What it is:
Accounting principles govern the rules of accounting and reflect the latest accounting methodologies.
How it works (Example):
Accounting principles govern how accountants calculate and present the details of a company's financial operations, such as net earnings, gross income, and net cash provided by operating activities. These details can be found in such places as quarterly balance sheets or income statements, 10-Q filings, or annual reports.
Accounting principles are the bases for the more specific Generally Accepted Accounting Principles (GAAP), which are established and administered by the American Institute of Certified Public Accountants (AICPA) and the Financial Accounting Standards Board (FASB). The International Accounting Standards Board also sets forth accounting principles, called International Financial Reporting Standards.
To see how accounting principles apply in the real world, let’s assume Company XYZ and Company ABC both sell widgets. They both earn revenue and incur costs, and they both record those revenues and costs to prepare their financial statements. Company XYZ sells $500,000 of widgets in the 2018 calendar year and incurs $250,000 of raw materials costs; Company ABC sells $750,000 of widgets in 2018 and incurs $450,000 of raw materials costs.
Accounting principles designate at the most fundamental level how both companies should record those revenues and expenses. For example, the accrual and matching principles require companies to match revenues and expenses with the period in which they are incurred, regardless of whether any cash changes hands. In our case, that means even though Company XYZ may not write a check to its vendors for the $250,000 of raw materials until 2019, it should record those costs in 2018 because that is the period in which they were incurred.
Examples of some other accounting principles include:
- Conservatism: recording revenues, assets, expenses and liabilities only when the company is reasonably certain they will occur.
- Consistency: once a company adopts a certain accounting method, it will continue to use it consistently going forward unless and until it adopts a different methodology in subsequent years.
- Materiality: companies should always record transactions that are important enough to the company that they may alter decisions shareholders may make regarding their investments in the firm.
Why it Matters:
Think of accounting principles as the basic philosophies of accounting. Accounting principles ensure that financial statements are created consistently and with integrity, providing investors and the financial markets with a way to reliably compare financial results from industry to industry and from year to year. However, accounting principles are sometimes subject to different interpretations, and unscrupulous companies often find a way to bend or manipulate them to their advantage. Furthermore, it is commonplace -- even for accurate results where accounting principles were conservatively applied -- for financial results to be restated at some point in the future.