Accounting Principles Explained: How They Work, GAAP, IFRS

Accounting Principles

Investopedia / Ryan Oakley

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 is the most widely-used set of accounting principles, with adoption in 166 jurisdictions. The United States uses a separate set of accounting principles, known as the Generally Accepted Accounting Principles (GAAP).

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 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.

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)

In the United States, the Generally Accepted Accounting Principles are largely set by the Financial Accounting Standards Board, a nonprofit organization whose members are chosen by the Financial Accounting Foundation.

Although privately-held companies are not required to abide by GAAP, publicly traded companies must file GAAP-compliant financial statements in order 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.

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

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.

The rules for U.S. GAAP are set by the Financial Accounting Standards Board (FASB), an industry organization that establishes uniform accounting principles for private companies and nonprofits. A similar organization, the Governmental Accounting Standards Board (GASB), is responsible for setting the GAAP standards for local and state governments. A third body, the Federal Accounting Standards Advisory Board (FASAB), publishes the accounting principles for federal agencies.

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 between companies would be extremely difficult, even within the same industry. 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 a legal 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 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.

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.

Who Sets Accounting Principles and Standards?

Various bodies are responsible for setting accounting standards. In the United States, GAAP is regulated by the Financial Accounting Standards Board (FASB). In Europe and elsewhere, the 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. 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.

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 which 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 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 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 in order to comply with industry standards.

Article Sources
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