Section 1: Principles of Accounting

Lo.1 An Overview of Accounting Principles and Key Terminology

Understanding Accounting Principles

The term “accounting principles” may initially seem intimidating, especially to those unacquainted with the field of accounting. However, a closer examination reveals that these principles were established out of necessity, not to intimidate aspiring entrepreneurs and novice accountants.

In this chapter, we will explore the foundational definition of accounting principles, their historical development, and their essential role in the accounting profession. Additionally, we will distinguish between the two primary categories of accounting principles: Generally Accepted Accounting Principles (GAAP) and alternative accounting principles. While GAAP is widely recognized and adhered to, alternative accounting principles, though less common, may offer valuable insights in specific contexts as discussed further in this book.

Let us proceed to unravel these concepts in detail.

Understanding Accounting Principles

Accounting principles can be succinctly described as a comprehensive set of guidelines established to regulate the entire domain of accounting. In layman’s terms, these principles form the essential bedrock upon which more intricate and potentially engaging accounting regulations are constructed.

Historically, accounting principles have evolved over time, shaped by the insights and requirements identified by industry professionals and regulatory bodies. These principles were not established in a single stroke but emerged progressively as the need for standardized rules became apparent.

In the contemporary context of the United States, adherence to the Generally Accepted Accounting Principles (GAAP) is mandatory. GAAP serves as the benchmark for accounting practices and is rigorously followed by all entities. Compliance with GAAP is particularly crucial for companies aiming to be listed on the stock exchange, as adherence to these foundational rules is a prerequisite.

It is noteworthy that accounting principles are not universally uniform. There can be significant variations in accounting regulations from one country to another. While most developed markets maintain relatively consistent principles, tailored adjustments are often made to align with the unique economic and political environments of each country. Conversely, in developing markets, these principles can differ markedly. Therefore, when considering business expansion to international markets, it is imperative to engage the expertise of a local accounting professional to navigate the distinct regulatory landscape effectively.

Global and National Accounting Principles

The International Accounting Standards Board (IASB) is the leading institution responsible for developing a consistent set of global accounting standards. However, as of now, there isn’t a universally accepted framework of accounting principles that the entire world adheres to.

Accounting Principles in the United States

In the United States, accounting principles are structured around three main components:

1. Basic Accounting Principles and Guidelines: These are the foundational rules governing accounting practices.
2. Generally Accepted Industry Practices: These encompass how the established rules are applied in practical, real-world scenarios.
3. Detailed Rules Issued by Regulatory Bodies: These include specific guidelines provided by the Financial Accounting Standards Board (FASB) and the Accounting Principles Board (APB).

Contrary to any misconceptions, accounting principles are not established to complicate the field but to provide clarity and assistance to professionals. These principles serve several crucial functions:

• For Potential Creditors and Investors: They offer a comprehensive view of a business’s financial status, essential for making informed investment and credit decisions.
• For Company Management: They act as a valuable resource for making sound financial decisions, both in the short term and long term.
• For Business Improvement: They help management improve overall business performance.
• For Record Maintenance: They ensure that a company maintains clear, coherent, and accurate financial records.

By adhering to these principles, businesses can maintain transparency and efficiency in their financial reporting, which is beneficial for all stakeholders involved.

Generally Accepted Accounting Principles (GAAP)

AFoundation of Accounting

Think of accounting as constructing a house, where the principles of accounting serve as its foundation. In this analogy, Generally Accepted Accounting Principles (GAAP) act as the essential pillars supporting this foundation.

Universal Adherence

While there are various principles that accountants might follow, GAAP are the universally recognized standards, especially critical for publicly traded companies. These principles ensure that financial records are transparent and accessible to potential investors, creditors, and shareholders.

Core Objectives of GAAP

1. Standardization: Accountants must adopt GAAP as the benchmark for financial reporting.
2. Consistency: Uniform standards must be applied throughout the reporting process to prevent errors and discrepancies.
3. Transparency: Any changes or updates to the standards must be disclosed and justified by the accountant.
4. Integrity: The accountant must provide an honest representation of the company’s financial status.
5. Consistency Over Time: All financial reporting procedures must remain consistent over time.
6. The accountant and the company shall not anticipate debt compensation, regardless of the presence of both positive and negative aspects in their reports.
7. Speculation must be eradicated, with financial data reporting being strictly grounded in factual information.
8. All entries in the report shall be allocated to the appropriate time periods, ensuring, for instance, that revenue is accurately divided according to its relevant timelines.
9. Full disclosure should be the objective of all financial reports.
10. Financial reporting shall operate under the assumption that the business will continue as a going concern.
11. All parties involved in transactions are expected to maintain integrity and honesty.

