Understanding the basic accounting principles that is very important as it affects the preparation of financial statements. The following accounting rules and assumptions dictate what, when and how to measure financial items.
These rules were created by the Financial Accounting Standards Board (FASB) and are called General Accepted Accounting Principles (GAAP). GAAP refers to the standard guidelines for financial accounting used in any given jurisdiction. GAAP includes the standards, conventions, and rules accountants follow in preparing and reporting financial statements.
The following are 12 basic but important accounting principles:
- Accounting Entity – is the business unit for which the financial statements are being prepared. The accounting entity recognizes that there is a business entity that is separate from its owner(s). In addition, the economic unit engages in identifiable economic activities and controls economic resources.
- Going Concern – Accounts assume that the life of the business entity is infinitely long and will never dissipate. In some cases, if there is a clear sign that a business may go bankrupt, the accountant must issue a qualified opinion stating the potential of a demise.
- Measurement – Accounting only deals with things that can be measured, quantifiable. Therefore, aspects that are crucial to profits may be overlooked such as customer loyalty.
- Units of Measure – The US Dollar (USD) is the standard value used in financial statements for companies in the United States. Any foreign transactions must be translated to USD based on the current exchange rate.
- Historical Cost – The transactions that results in what a business owns and owes are recorded at their original cost. This may cause the company’s books to be understated. For example, a company can own a manufacturing facility that is valued at $25,000,000 but carry it on the books for their purchase price of $7,000,000.
- Materiality – The concept of materiality allows you to violate another accounting principle if the value is so tiny that the financial reports will not have an impact. Materiality is a judgment call by the accountant.
- Estimates and Judgments – Often times, it is OK to guess due to the nature that businesses are complex. It is legal, if the accounting is the best you can do, the expected error would not affect the financial reports and the “guesses” are consistent for each period.
- Consistency - Each individual enterprise must choose a single method of accounting and reporting consistently over time.
- Conservatism – Accountants must agree more with an understatement than an overvaluation. This accounting guideline states that if doubt exists between two alternatives, the accountant should choose the result with a lesser asset amount and/or a lesser profit.
- Periodicity – Is the activity within the scope of an accounting period that must be recorded within the time period on a financial statement. Normally the life of a business can be divided into periods of time (month, quarter or year).
- Substance Over Form – This is a concept where the entity is accounting for items according to their substance and economic reality and not just its form.
- Accrual Basis of Presentation – In accrual accounting, if a business transaction makes money in a period then all of its associated costs and business expenses should also be reported in that particular period. All businesses with inventory must use the accrual basis. The alternative for business that don’t carry inventory is “cash basis” accounting in which transactions are recorded as they are physically received or paid out.