Accounting / Bookkeeping Basics: Accounting Principles

What are Accounting Principles?

The simplest way to define accounting principles is by calling them a “set of rules created to govern the entire field of accounting”. In everyday terms, accounting principles are the very foundation  upon
which the more complex (and potentially more intriguing and interesting) regulations created around accounting are built.
Mind you, accounting principles have not always been the same - they were created along the way, as professionals in the field and regulators discovered the need for such rules to be implemented.
In the United States of America today, generally accepted accounting principles (GAAP) are strictly followed by everyone. Even more, if you want your company to be part of the stock exchange, you need to follow these basic rules to a T.
It is important to note that accounting principles are not the same all around the world and that sometimes, the difference between the regulations of one country and another might be staggering. In most developed markets, the principles stay more or less the same, with certain adjustments made to fit the economic and political landscape of those specific countries. In developing markets, however, things might be severely different - and this is why it is crucial that you hire the services of a local accounting expert if you want to expand your business to any other country on Earth.
The institution that deals with creating a uniform set of rules to govern accounting at a global level is called IASB (International Accounting Standards Board), but at the moment, there is no universally accepted set of accounting principles the entire (or at least the vast majority) world abides by.

Coming back home to the US, accounting principles here consist of three main pillars: the basic accounting principles and guidelines (the rules themselves), generally accepted industry practices (how the rules are and should be applied in “real life”), and the detailed rules issued by the FASB (Financial Accounting Standards Board) and by the Accounting Principles Board (APB).
As mentioned in the beginning, accounting principles have not been created and adopted to torment anyone trying to enter into this field of expertise, but rather with the purpose of helping them. In short, accounting principles help accountants and business owners achieve the following:
- Is useful to potential creditors, as well as potential investors, so that they have the full picture of what your business’ books look like, both from an investment point of view and from that of the cash receipts and economic resources;
- As a resource to those who run the company to help them make sane financial decisions - short term and long-term alike;
- Is used by those who run the company to help them improve the way the business is performing;
- Useful in maintaining clean, clear, and coherent records of he company’s financial state.

Generally Accepted Accounting Principles
If we look at accounting as a house, and consider accounting principles as its foundation, then the generally accepted accounting principles are pillars upon which the foundation is poured.
While not the only principles accountants abide by, GAAP are the principles everyone should follow - especially if the company is public and its financial records have to be available for potential investors, creditors, and shareholders.

Generally accepted accounting principles are based on the following goals:

1.  The accountant has taken GAAP as the standard.

2. The same standards are to be applied throughout the entire reporting process so that any kind of errors and discrepancies are avoided.

3. If any standards are changed or updated, the accountant is expected to disclose and explain the reasoning behind the decision.

4. The accountant must be sincere in the depiction of the business’ financial situation.

5. All the procedures used in financial reporting have to be consistent in time.

6. The accountant (and company) will not expect debt compensation despite showing both positives and negatives in their reports.

7. Speculation should be eliminated and financial data reporting should be fact-based.

8. All the report entries will be distributed across the right time periods (e.g. revenue is to be divided by its relevant time periods).

9.  Full disclosure should be a goal of all financial reports.

10. When reporting, the assumption is that the business will continue to operate.

11. The parties involved in transactions should remain honest.

In order to achieve the aforementioned goals, generally accepted accounting principles have been split into twelve concepts: basic assumptions (four of them), basic principles (four of them) and basic constraints (five of them). They come as follows:
1. Basic assumptions: Business Entity, Going Concern, Monetary Unit, and Periodicity;
2. Basic Principles: Historical Cost, Revenue Recognition, Matching Principle, Full Disclosure Principle;
3. Basic Constraints: Objectivity, Materiality, Consistency, Conservatism, and Cost.

The Alternative Accounting  Principles
While we do not aim to go in-depth with these, it is important to be aware of their existence and of the fact that they are practiced as a complement to generally accepted accounting principles.
Most large companies simply abide by generally accepted accounting principles, as they are the most widely used and best understood rules in the financial community. However, in some cases, generally accepted accounting principles may be too broad or they simply may be incompatible with how some businesses function. For instance, a small business will find it difficult to follow the same guidelines as a large business, and additional accounting principles may be used.

