASB and its predecessor the Accounting
Principles Board (APB), and (3) the generally 2. Monetary Unit Assumption
accepted industry practices.
Economic activity is measured in U.S.
If a company distributes its financial dollars, and only transactions that can be
statements to the public, it is required to follow expressed in U.S. dollars are recorded. Because of
generally accepted accounting principles in the this basic accounting principle, it is assumed that
preparation of those statements. Further, if a the dollar's purchasing power has not changed
company's stock is publicly traded, federal law over time. As a result accountants ignore the effect
requires the company's financial statements be of inflation on recorded amounts. For example,
audited by independent public accountants. Both dollars from a 1960 transaction are combined (or
the company's management and the independent shown) with dollars from a 2014 transaction.
accountants must certify that the financial
statements and the related notes to the financial 3. Time Period Assumption
statements have been prepared in accordance with
GAAP. This accounting principle assumes that it is
possible to report the complex and ongoing
GAAP is exceedingly useful because it activities of a business in relatively short, distinct
attempts to standardize and regulate accounting time intervals such as the five months ended May
definitions, assumptions, and methods. Because of 31, 2014, or the 5 weeks ended May 1, 2014. The
generally accepted accounting principles we are shorter the time interval, the more likely the need
able to assume that there is consistency from year for the accountant to estimate amounts relevant to
to year in the methods used to prepare a that period. For example, the property tax bill is
company's financial statements. And although received on December 15 of each year. On the
variations may exist, we can make reasonably income statement for the year ended December
31, 2013, the amount is known; but for the income 5. Full Disclosure Principle
statement for the three months ended March 31,
2014, the amount was not known and an estimate If certain information is important to an
had to be used. investor or lender using the financial statements,
that information should be disclosed within the
It is imperative that the time interval (or statement or in the notes to the statement. It is
period of time) be shown in the heading of each because of this basic accounting principle that
income statement, statement of stockholders' numerous pages of "footnotes" are often attached
equity, and statement of cash flows. Labeling one to financial statements.
of these financial statements with "December 31"
is not good enough–the reader needs to know if As an example, let's say a company is
the statement covers the one week ended named in a lawsuit that demands a significant
December 31, 2014 the month ended December amount of money. When the financial statements
31, 2014 the three months ended December 31, are prepared it is not clear whether the company
2014 or theyear ended December 31, 2014. will be able to defend itself or whether it might
lose the lawsuit. As a result of these conditions and
4. Cost Principle because of the full disclosure principle the lawsuit
will be described in the notes to the financial
From an accountant's point of view, the statements.
term "cost" refers to the amount spent (cash or the
cash equivalent) when an item A company usually lists its significant
was originally obtained, whether that purchase accounting policies as the first note to its financial
happened last year or thirty years ago. For this statements.
reason, the amounts shown on financial
statements are referred to as historical cost 6. Going Concern Principle
amounts.
This accounting principle assumes that a
Because of this accounting principle asset company will continue to exist long enough to
amounts are not adjusted upward for inflation. In carry out its objectives and commitments and will
fact, as a general rule, asset amounts are not not liquidate in the foreseeable future. If the
adjusted to reflect any type of increase in value. company's financial situation is such that the
Hence, an asset amount does not reflect the accountant believes the company will not be able
amount of money a company would receive if it to continue on, the accountant is required to
were to sell the asset at today's market value. (An disclose this assessment.
exception is certain investments in stocks and The going concern principle allows the company to
bonds that are actively traded on a stock defer some of its prepaid expenses until future
exchange.) If you want to know the current value accounting periods.
of a company's long-term assets, you will not get
this information from a company's financial 7. Matching Principle
statements–you need to look elsewhere, perhaps
to a third-party appraiser. This accounting principle requires
companies to use the accrual basis of
accounting. The matching principle requires that
expenses be matched with revenues. For example, Because of this basic accounting principle or
sales commissions expense should be reported in guideline, an accountant might be allowed to
the period when the sales were made (and not violate another accounting principle if an amount is
reported in the period when the commissions were insignificant. Professional judgement is needed to
paid). Wages to employees are reported as an decide whether an amount is insignificant or
expense in the week when the employees worked immaterial.
and not in the week when the employees are paid.
If a company agrees to give its employees 1% of its An example of an obviously immaterial item
2014 revenues as a bonus on January 15, 2015, the is the purchase of a $150 printer by a highly
company should report the bonus as an expense in profitable multi-million dollar company. Because
2014 and the amount unpaid at December 31, the printer will be used for five years,
2014 as a liability. (The expense is occurring as the the matching principle directs the accountant to
sales are occurring.) expense the cost over the five-year period.
Because we cannot measure the future economic The materiality guideline allows this company to
benefit of things such as advertisements (and violate the matching principle and to expense the
thereby we cannot match the ad expense with entire cost of $150 in the year it is purchased. The
related future revenues), the accountant charges justification is that no one would consider it
the ad amount to expense in the period that the ad misleading if $150 is expensed in the first year
is run. instead of $30 being expensed in each of the five
years that it is used.
8. Revenue Recognition Principle Because of materiality, financial statements usually
show amounts rounded to the nearest dollar, to
Under the accrual basis of accounting (as the nearest thousand, or to the nearest million
opposed to the cash basis of dollars depending on the size of the company.
accounting), revenues are recognized as soon as a
product has been sold or a service has been
performed, regardless of when the money is 10. Conservatism
actually received. Under this basic accounting
principle, a company could earn and report If a situation arises where there are two
$20,000 of revenue in its first month of operation acceptable alternatives for reporting an item,
but receive $0 in actual cash in that month. conservatism directs the accountant to choose the
alternative that will result in less net income
For example, if ABC Consulting completes and/or less asset amount. Conservatism helps the
its service at an agreed price of $1,000, ABC should accountant to "break a tie." It does not direct
recognize $1,000 of revenue as soon as its work is accountants to be conservative. Accountants are
done—it does not matter whether the client pays expected to be unbiased and objective.
the $1,000 immediately or in 30 days. Do not
confuse revenue with a cash receipt. The basic accounting principle of
conservatism leads accountants to anticipate or
9. Materiality 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 For example, if a company has an investment in
inventory downto an amount that is lower than the stock that is actively traded on a stock exchange,
original cost, but will not write inventory up to an the company may be required to show the current
amount higher than the original cost. value of the stock instead of its original cost.

