Accounting principles are the foundation of accurate, consistent and comparable financial reporting. Unlike some other finance-based rules that vary across countries, many accounting principles are the same the world over.
In this article, we’ll introduce some of the most relevant to the Australian market and provide context for their formation.
Generally accepted accounting principles (GAAP) describe a suite of procedures, rules and standards issued by the Financial Accounting Standards Board (FASB) and the Governmental Accounting Standards Board (GASB) in the United States.
All publicly traded companies in the country adhere to GAAP rules in addition to some non-publicly traded companies and governmental departments.
These principles are a combination of widely accepted accounting practices and standards set by policy boards covering such topics as:
Guidelines are also influenced by ten key GAAP tenets or principles:
While US companies follow GAAP, Australia (and 167 other jurisdictions) follow International Financial Reporting Standards (IFRS).
In Australia, public companies as well as state and local governments must comply with accounting principles set down by the Australian Accounting Standards Board (AASB).
The AASB uses fundamental principles from the IFRS system to develop technical, specific and legally-oriented accounting rules and standards.
In the next section, we’ll explain some of foundational accounting principles on which the IFRS system is based.
The accrual principle mandates that revenue and expenses are recognised when they are earned or incurred (and not when cash is received or paid). This principle ensures that financial statements reflect the true financial activities over a specific period.
Suppose a firm provides investment management services to its clients and charges them a monthly fee for assets under management.
In December, the firm earns a $50,000 fee for services rendered, invoiced and paid in January. Under the accrual principle, the firm recognises the $50,000 revenue in December when the service was provided and not in January when the payment was received.
The conservatism principle asks accountants to adopt a more conservative approach if faced with uncertainty in financial reporting.
This means that potential expenses and liabilities are recognized quickly, while revenues and assets are only recognised when they are assured of being realised.
The objective here is to avoid a situation where the financial health and performance of a company is overstated (and by extension, establish a more cautious and prudent position).
The economic entity principle stipulates that the financial transactions of a business are separate from those of the owners (or other businesses).
This separation is crucial for accurate and transparent financial analysis and reporting. It ensures that investors and creditors can make informed decisions based on the actual financial performance of a company.
It also avoids the compounding of personal and inter-organisational assets and liabilities that confuses auditors.
The cost principle – also known as the historical cost principle – dictates that assets should be recorded and reported at their original purchase price (and not their current market value).
Say a financial firm purchased an investment property for $3 million. According to the cost principle, the firm must record the property on its balance sheet at the purchase price of $3 million – irrespective of whether the price appreciates over time.
There are exceptions to the cost principle, however. Highly liquid assets such as stocks and bonds should be recorded at their current market value.
This accounting principle states that only transactions able to be expressed in monetary terms should be recorded. In other words, non-quantifiable “transactions” such as customer service quality or employee talent cannot be recorded.
The monetary unit principle is linked to the monetary unit assumption and the idea that a currency remains stable and does not lose purchasing power over time. But while this accounting concept provides a uniform basis for financial reporting, it does ignore the effects of inflation on the amounts recorded.
The time-period (periodicity) principle states that a company’s financial activities be reported at regular intervals – whether that be monthly, quarterly or annually.
This is one of the more obvious accounting principles on the list, but it does establish a set of comparable periods that can be analysed for trends.
The matching principle dictates that when recording revenue, all the expenses related to earning that revenue are recorded in the same accounting period.
This ensures that financial statements properly reflect the profitability of a company over a specific period since expenses are matched to the revenues they helped generate.
Consider a SaaS company that sells software on a subscription basis. The company incurs costs for developing and maintaining the software in addition to marketing and customer support.
According to the matching principle, the SaaS company must recognise revenue from subscription sales in the month they are earned (irrespective of when payment is received). Expenses associated with developing, marketing and supporting the software are recognised in the same month as the subscription revenue.
The going-concern principle assumes that a business will continue to operate for years into the future. In other words, that the business will earn revenue, meet its obligations and have no plans to liquidate.
Based on this assumption, it would be reasonable for the business to delay recognition of certain expenses (such as depreciation) until a later date.
As the name suggests, the objectivity principle requires financial information to be evidence-based and free from personal bias or subjectivity. The principle ensures financial statements accurately represent the reality of a company’s economic situation, which in turn informs investors and other key stakeholders.
The Enron Scandal is perhaps the most well-known example of a violation of the objectivity principle in accounting. Among other indiscretions, Enron utilized special purpose entities to keep significant debts off its balance sheet and also overvalued assets to inflate its profits.
Materiality concerns the disclosure of any information that could affect the economic decisions of the readers of financial statements.
The principle helps accountants and auditors determine what information could impact the decision of these readers, which could be investors, creditors or other stakeholders.
Materiality is measured by both quantitative and qualitative factors. For example, one item may be material if it exceeds 5% of total revenue, while another may be material if involved in a legal settlement.
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