Accountants utilize generally accepted accounting principles to guide them in recording and reporting financial information. This broad set of principles was developed by those in the accounting profession and the Securities and Exchange Commission. In order to remain listed on many major stock exchanges in the U.S., companies must file regular financial statements that are reported according to these principles of accounting, though principles can vary slightly in other countries around the world. The following principles apply to most financial statements:
- Economic Entity Assumption – Financial records must be maintained separately for each economic entity, and must not include the personal assets or liabilities of the owners.
- Monetary Unit Assumption – An entity’s accounting records should include only quantifiable transactions and they must be recorded using a stable currency.
- Full Disclosure Principle – Financial statements must include information about a company’s past performance, as well as any pending lawsuits, incomplete transactions or other conditions that may have significant effects on the company’s financial status.
- Time Period Assumption – Specific time periods must be used to report the results of business activity to establish consistent records and reports. Under this assumption, financial statements are prepared monthly, quarterly, half-yearly or annually.
- Accrual Basis Accounting – Accrual basis accounting, as opposed to cash basis, adheres to revenue recognition, matching and cost principles, and captures other financial aspects of each economic event in the accounting period in which it occurs, regardless of when the cash changes hands.
- Revenue recognition principle – Revenue is recognized and earned upon service completion or product delivery, without regard to the timing of cash flow. However, it is important to note there may be exceptions regarding revenue recognition due to specific Incoterms, and your CPA should be consulted to ensure proper compliance.
- Matching Principle – The costs of doing business are recorded in the same period as the revenue in which they help to generate.
- Cost Principle – Assets are recorded at cost, which equals the value exchanged at the time of their acquisition.
- Going Concern Principle – Financial statements are prepared under the assumption that the company will remain in business indefinitely, unless otherwise noted.
- Relevance, Reliability, and Consistency – Financial information must be relevant, reliable and prepared in a consistent manner in order to be useful. This helps a decision maker understand the company’s past performance, present state and future outlook, in order to make decisions in a timely manner.
- Principles of Conservatism – Accountants must use their judgment to record transactions that require estimation, and in doing so, use the less optimistic estimate when two estimates are considered likely.
- Materiality Principle – Any accounting principle may be ignored when there is no effect on the financial information being reported, and the users of the financial information would not be misguided.
In instances where the application of one particular accounting principle leads to conflict with another concept, accountants should consider what is best for the users of the financial information. While this guide to the principles of accounting offers a helpful guide to understanding the general rules to be followed when reporting financial data, there are, of course, many more important aspects to take into account when it comes to financial decision-making. Also keep in mind that the principles of accounting can vary from country to country, so it’s vital to take these potential differences into account when comparing companies from around the world.
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