Introduction to Accounting Principles

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There are general rules and concepts that govern the field of accounting. These general rules–
referred to as basic accounting principles and guidelines–form the groundwork on which more
detailed, complicated, and legalistic accounting rules are based. For example, the Financial
Accounting Standards Board (FASB) uses the basic accounting principles and guidelines as a
basis for their own detailed and comprehensive set of accounting rules and standards.

The phrase "generally accepted accounting principles" (or "GAAP") consists of three important
sets of rules: (1) the basic accounting principles and guidelines, (2) the detailed rules and
standards issued by FASB and its predecessor the Accounting Principles Board (APB), and (3)
the generally accepted industry practices.

If a company distributes its financial statements to the public, it is required to follow generally
accepted accounting principles in the preparation of those statements. Further, if a company's
stock is publicly traded, federal law requires the company's financial statements be audited by
independent public accountants. Both the company's management and the independent
accountants must certify that the financial statements and the related notes to the financial
statements have been prepared in accordance with GAAP.

GAAP is exceedingly useful because it attempts to standardize and regulate accounting

definitions, assumptions, and methods. Because of generally accepted accounting principles we
are able to assume that there is consistency from year to year in the methods used to prepare a
company's financial statements. And although variations may exist, we can make reasonably
confident conclusions when comparing one company to another, or comparing one company's
financial statistics to the statistics for its industry. Over the years the generally accepted
accounting principles have become more complex because financial transactions have become
more complex.

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Basic Accounting Principles and Guidelines

Since GAAP is founded on the basic accounting principles and guidelines, we can better
understand GAAP if we understand those accounting principles. The following is a list of the ten
main accounting principles and guidelines together with a highly condensed explanation of each.

1. Economic Entity Assumption

The accountant keeps all of the business transactions of a sole proprietorship separate from the
business owner's personal transactions. For legal purposes, a sole proprietorship and its owner
are considered to be one entity, but for accounting purposes they are considered to be two
separate entities.

2. Monetary Unit Assumption

Economic activity is measured in U.S. dollars, and only transactions that can be expressed in
U.S. dollars are recorded.

Because of this basic accounting principle, it is assumed that the dollar's purchasing power has
not changed over time. As a result accountants ignore the effect of inflation on recorded
amounts. For example, dollars from a 1960 transaction are combined (or shown) with dollars
from a 2018 transaction.

3. Time Period Assumption

This accounting principle assumes that it is possible to report the complex and ongoing activities
of a business in relatively short, distinct time intervals such as the five months ended May 31,
2018, or the 5 weeks ended May 1, 2018. The shorter the time interval, the more likely the need
for the accountant to estimate amounts relevant to that period. For example, the property tax bill
is received on December 15 of each year. On the income statement for the year ended December
31, 2017, the amount is known; but for the income statement for the three months ended March
31, 2018, the amount was not known and an estimate had to be used.

It is imperative that the time interval (or period of time) be shown in the heading of each income
statement, statement of stockholders' equity, and statement of cash flows. Labeling one of these
financial statements with "December 31" is not good enough–the reader needs to know if the
statement covers the one week ended December 31, 2018 the month ended December 31, 2018
the three months ended December 31, 2018 or the year ended December 31, 2018.

4. Cost Principle

From an accountant's point of view, the term "cost" refers to the amount spent (cash or the cash
equivalent) when an item was originally obtained, whether that purchase happened last year or
thirty years ago. For this reason, the amounts shown on financial statements are referred to as
historical cost amounts.

Because of this accounting principle asset amounts are not adjusted upward for inflation. In fact,
as a general rule, asset amounts are not adjusted to reflect any type of increase in value. Hence,
an asset amount does not reflect the amount of money a company would receive if it were to sell
the asset at today's market value. (An exception is certain investments in stocks and bonds that
are actively traded on a stock exchange.) If you want to know the current value of a company's
long-term assets, you will not get this information from a company's financial statements–you
need to look elsewhere, perhaps to a third-party appraiser.

5. Full Disclosure Principle

If certain information is important to an investor or lender using the financial statements, that
information should be disclosed within the statement or in the notes to the statement. It is
because of this basic accounting principle that numerous pages of "footnotes" are often attached
to financial statements.

As an example, let's say a company is named in a lawsuit that demands a significant amount of
money. When the financial statements are prepared it is not clear whether the company will be
able to defend itself or whether it might lose the lawsuit. As a result of these conditions and
because of the full disclosure principle the lawsuit will be described in the notes to the financial
statements.

A company usually lists its significant accounting policies as the first note to its financial
statements.

6. Going Concern Principle

This accounting principle assumes that a company will continue to exist long enough to carry out
its objectives and commitments and will not liquidate in the foreseeable future. If the company's
financial situation is such that the accountant believes the company will not be able to continue
on, the accountant is required to disclose this assessment.

The going concern principle allows the company to defer some of its prepaid expenses until
future accounting periods.