These complementary or additional principles are sometimes referred to as alternative accounting principles.
 

Why Are Accounting Principles Needed?
These principles are the guidelines to doing good work - work that is consistent, work that is congruent, work that is relevant, and work that is honest both to internal stakeholders and to external investors and creditors.
The accounting principles are needed for one simple reason: there has to be a set of rules that govern how accounting is done across different industries, types of businesses and business purposes.

In accounting and financial reporting, there are no set international standards - but there are country-specific laws and regulations meant to make the reporting uniform and easily understandable by everyone.
Not having accounting principles in place means not having a basic understanding of how the traffic of financial reporting works. It means navigating aimlessly, on your own terms - but even worse, it could mean every business has the option of being unjust and dishonest with their reporting. How would investors know which business is worthy of their attention, then? How would stock markets themselves be able to assess the value of a share?

Generally accepted accounting principles haven’t always been around. The group of standards and regulations we now call GAAP has been set for little over a decade. They did exist before that as well - but they consisted of exhaustive rules that allowed for plenty of error (intentional or not), and they constantly needed to be updated as soon as a new situation arose. Until 2002, when this problem was brought forward by multiple institutions (including the US Congress), accounting was ruled by fixed regulations, rather than principles. The first accounting rules were set by the American Institute of Certified Public Accountants in 1939 through the Committee on Accounting Procedures, and they were subjected to the regulations of the US Securities and Exchange Commission. Later on, in 1959, the Committee on Accounting Procedures were replaced by the Accounting  Principles Board, and in 1973, this became the Financial Accounting Standards Board. To date, they are the ones overseeing generally accepted accounting principles.
They were not always seen in a good light by both investors and the accounting community, though, not because their rules were too strict, but for the exact opposite. Until 2002, FASB oversaw a set of rules that were too ambiguous in terms of what should and shouldn’t be done. This allowed accountants and audit professionals to find ways to circumvent them and to create new situations that were not stipulated in the set of rules the FASB enforced.
The entire situation generated a lot of turmoil in the financial world. In 2002, several famous cases brought the FASB system to the attention of the public and the US Congress. In the wake of several huge scandals (such as the one where Enron and the Arthur Andersen Firm were the main actors), equity holders in the US realized one very dangerous fact
- they could not trust audit firms, and this needed to change.

We will not dive deeper into the Enron scandal, but the point we’re trying to make is that it was one of the first moments that pushed for the creation of generally accepted accounting principles as they are known today. The loopholes and weaknesses of the previous system were aggressively exploited by Enron's auditors to mask the tremendous amount of debt the company was in. It was high time that this drove a change for a principle-based accounting standard.
And it did. While far from perfect (and still debated), generally accepted accounting principles are, thus far, a better and more comprehensive way of standardizing the industry’s guidelines.
Generally accepted accounting principles are needed, and they should be followed. While some of them might be connected to actual US legislation, most of them are authoritative best practices (at their best). However, as the vast majority of companies abide by these rules (or, to be more precise, principles); it is important to do the same because it creates a sense of trustworthiness and coherence between businesses, creditors, and investors alike.
As for the progress on delivering an international set of principles for accountants, it is still slow and steady - but with globalization becoming increasingly real and with trades being made across borders every day, this international set of principles is getting closer by the minute.

At the moment, the main hinge in the development of an internationally-accepted set of principles lies in, well, methodology. The International Financial Reporting Standards (IFRS) are more of a set of principles, whereas GAAP are a set of rules. The first ones make it easier for accountants to mold business reporting on the given set of principles but allow for misinterpretation and intentional mistakes. The latter ones, however, are strict and, at times, they make it difficult for businesses to mold financials to suit their needs.
It is an exhibition of what they are, why they are needed, and how they work in real life. Hopefully, the information presented below will help you understand why accounting works the way it does and why a set of principles to abide by is actually necessary in the context of businesses interacting with each other every day.