Other Characteristics of Accounting Information 2. Consistency

Accountants are expected to

When financial reports are generated by
be consistent when applying accounting principles,
professional accountants, we have certain
procedures, and practices. For example, if a
expectations of the information they present to us:
company has a history of using the FIFO cost flow
assumption, readers of the company's most
1. We expect the accounting information to
current financial statements have every reason to
be reliable, verifiable, and objective.
expect that the company is continuing to use the
2. We expect consistency in the accounting
FIFO cost flow assumption. If the company changes
information.
this practice and begins using the LIFO cost flow
3. We expect comparability in the accounting
assumption, that change must be clearly disclosed.
information.

3. Comparability
1. Reliable, Verifiable, and Objective
Investors, lenders, and other users of
In addition to the basic accounting
financial statements expect that financial
principles and guidelines listed in Part 1,
statements of one company can be compared to
accounting information should be reliable,
the financial statements of another company in the
verifiable, and objective. For example, showing
same industry.Generally accepted accounting
land at its original cost of $10,000 (when it was
principles may provide for comparability between
purchased 50 years ago) is considered to be
the financial statements of different companies.
more reliable, verifiable, and objective than
For example, the FASB requires that expenses
showing it at its current market value of $250,000.
related to research and development (R&D) be
Eight different accountants will wholly agree that
expensed when incurred. Prior to its rule, some
the original cost of the land was $10,000—they can
companies expensed R&D when incurred while
read the offer and acceptance for $10,000, see a
other companies deferred R&D to the balance
transfer tax based on $10,000, and review
sheet and expensed them at a later date.
documents that confirm the cost was $10,000. If
you ask the same eight accountants to give you the
land's current value, you will likely receive eight
different estimates. Because the current value
amount is less reliable, less verifiable, and less
objective than the original cost, the original cost is
used.

The accounting profession has been willing

to move away from the cost principle if there are
reliable, verifiable, and objective amounts involved.