7. Matching Principle

This accounting principle requires companies to use the accrual basis of accounting. The
matching principle requires that expenses be matched with revenues. For example, sales
commissions expense should be reported in the period when the sales were made (and not
reported in the period when the commissions were paid). Wages to employees are reported as an
expense in the week when the employees worked and not in the week when the employees are
paid. If a company agrees to give its employees 1% of its 2018 revenues as a bonus on January
15, 2019, the company should report the bonus as an expense in 2018 and the amount unpaid at
December 31, 2018 as a liability. (The expense is occurring as the sales are occurring.)

Because we cannot measure the future economic benefit of things such as advertisements (and
thereby we cannot match the ad expense with related future revenues), the accountant charges
the ad amount to expense in the period that the ad is run.

(To learn more about adjusting entries go to Explanation of Adjusting Entries and Quiz for
Adjusting Entries.)

8. Revenue Recognition Principle

Under the accrual basis of accounting (as opposed to the cash basis of accounting), revenues
are recognized as soon as a product has been sold or a service has been performed, regardless of
when the money is actually received. Under this basic accounting principle, a company could
earn and report $20,000 of revenue in its first month of operation but receive $0 in actual cash in
that month.

For example, if ABC Consulting completes its service at an agreed price of $1,000, ABC should
recognize $1,000 of revenue as soon as its work is done—it does not matter whether the client
pays the $1,000 immediately or in 30 days. Do not confuse revenue with a cash receipt.

9. Materiality

Because of this basic accounting principle or guideline, an accountant might be allowed to

violate another accounting principle if an amount is insignificant. Professional judgement is
needed to decide whether an amount is insignificant or immaterial.

An example of an obviously immaterial item is the purchase of a $150 printer by a highly

profitable multi-million dollar company. Because the printer will be used for five years, the
matching principle directs the accountant to expense the cost over the five-year period. The
materiality guideline allows this company to violate the matching principle and to expense the
entire cost of $150 in the year it is purchased. The justification is that no one would consider it
misleading if $150 is expensed in the first year instead of $30 being expensed in each of the five
years that it is used.

Because of materiality, financial statements usually show amounts rounded to the nearest dollar,
to the nearest thousand, or to the nearest million dollars depending on the size of the company.

10. Conservatism

If a situation arises where there are two acceptable alternatives for reporting an item,
conservatism directs the accountant to choose the alternative that will result in less net income
and/or less asset amount. Conservatism helps the accountant to "break a tie." It does not direct
accountants to be conservative. Accountants are expected to be unbiased and objective.

The basic accounting principle of conservatism leads accountants to anticipate or disclose losses,
but it does not allow a similar action for gains. For example, potential losses from lawsuits will
be reported on the financial statements or in the notes, but potential gains will not be reported.
Also, an accountant may write inventory down to an amount that is lower than the original cost,
but will not write inventory up to an amount higher than the original cost.

Other Characteristics of Accounting Information

When financial reports are generated by professional accountants, we have certain expectations
of the information they present to us:

1. We expect the accounting information to be reliable, verifiable, and objective.

2. We expect consistency in the accounting information.
3. We expect comparability in the accounting information.
1. Reliable, Verifiable, and Objective

In addition to the basic accounting principles and guidelines listed in Part 1, accounting
information should be reliable, verifiable, and objective. For example, showing land at its
original cost of $10,000 (when it was purchased 50 years ago) is considered to be more reliable,
verifiable, and objective than showing it at its current market value of $250,000. Eight different
accountants will wholly agree that the original cost of the land was $10,000—they can read the
offer and acceptance for $10,000, see a transfer tax based on $10,000, and review documents that
confirm the cost was $10,000. If you ask the same eight accountants to give you the land's
current value, you will likely receive eight different estimates. Because the current value amount
is less reliable, less verifiable, and less objective than the original cost, the original cost is used.

The accounting profession has been willing to move away from the cost principle if there are
reliable, verifiable, and objective amounts involved. For example, if a company has an
investment in stock that is actively traded on a stock exchange, the company may be required to
show the current value of the stock instead of its original cost.

2. Consistency

Accountants are expected to be consistent when applying accounting principles, procedures, and
practices. For example, if a company has a history of using the FIFO cost flow assumption,
readers of the company's most current financial statements have every reason to expect that the
company is continuing to use the FIFO cost flow assumption. If the company changes this
practice and begins using the LIFO cost flow assumption, that change must be clearly
disclosed.

3. Comparability

Investors, lenders, and other users of financial statements expect that financial statements of one
company can be compared to the financial statements of another company in the same industry.
Generally accepted accounting principles may provide for comparability between the
financial statements of different companies. For example, the FASB requires that expenses
related to research and development (R&D) be expensed when incurred. Prior to its rule, some
companies expensed R&D when incurred while other companies deferred R&D to the balance
sheet and expensed them at a later date.

