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 (IFRS)  is the most widely

used set of accounting principles, with adoption in 167 jurisdictions. The
United States uses a separate set of accounting principles, known
as generally accepted accounting principles (GAAP).1

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 the 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.

The Purpose of 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.

 
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.

Comparability

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 are

developed to minimize the negative effects of inconsistent data. Without
these rules, comparing financial statements among companies would be
extremely difficult, even within the same industry. Inconsistencies and errors
also would be harder to spot.

What Are the Basic Accounting Principles?

Some of the most fundamental accounting principles include the following:

 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

The most notable principles include the revenue recognition principle,

matching principle, materiality principle, and consistency principle.
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 among 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 .

Generally Accepted Accounting Principles (GAAP)

Generally accepted accounting principles (GAAP) are uniform accounting
principles for private companies and nonprofits in the U.S. These principles
are largely set by the Financial Accounting Standards Board (FASB) , an
independent nonprofit organization whose members are chosen by
the Financial Accounting Foundation.2

A similar organization, the Governmental Accounting Standards Board

(GASB), is responsible for setting the GAAP standards for local and state
governments.3 And a third body, the Federal Accounting Standards Advisory
Board (FASAB), publishes the accounting principles for federal agencies.4

Although privately held companies are not required to abide by GAAP,

publicly traded companies must file GAAP-compliant financial statements 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.5

Privately held companies and nonprofit organizations also may 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 U.S. comply with GAAP, even though it is
not a legal requirement.

 
Accounting principles differ around the world, meaning that it’s not always
easy to compare the financial statements of companies from different
countries.

International Financial Reporting Standards (IFRS)

The International Accounting Standards Board (IASB) issues International
Financial Reporting Standards (IFRS). These standards are used in more
than 120 countries, including those in the European Union (EU).6
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.5

However, the FASB and the IASB continue to work together to issue similar
regulations on certain topics as accounting issues arise.7 For example, in
2014, the FASB and the IASB jointly announced new revenue recognition
standards.8

Since accounting principles differ around 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, generally accepted accounting principles (GAAP) are
regulated by the Financial Accounting Standards Board (FASB). In Europe
and elsewhere, International Financial Reporting Standards (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. 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 first in, first out (FIFO) or last
in, first out (LIFO) as an inventory cost method. LIFO, however, is banned
under IFRS.910

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.11 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. What
would become the American Institute of Certified Public Accountants (AICPA)
and the New York Stock Exchange (NYSE) attempted to launch the first
accounting standards to be used by firms in the United States in the
1930s.12

What are some critiques of accounting principles?

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 to comply with industry standards.

The Bottom Line

Accounting principles are rules and guidelines that companies must abide by
when reporting financial data. Whether it’s GAAP in the U.S. or IFRS
elsewhere, the overarching goal of these principles is to boost transparency
and basically make it easier for investors to compare the financial statements
of different companies.

Without these rules and standards, publicly traded companies would likely
present their financial information in a way that inflates their numbers and
makes their trading performance look better than it actually was. If companies
were able to pick and choose what information to disclose and how, it would
be a nightmare for investors.