What are accounting principles?
Accounting principles are the basic rules and guidelines a company must follow when preparing its financial statements in order to report financial information to stakeholders such as shareholders, lenders, and creditors, as well as potential investors.
What is GAAP?
GAAP is the abbreviation for Generally Accepted Accounting Principles, a widely accepted standard set of accounting principles, concepts, and rules companies are required to follow in the preparation of their financial statements.
In order to enable investors, creditors, and lenders to properly compare and analyse the financial results of companies, financial statements must disclose similar information in a similar format.
GAAP is an international framework and convention of acceptable accounting practices, observed by accountants when recording and presenting a company’s financial statements.
The core principles of GAAP
GAAP comprises, inter alia, the following core principles or concepts.
The Business Entity Concept
The business entity concept implies that every business should be regarded as its own accounting entity. This means that the accounting for a business or organisation must be kept separate from the personal financial transactions of its owner, or from the financial recordings of any other business or organisation.
The business balance sheet must only reflect the financial position of the business, excluding all the personal assets of the owner.
In addition, only revenue and expenditures pertaining to the business are recorded to determine the profit or loss of the business. Income and expenditures of a personal nature are charged to the owner and are not allowed to have an effect on the operating results of the business.
To record the amounts of money the business owner gives to or takes from the business, capital and drawings accounts are created.
The Going Concern Concept
The going concern concept, also referred to as the continuing concern concept, indicates that a business will continue its operating activities for an indefinite period of time. Put differently, this principle assumes that a business will not close down for the foreseeable future.
This assumption is important in accounting, as it provides a basis for reporting the value of assets in the balance sheet. Utilising this basis, the assets of a business are recorded according to their original cost and not according to their market value. The reasoning behind this is that the assets are assumed to be used for an indefinite period of time and not expected to be sold or disposed of in the near future.
On the basis of the going concern concept, depreciation is calculated on the fixed assets which are valued at historical cost (original cost) less accumulated depreciation and not on the disposable value because there is no intention to dispose of the assets.
If this concept is not applied, the cost of a fixed asset will be recorded as an expense in the year of its acquisition.
Other implications of the continuing concern concept are:
- A useful indication for investors that they will continue to earn income on their investments.
- If a business is not to continue its activities, the market value will come into play. Usually, the values of the assets decline because they have to be sold under unfavourable financial conditions. The market value of such assets can often only be determined until they are actually sold.
- Existing liabilities will be honoured at maturity.
The Materiality Principle
Basically, the materiality principle states that financial transactions that can influence the users (investors, creditors, or lenders) of the financial statements of a business are considered material (significant and consequential) and must therefore be properly reported within a certain time frame.
Accountants of businesses are required to apply generally accepted accounting principles except under the following circumstances:
- When using GAAP would be expensive or difficult, and
- where it makes no difference if the requirements are disregarded or when there is no effect on the users of the financial information.
When a rule is temporarily ignored, the following requirements are applicable:
- The net income of the business must not be considerably affected, and
- the ability of people analysing the financial statements must not be disabled.
Materiality depends on the nature and size of the item.
Further, the materiality concept implies also:
- Immaterial amounts need not be reported separately and may be grouped with amounts of similar function or nature, and
- that any information, which is important to the readers of the financial statements, must be pointed out or reported separately.
When deciding on the materiality of a financial item, accountants are required to apply sound judgement.
The Principle of Prudence
The principle of prudence, also called the principle of conservatism, requires that the accounting for a business should be fair and reasonable.
An integral part of the work of accountants is to select procedures, make estimates and evaluations, and deliver opinions. While doing so, they should never overstate nor understate the affairs of the business or the outcome of operations. Put differently, losses should not be understated, and profits should not be overstated.
Put into practice, the principle of prudence provides, inter alia, that:
- Accountants must apply sound judgement when recording financial transactions that require estimations.
- When two estimates are judged to be equally likely, the prudent way is to choose the less optimistic estimate.
- Accountants are allowed to anticipate or reveal losses but are not allowed a similar decision regarding profits.
- Provisions for doubtful debts are made for potential loss of money owed by debtors.
- Inventory of goods is valued at the lower of cost and net realisable value.
The Objectivity Principle
The objectivity principle specifies that objective evidence will be the basis of the recording of accounting transactions.
Objective evidence refers to the principle that different people looking at the evidence will get to the same values for the transactions. Put in other words, accounting entries will be based on facts and not on the personal opinions or feelings of the accountant or manager of a business.
