What are Accounting Principles?
Double entry bookkeeping is the first stage in producing a set of financial statements for a business. For the financial statements to be useful the users (the bank manger, tax authorities, owners, investors, etc) need to have agreed and understand how they were compiled from the underlying information.
For example, inventory could be valued at cost, or selling price, or on the basis of its personal value to the user, a subjective measure. Each user would come up with a different value and have a different understanding of what the figure in the financial statements referred to.
For this reason a general consensus for all users (objective measure) has to be reached. In the case of inventory, for example, the agreed accounting principle is that inventory is shown in the financial statements at the lower of its cost and net realizable value.
Over time, to ensure financial statements remain useful, the accounting industry has developed many standard accounting principles covering all aspects of accounting.
Today, these accounting principles are made up from accounting assumptions, concepts and constraints, and standards issued by regulatory bodies, as illustrated in the diagram.
The accounting principles diagram is available for download in PDF format by following the link below.
Accounting assumptions are the foundation of the accounting framework. They are generally accepted practices and customs which have been agreed and adopted by the accounting industry over time.
- Money measurement – accounting is only concerned with money transactions.
- Business entity or Economic entity – the business is separate from the owner.
- Going concern – assume the business will continue for the long term.
- Time period – The business reports its financial activities over a fixed time period usually annually.
The accounting concepts offer more specific guidance on how particular business transactions should be reported in financial statements.
- Revenue recognition or realization – revenue is recognized when it is earned, e.g. when goods pass to the customer and they incur liability for them.
- Matching or accruals – expenses are matched to revenues not payments matched to receipts.
- Full disclosure – disclose all information significant to the user.
- Historical cost – transactions are shown at cost.
- Dual aspect – double entry bookkeeping is used, and assets equals liabilities plus equity.
- Verifiable and objective evidence – transactions should have adequate documentary evidence.
Accounting constraints, modify and constrain accounting assumptions, concepts and standards in certain situations.
- Materiality – Override other accounting principles if the transaction is insignificant.
- Prudence or conservatism – Recognize losses, don’t anticipate profits.
- Consistency – Apply same methods of recording transactions each year.
- Cost benefit – The cost of applying an accounting principles should not be more than the benefit derived from them.
Accounting standards are issued by regulatory authorities within a particular country to support accounting principles, conventions and concepts.
In the US, the Financial Accounting Standards Board (FASB) is a private organization responsible for developing and issuing financial accounting standards which form a large part of US Generally Accepted Accounting Principles or GAAP. The US FASB is currently in discussions with the IASB (see below) to converge their regulations.
Europe and International
The IASB, an abbreviation for International Accounting Standards Board, is the independent standard setting body of the IFRS Foundation responsible for the development of financial reporting standards both in Europe and Internationally.
They are also responsible for issuing International Financial Reporting Standards (IFRS) which offer guidance and rules on the preparation of financial statements.
In the UK accounting principles, conventions, concepts and standards come under the heading of UK GAAP (Generally Accepted Accounting Practice). The regulatory authority is the Financial Reporting Council (FRC) which is responsible for issuing UK Financial Reporting Standards (FRS), and for the previously issued Statements of Standard Accounting Practice (SSAP).
With the issue of FRS 100 to FRS 102, the UK is due to adopt what has been referred to as new UK GAAP from January 2015. However a listed company in the UK must follow the European and International IFRS standards.
Accounting policies are the specific principles, bases, conventions, rules and practices applied by a business in preparing and presenting its financial statements.
A business will have an accounting policy for all types of financial transactions. For example in relation to inventory the accounting policy might be stated as:
Inventory Accounting Policy
Inventories comprise goods and properties held for resale and properties held for, or in the course of, development with a view to sell. Inventories are valued at the lower of cost and fair value less costs to sell using the weighted average cost basis.
or for depreciation its accounting policy might be shown as:
Depreciation Accounting Policy
Property, plant and equipment is carried at cost less accumulated depreciation and any recognized impairment in value. Property, plant and equipment is depreciated on a straight-line basis to its residual value over its anticipated useful economic life. The following depreciation rates are applied for the business:
- Freehold and leasehold buildings with greater than 40 years unexpired – at 2.5% of cost;
- Leasehold properties with less than 40 years unexpired are depreciated by equal annual installments over the unexpired period of the lease; and
- Plant, equipment, fixtures and fittings and motor vehicles – at rates varying from 9%-50%.
Once a business has developed accounting policies, then they should be applied consistently for similar transactions, events and conditions. Accounting policies are normally only changed if it is required by an Accounting Standard issued by regulatory authorities within a particular country, or if it provides more reliable and relevant information about the effects of the transactions.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years in all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.