To fulfill these objectives, generally accepted accounting principles (GAAP) have been categorized into twelve fundamental concepts, which include:

1. Basic Assumptions:
   • Business Entity
   • Going Concern
   • Monetary Unit
   • Periodicity
2. Basic Principles:
   • Historical Cost
   • Revenue Recognition
   • Matching Principle
   • Full Disclosure Principle
3. Basic Constraints:
   • Objectivity
   • Materiality
   • Consistency
   • Conservatism
   • Cost

The Alternative Accounting Principles

While we won’t delve deeply into these, it’s essential to recognize their existence and understand that they complement generally accepted accounting principles (GAAP). Most large corporations adhere strictly to GAAP, as these are the most widely adopted and comprehensible rules within the financial community. However, GAAP can sometimes be too broad or may not align well with the operational realities of certain businesses. For example, a small business might find it challenging to follow the same guidelines as a large corporation, necessitating the use of additional accounting principles. These supplementary guidelines are often referred to as alternative accounting principles.

The Necessity of Accounting Principles

For those outside the realms of accounting and entrepreneurship, accounting principles might seem like mere regulations on paper. However, for those with some experience in accounting, these principles serve as the foundation for conducting reliable, relevant, and honest work—work that maintains consistency and credibility for both internal stakeholders and external parties such as investors and creditors.

The fundamental reason for the existence of accounting principles is straightforward: there must be a standardized set of rules governing how accounting is performed across various industries, business types, and purposes. To illustrate their importance, consider accounting principles as akin to the rules of the road for drivers and pedestrians. Imagine a world without any traffic rules—chaos would ensue. In some places, traffic conditions approach such disorder, with people crossing streets haphazardly, cars failing to yield where they should, and pedestrians not being given the right of way at crosswalks.

In essence, without these guiding principles, the world of accounting would be as chaotic and anarchic as streets without traffic laws.

Driving regulations are largely consistent worldwide, with a few notable exceptions that are prominently highlighted upon entering certain countries. For instance, the United Kingdom mandates driving on the left side of the road, a well-publicized fact evident from large banners at every entry point.

In contrast, the realm of accounting and financial reporting lacks universal standards. Instead, it relies on country-specific laws and regulations designed to ensure uniformity and comprehensibility. The absence of standardized accounting principles equates to a lack of foundational understanding in financial reporting, leading to chaotic and subjective navigation. This scenario allows businesses the latitude to be unjust and dishonest in their reporting, posing significant challenges for investors in identifying credible ventures and for stock markets in accurately valuing shares.

You might wonder: Haven’t generally accepted accounting principles (GAAP) always existed? The truth is, they haven’t. The comprehensive set of standards and regulations known as GAAP has only been firmly established for a little over a decade. Prior to that, there were numerous detailed rules, susceptible to errors (both intentional and accidental), and they required constant updates to address new situations.

Until 2002, accounting practices were governed by rigid regulations rather than guiding principles, a situation brought to the forefront by various institutions including the US Congress. The American Institute of Certified Public Accountants laid down the first set of accounting rules in 1939 through the Committee on Accounting Procedures, under the oversight of the US Securities and Exchange Commission. This committee was replaced in 1959 by the Accounting Principles Board, which later evolved into the Financial Accounting Standards Board (FASB) in 1973. To this day, the FASB oversees the establishment of generally accepted accounting principles (GAAP).

Historically, both investors and the accounting community often viewed these standards unfavorably, not due to their stringency but because of their ambiguity. Until 2002, FASB’s rules were so vague that they allowed accountants and audit professionals to exploit loopholes and create scenarios not explicitly covered by the regulations. This ambiguity led to significant turmoil within the financial sector.

In 2002, high-profile cases brought the inadequacies of the FASB system into the spotlight, drawing public and congressional attention. The notorious Enron scandal, involving Enron Corporation and the Arthur Andersen accounting firm, underscored the urgent need for change. The scandal revealed a stark reality: investors could no longer trust audit firms, necessitating a transformation. Although we won’t delve deeply into the Enron case, it served as a catalyst for the establishment of today’s generally accepted accounting principles. Enron’s auditors had exploited the system’s weaknesses to conceal the company’s massive debt, highlighting the need for a principle-based accounting standard.

This shift towards principle-based standards marked a significant improvement, although the system remains imperfect and subject to ongoing debate. Nonetheless, GAAP provides a more comprehensive and standardized framework for the accounting industry. These principles are essential and should be adhered to, as they foster trust and coherence among businesses, creditors, and investors. While some GAAP guidelines are interwoven with US legislation, most are authoritative best practices.

Efforts to establish an international set of accounting principles have been slow yet steady. With globalization and daily cross-border trades, the realization of a unified international standard is drawing nearer.

Presently, the primary challenge in establishing a universally accepted framework of principles centers around methodology. The International Financial Reporting Standards (IFRS) operate as a principle-based system, whereas Generally Accepted Accounting Principles (GAAP) are rule-based. IFRS facilitates accountants in tailoring business reports to align with established principles, yet this flexibility can lead to misinterpretation and intentional errors. Conversely, GAAP’s stringent rules can sometimes hinder businesses from adapting financial statements to better serve their purposes.

This text aims to elucidate what these frameworks are, their necessity, and their practical applications. The information provided below is intended to enhance your understanding of the operational dynamics of accounting and underscore the importance of adhering to a standardized set of principles in the daily interactions between businesses.