Principles

 

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)

Publicly traded companies in the United States are required to regularly file generally accepted accounting principles, or GAAP-compliant financial statements in order to remain publicly listed on stock exchanges. 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.

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

Accounting principles help govern the world of accounting according to general rules and guidelines. GAAP attempts to standardize and regulate the definitions, assumptions, and methods used in accounting. 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.

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 of companies would be extremely difficult, even within the same industry, making an apples-to-apples comparison hard. 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 necessarily a requirement.

International Financial Reporting Standards (IFRS)

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). The Securities and Exchange Commission (SEC), the U.S. government agency responsible for protecting investors and maintaining order in the securities markets, has expressed that the U.S. will not be switching to IFRS in the foreseeable future. However, the FASB and the IASB continue to work together to issue similar regulations on certain topics as accounting issues arise. For example, in 2014 the FASB and the IASB jointly announced new revenue recognition standards.

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.

Frequently Asked Questions

Who sets accounting principles and standards?

Various bodies set forth accounting standards. In the United States, GAAP is regulated by the Financial Accounting Standards Board (FASB). In Europe and elsewhere, the IFRS are set out 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. Although the majority of the world uses IFRS standards, it is still not part of the U.S. financial accounting world. The SEC continues to review switching to the IFRS but has yet to do so.

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.

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 that introduced a T-ledger with matched entries for assets and liabilities. 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 Accountants, which is now known as 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

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 its financial health. In the case of rules-based methods like GAAP, complex rules can cause unnecessary complications in the preparation of financial statements. And having strict rules means that accountants may try to make their companies more profitable than they actually are because of the responsibility to their shareholders.

GAAP VS. IFRS: WHICH SHOULD YOU USE?

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Accounting is often referred to as the “language of business.” It’s one of the most fundamental business skills, capable of revealing key insights into a company’s financial health and potential, and driving strategic decision-making that leads to new ventures and investment opportunities.

For professionals in non-accounting roles, understanding what’s behind an organization’s numbers can be immensely valuable. Knowing how to analyze financial statements can improve your ability to communicate results and boost collaboration with colleagues in more numbers-focused positions.

If you want to further your accounting knowledge, it’s critical to understand the standards that guide how companies record transactions and report finances. Here’s a look at the two primary sets of accounting standards—GAAP and IFRS—and how they compare.

AN OVERVIEW OF GAAP VS. IFRS

Accounting standards are critical to ensuring a company’s financial information and statements are accurate and can be compared to the data reported by other organizations.

The two main sets of accounting standards followed by businesses are GAAP and IFRS.

• GAAP, also referred to as US GAAP, is an acronym for Generally Accepted Accounting Principles. This set of guidelines is set by the Financial Accounting Standards Board (FASB) and adhered to by most US companies.
• IFRS stands for International Financial Reporting Standards. These principles are dictated by the International Accounting Standards Board (IASB) and followed in many countries outside the US.

Deciding which set of standards to use depends on whether your company operates in the US or internationally. Work is being done to converge GAAP and IFRS, but the process has been slow going.

THE KEY DIFFERENCES BETWEEN GAAP VS. IFRS

While GAAP and IFRS share many similarities, there are several contrasts, beyond the regions in which they’re applied. Here are four key differences between GAAP and IFRS.

1. The Balance Sheet

The way a balance sheet is formatted is different in the US than in other countries. Under GAAP, current assets are listed first, while a sheet prepared under IFRS begins with non-current assets.

The two standards also dictate different approaches to ordering categories on the balance sheet. GAAP calls for accounts to be listed in the order of liquidity—or how quickly and easily they can be converted to cash. The items are arranged in descending order (most liquid to least liquid): current assets, non-current assets, current liabilities, non-current liabilities, and owners’ equity.

Under IFRS, the order is reversed (least liquid to most liquid): non-current assets, current assets, owners’ equity, non-current liabilities, and current liabilities.

2. The Cash Flow Statement

A company’s cash flow statement is also prepared differently under GAAP and IFRS. This is most acutely seen in how interest and dividends are classified.

GAAP prescribes that interest paid and interest received should be classified as operating activities, while international standards are a bit more flexible. Under IFRS, a firm can choose its own policy for classifying interest based on what it considers to be appropriate. Interest paid can be placed in either the operating or financing section of the cash flow statement, and interest received in the operating or investing sections.

The same goes for dividends. GAAP specifies that dividends paid be accounted for in the financing section, and dividends received in the operating section. When following IFRS standards, companies have a choice of how they categorize dividends. Dividends paid can be put in either the operating or financing section, and dividends received in the operating or investing section.

To summarize, here’s a detailed breakdown of how the two standards differ in their treatment of interest and dividends.

3. Asset Revaluation

When an asset experiences a reduction in value due to market or technological factors—which in turn, causes it to fall below its current value in a company’s account—it’s classified as a loss on impairment. While impairment is often permanent, an asset’s value can increase after this loss has been recognized if the elements that caused it no longer exist.

GAAP and IFRS handle this ensuing rise in value differently. The rules of GAAP do not allow for an asset’s value to be written back up after it’s been impaired. IFRS standards, however, permit that certain assets can be revaluated up to their original cost and adjusted for depreciation.

4. Inventory Valuation Methods

GAAP and IFRS contrast in how they handle inventory valuation, too. Three methods that companies use to value inventory are FIFO, LIFO, and weighted inventory.

• FIFO stands for First In First Out. This inventory valuation method follows the natural flow of inventory, assuming that the first items in inventory (i.e. the oldest) are the first sold.
• LIFO, or Last In First Out, takes the opposite approach of FIFO. Under this method, the last items to arrive in inventory (i.e. the newest) are assumed to be the first sold.
• Weighted average looks at the weighted average cost of items remaining in inventory at the time of an associated sale, which yields a figure that can then be used to value ending inventory and the related cost of goods sold. 

In the US, under GAAP, all of these approaches to inventory valuation are permitted, while IFRS allows for the FIFO and weighted average methods to be used, but not LIFO.

THE VALUE OF ACCOUNTING KNOWLEDGE

There are some key differences between how corporate finances are governed in the US and abroad. Understanding GAAP and IFRS guidelines can be an asset, no matter your profession or industry. By furthering your knowledge of these accounting standards through such avenues as an online course, you can more effectively analyze financial statements and gain greater insight into your company’s performance.