Source documents that indicate the agreed amounts between buyers and sellers are almost consistently the best objective evidence available.
This principle implies that the recording of financial transactions in accounting should be executed with independence, not allowing for any bias and prejudice.
The Revenue Recognition Convention
Simply put, the revenue recognition convention in accounting states that revenues are recorded at the time when the transaction (sale) is completed and the invoice for the transaction is sent to the customer (debtor).
If it is a cash transaction, the revenue is recorded when the sale is completed, and the cash received.
It is crucial to record revenue properly in the accounting system. Negligence will lead to incorrect income statements, misinforming the users of a company’s financial statements.
The Matching Principle
The matching principle, an extension of the revenue recognition convention, provides that each expense item related to revenue earned must be recorded in the same accounting period as the revenue it helped to generate.
This principle is applied to ensure that the financial statements of a business measure the results of all business operations fairly.
The Accounting Period Concept
The accounting period concept, also known as the time period concept, indicates that accounting takes place over specific periods of time, referred to as financial periods, fiscal periods, or accounting periods.
Put differently, the financial statements of a business should be prepared at certain intervals such as monthly, quarterly, bi-annually, or annually. Hence, the accounting period concept assumes that the indefinite life of a business is divided into certain time periods. These financial periods are used when determining and evaluating the financial progress of a business.
The accounting time period of one year in length is usually called a fiscal year, while periods of less than a year, such as a quarter, are referred to as interim periods.
Financial statements should be prepared at regular intervals in order to enable the management of a business, among other things, to determine profit (or loss), calculate tax liabilities, and to verify the financial position of the business.
The time period concept is also useful in the following ways:
- It enables lenders (banks and financial institutions) and creditors to analyse and evaluate the performance of a business for a certain time period.
- It helps management to predict the future prospects of a business.
- It allows companies to distribute their income at regular intervals via dividends to shareholders.
- It enables accountants to calculate tax on business profits for a particular time frame.
The Consistency Principle
According to the consistency principle, accountants are required to apply the same accounting concepts, methods, and procedures in the same way in each accounting period. Methods and standards to value inventory, accrued expenses, and to determine depreciation on assets, must be consistent from one accounting period to the next one.
When a method is changed from one accounting period to another, the change must be clearly explained in the financial statements. If there are no explanations or notes regarding variations or changes, the readers of financial statements have the right to assume that consistency has been applied in the accounting process.
Changes in accounting policy must be justifiable.
The consistency principle is important because:
- It requires that similar items should receive similar accounting treatment.
- It prevents the manipulation of financial figures on the financial statements.
- It enables the proper comparison of financial information between two accounting periods of the same time period.
The Money Measurement Concept
The money measurement concept, also known as the monetary assumption, assumes that all business transactions must be recorded in terms of the currency of a country, which is the South African rand (ZAR) for businesses registered and operating in South Arica.
Business transactions that cannot be expressed in monetary units, cannot be recorded in an accounting system.
This concept enables accountants to record business transactions uniformly.
The dual aspect concept
The dual aspect concept, also known as the double aspect concept, is regarded as the basic principle of accounting.
Business transactions are recorded according to the double-entry system, meaning that each transaction has at least one debit entry and one corresponding credit entry.
The double aspect concept can also be expressed in terms of the fundamental accounting equation: Assets = Liabilities + Owner’s equity. Put differently, the assets of a business are always equal to the claims of the owner(s) (owner’s equity) and the claims of outsiders (liabilities).
The equation above implies that every transaction recorded has an equal impact on assets on the one side, and liabilities or owner’s equity on the other side.
In addition, this concept enables accountants to detect recording errors before the finalisation of the financial statements.
The Full Disclosure Principle
The full disclosure principle implies that all relevant information that affects the full understanding of the financial statements must be disclosed in the financial statements, enabling users to make valid decisions.
Some items, such as tax disputes and outstanding lawsuits, that may not affect the ledger accounts directly are typically included in accompanying footnotes.
The Cost Principle
The cost principle, also known as the historical cost principle, states that all assets are recorded at their purchase price, also referred to as the cost price. The cost price includes cost of acquisition, transport fees, and installation costs.
Put in other words, if a business does not pay any amount for an asset, this item will not be recorded in the accounting system.
Usually, the cost price is indicated on the source document of the transaction.
The value of the asset is not changed until its market value changes. However, an entirely new transaction based on new objective evidence is required to change the original value of an asset.
When no objective evidence is available, the transaction must be recorded at fair market value, which must be determined by using an independent method.
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