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How Principles and Guidelines Affect Financial Statements

The basic accounting principles and guidelines directly affect the way financial statements are
prepared and interpreted. Let's look below at how accounting principles and guidelines influence
the (1) balance sheet, (2) income statement, and (3) the notes to the financial statements.
1. Balance Sheet

Let's see how the basic accounting principles and guidelines affect the balance sheet of Mary's
Design Service, a sole proprietorship owned by Mary Smith. (To learn more about the balance
sheet go to Explanation of Balance Sheet and Quiz for Balance Sheet.)

A balance sheet is a snapshot of a company's assets, liabilities, and owner's equity at one point
in time. (In this case, that point in time is after all of the transactions through September 30, 2018
have been recorded.) Because of the economic entity assumption, only the assets, liabilities,
and owner's equity specifically identified with Mary's Design Service are shown—the personal
assets of the owner, Mary Smith, are not included on the company's balance sheet.

The assets listed on the balance sheet have a cost that can be measured and each amount shown
is the original cost of each asset. For example, let's assume that a tract of land was purchased in
1956 for $10,000. Mary's Design Service still owns the land, and the land is now appraised at
$250,000. The cost principle requires that the land be shown in the asset account Land at its
original cost of $10,000 rather than at the recently appraised amount of $250,000.

If Mary's Design Service were to purchase a second piece of land, the monetary unit
assumption dictates that the purchase price of the land bought today would simply be added to
the purchase price of the land bought in 1956, and the sum of the two purchase prices would be
reported as the total cost of land.

The Supplies account shows the cost of supplies (if material in amount) that were obtained by
Mary's Design Service but have not yet been used. As the supplies are consumed, their cost will
be moved to the Supplies Expense account on the income statement. This complies with the
matching principle which requires expenses to be matched either with revenues or with the time
period when they are used. The cost of the unused supplies remains on the balance sheet in the
asset account Supplies.

The Prepaid Insurance account represents the cost of insurance that has not yet expired. As the
insurance expires, the expired cost is moved to Insurance Expense on the income statement as
required by the matching principle. The cost of the insurance that has not yet expired remains on
Mary's Design Service's balance sheet (is "deferred" to the balance sheet) in the asset account
Prepaid Insurance. Deferring insurance expense to the balance sheet is possible because of
another basic accounting principle, the going concern assumption.

The cost principle and monetary unit assumption prevent some very valuable assets from ever
appearing on a company's balance sheet. For example, companies that sell consumer products
with high profile brand names, trade names, trademarks, and logos are not reported on their
balance sheets because they were not purchased. For example, Coca-Cola's logo and Nike's logo
are probably the most valuable assets of such companies, yet they are not listed as assets on the
company balance sheet. Similarly, a company might have an excellent reputation and a very
skilled management team, but because these were not purchased for a specific cost and we
cannot objectively measure them in dollars, they are not reported as assets on the balance sheet.
If a company actually purchases the trademark of another company for a significant cost, the
amount paid for the trademark will be reported as an asset on the balance sheet of the company
that bought the trademark.

2. Income Statement

Let's see how the basic accounting principles and guidelines might affect the income statement
of Mary's Design Service. (To learn more about the income statement go to Explanation of
Income Statement and Quiz for Income Statement.)

An income statement covers a period of time (or time interval), such as a year, quarter, month,
or four weeks. It is imperative to indicate the period of time in the heading of the income
statement such as "For the Nine Months Ended September 30, 2018". (This means for the period
of January 1 through September 30, 2018.) If prepared under the accrual basis of accounting,
an income statement will show how profitable a company was during the stated time interval.
Revenues are the fees that were earned during the period of time shown in the heading.
Recognizing revenues when they are earned instead of when the cash is actually received follows
the revenue recognition principle and the matching principle. (The matching principle is what
steers accountants toward using the accrual basis of accounting rather than the cash basis. Small
business owners should discuss these two methods with their tax advisors.)

Gains are a net amount related to transactions that are not considered part of the company's main
operations. For example, Mary's Design Service is in the business of designing, not in the land
development business. If the company should sell some land for $30,000 (land that is shown in
the company's accounting records at $25,000) Mary's Design Service will report a Gain on Sale
of Land of $5,000. The $30,000 selling price will not be reported as part of the company's
revenues.

Expenses are costs used up by the company in performing its main operations. The matching
principle requires that expenses be reported on the income statement when the related sales are
made or when the costs are used up (rather than in the period when they are paid).

Losses are a net amount related to transactions that are not considered part of the company's
main operating activities. For example, let's say a retail clothing company owns an old computer
that is carried on its accounting records at $650. If the company sells that computer for $300, the
company receives an asset (cash of $300) but it must also remove $650 of asset amounts from its
accounting records. The result is a Loss on Sale of Computer of $350. The $300 selling price
will not be included in the company's sales or revenues.
3. The Notes To Financial Statements

Another basic accounting principle, the full disclosure principle, requires that a company's
financial statements include disclosure notes. These notes include information that helps readers
of the financial statements make investment and credit decisions. The notes to the financial
statements are considered to be an integral part of the financial statements.