Accounting can make or break a company, and accountants need a set of principles to help them stay on track. Companies in the U.S. are guided by Generally Accepted Accounting Principles (GAAP), which are established and upheld by the Financial Accounting Standards Board (FASB) and the American Institute of Certified Public Accountants (AICPA). By following GAAP, companies of all sizes can keep clean books and make it easy for audits to be carried out. This article will explore these principles, what they entail and their purpose.
Accrual
Ideally, all the transactions in a company should be recorded in the period they happen and not when the cash flow associated with them is reflected. Essentially, you should take note of when the product gets to the consumer, even if the payment is supposed to be given at a later date. Failure to adhere to this principle could result in the artificial acceleration of delayed transactions and a mix-up of the accounts.
Conservatism
This principle advises accountants to record expenses and liabilities immediately. On the other hand, revenues and assets should only be put on the record when the accountant is certain about them. However, this should not be done over an extended period as it can give a false impression of the company’s finances.
Consistency
According to this principle, a company should use its current financial management methods consistently until another method is agreed upon. Before agreeing to switch to the new method, it must have been tested and demonstrated to work better than the existing one. If a company decides to take up a different financial management option, it should do away with the old one and completely shift into and adopt the new method. Jumping from one aspect of accounting to another can cause confusion and losses.
Cost
An accountant is required by the accounting principle to record all items at the time of occurrence in cash or its equivalent. This cost is not adjusted for market inflation or predicted changes in value. Some companies are phasing out this principle and edging towards fair value adjustments to help reduce inconsistent records.
Economic Entity
The business should be considered a separate entity in all companies, including those run as sole proprietorships. The owners’ and businesses’ finances should not be mixed up. Failing to adhere to this can lead to losses and financial mix-ups.
Full Disclosure
Financial information about the business should be disclosed to investors and lenders without omission. To follow this principle, footnotes that are often part of the financial statements are included. Disclosing all the information gives the investor or lender the tools to decide whether or not they should go into business with you.
Going Concern
Following this principle aligns with the owner’s intent to follow through with their operations, missions, and visions for the foreseeable future. An accountant should be able to tell by the accounts the financial health of the company, which allows them to make the going concern assumption. They should, ideally, not be planning to close shop soon. This principle also allows investors, shareholders or employees to know whether they should invest in the company or not.
Matching
In the matching principle, an accountant should ideally match all expenses with the related revenue. Expenses are included on the statement from when they are used or expire if they are not directly related to business revenue. Any costs to which the company cannot immediately attribute a future benefit must be immediately attributed to the segment of the financial statements.
Monetary Unit
Following the monetary principle, accountants can only make recordings in a known currency. For the U.S., this means transactions should be recorded in U.S. dollars. A business cannot record aspects such as customer service, skill levels or motivation speeches as they are not quantifiable. This principle also assumes that the currency used is stable over time, so it is not adjusted for market instability or inflation. It gives the accountants the correct data to determine the company’s state, the steps they can take and the ones they cannot.
Reliability
Accountants should only record transactions that can be proven. Data from third-party entities such as promissory notes, bank statements or receipts hold more water than those generated in-house. The accounting department could lose its credibility if it does not adhere to this principle.
Revenue Recognition
Regardless of whether money is paid at that instant or not, once a product is sold or a service is rendered, the revenue should be recognized. Under this principle, revenue should be recorded when earned and not necessarily when it is collected. To control the aspect of fraud, regulation boards have provided different details on what to include in recognition of revenue in a company.
Time Period
This principle dictates that businesses should report their financial activity in short periods, such as weeks, months or the fiscal year. The time used should be stated as a headline on each financial statement the company produces. This allows businesses to see their financial journey, what they are doing wrong and what they can invest in to boost their growth. Not adhering to this principle means a business could be flying blind, which is a dangerous maneuver in all aspects.
Utmost Good Faith
Also known by its Latin name, “uberrimae fidei,” this is the bare minimum of running a business. According to it, businesses should aim to be honest and transparent in all their transactions and business engagements with different parties. In addition, they should avoid misleading or withholding information that might sway decisions.
Although publicly traded companies are not required to follow these principles, it is wise to do so. Following these principles in any sized company lays the proper foundation for your financial journey, and auditors often require GAAP-compliant statements. Therefore, it is ideal to follow all or many of them to help create a trustworthy, reliable and financially robust environment that will keep the company in operation.
