Introduction to Accounting Principles

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There are general rules and concepts that govern the field of accounting. These
general rules–referred to as basic accounting principles and guidelines–form the
groundwork on which more detailed, complicated, and legalistic accounting rules are
based. For example, the Financial Accounting Standards Board (FASB) uses the basic
accounting principles and guidelines as a basis for their own detailed and
comprehensive set of accounting rules and standards.

The phrase "generally accepted accounting principles" (or "GAAP") consists of three
important sets of rules: (1) the basic accounting principles and guidelines, (2) the
detailed rules and standards issued by FASB and its predecessor the Accounting
Principles Board (APB), and (3) the generally accepted industry practices.

If a company distributes its financial statements to the public, it is required to follow

generally accepted accounting principles in the preparation of those statements.
Further, if a company's stock is publicly traded, federal law requires the company's
financial statements be audited by independent public accountants. Both the
company's management and the independent accountants must certify that the
financial statements and the related notes to the financial statements have been
prepared in accordance with GAAP.

GAAP is exceedingly useful because it attempts to standardize and regulate

accounting definitions, assumptions, and methods. Because of generally accepted
accounting principles we are able to assume that there is consistency from year to year
in the methods used to prepare a company's financial statements. And although
variations may exist, we can make reasonably confident conclusions when comparing
one company to another, or comparing one company's financial statistics to the
statistics for its industry. Over the years the generally accepted accounting principles
have become more complex because financial transactions have become more
complex.

Basic Accounting Principles and Guidelines

Since GAAP is founded on the basic accounting principles and guidelines, we can
better understand GAAP if we understand those accounting principles. The following
is a list of the ten main accounting principles and guidelines together with a highly
condensed explanation of each.

1. Economic Entity Assumption

The accountant keeps all of the business transactions of a sole proprietorship separate
from the business owner's personal transactions. For legal purposes, a sole
proprietorship and its owner are considered to be one entity, but for accounting
purposes they are considered to be two separate entities.

2. Monetary Unit Assumption

Economic activity is measured in U.S. dollars, and only transactions that can be
expressed in U.S. dollars are recorded.

Because of this basic accounting principle, it is assumed that the dollar's purchasing
power has not changed over time. As a result accountants ignore the effect of inflation
on recorded amounts. For example, dollars from a 1960 transaction are combined (or
shown) with dollars from a 2019 transaction.

3. Time Period Assumption

This accounting principle assumes that it is possible to report the complex and
ongoing activities of a business in relatively short, distinct time intervals such as the
five months ended May 31, 2019, or the 5 weeks ended May 1, 2019. The shorter the
time interval, the more likely the need for the accountant to estimate amounts relevant
to that period. For example, the property tax bill is received on December 15 of each
year. On the income statement for the year ended December 31, 2018, the amount is
known; but for the income statement for the three months ended March 31, 2019, the
amount was not known and an estimate had to be used.

It is imperative that the time interval (or period of time) be shown in the heading of
each income statement, statement of stockholders' equity, and statement of cash flows.
Labeling one of these financial statements with "December 31" is not good enough–
the reader needs to know if the statement covers the one week ended December 31,
2019 the month ended December 31, 2019 the three months ended December 31,
2019 or the year ended December 31, 2019.

4. Cost Principle

From an accountant's point of view, the term "cost" refers to the amount spent (cash or
the cash equivalent) when an item was originally obtained, whether that purchase
happened last year or thirty years ago. For this reason, the amounts shown on
financial statements are referred to as historical cost amounts.

Because of this accounting principle asset amounts are not adjusted upward for
inflation. In fact, as a general rule, asset amounts are not adjusted to reflect any type
of increase in value. Hence, an asset amount does not reflect the amount of money a
company would receive if it were to sell the asset at today's market value. (An
exception is certain investments in stocks and bonds that are actively traded on a stock
exchange.) If you want to know the current value of a company's long-term assets,
you will not get this information from a company's financial statements–you need to
look elsewhere, perhaps to a third-party appraiser.

5. Full Disclosure Principle

If certain information is important to an investor or lender using the financial

statements, that information should be disclosed within the statement or in the notes to
the statement. It is because of this basic accounting principle that numerous pages of
"footnotes" are often attached to financial statements.

As an example, let's say a company is named in a lawsuit that demands a significant

amount of money. When the financial statements are prepared it is not clear whether
the company will be able to defend itself or whether it might lose the lawsuit. As a
result of these conditions and because of the full disclosure principle the lawsuit will
be described in the notes to the financial statements.

A company usually lists its significant accounting policies as the first note to its
financial statements.

6. Going Concern Principle

This accounting principle assumes that a company will continue to exist long enough
to carry out its objectives and commitments and will not liquidate in the foreseeable
future. If the company's financial situation is such that the accountant believes the
company will not be able to continue on, the accountant is required to disclose this
assessment.

The going concern principle allows the company to defer some of its prepaid
expenses until future accounting periods.

7. Matching Principle

This accounting principle requires companies to use the accrual basis of accounting.
The matching principle requires that expenses be matched with revenues. For
example, sales commissions expense should be reported in the period when the sales
were made (and not reported in the period when the commissions were paid). Wages
to employees are reported as an expense in the week when the employees worked and
not in the week when the employees are paid. If a company agrees to give its
employees 1% of its 2019 revenues as a bonus on January 15, 2020, the company
should report the bonus as an expense in 2019 and the amount unpaid at December
31, 2019 as a liability. (The expense is occurring as the sales are occurring.)

Because we cannot measure the future economic benefit of things such as

advertisements (and thereby we cannot match the ad expense with related future
revenues), the accountant charges the ad amount to expense in the period that the ad is
run.

(To learn more about adjusting entries go to Explanation of Adjusting Entries and
Quiz for Adjusting Entries.)

8. Revenue Recognition Principle

Under the accrual basis of accounting (as opposed to the cash basis of accounting),
revenues are recognized as soon as a product has been sold or a service has been
performed, regardless of when the money is actually received. Under this basic
accounting principle, a company could earn and report $20,000 of revenue in its first
month of operation but receive $0 in actual cash in that month.

For example, if ABC Consulting completes its service at an agreed price of $1,000,
ABC should recognize $1,000 of revenue as soon as its work is done—it does not
matter whether the client pays the $1,000 immediately or in 30 days. Do not confuse
revenue with a cash receipt.

9. Materiality

Because of this basic accounting principle or guideline, an accountant might be

allowed to violate another accounting principle if an amount is insignificant.
Professional judgement is needed to decide whether an amount is insignificant or
immaterial.

An example of an obviously immaterial item is the purchase of a $150 printer by a

highly profitable multi-million dollar company. Because the printer will be used for
five years, the matching principle directs the accountant to expense the cost over the
five-year period. The materiality guideline allows this company to violate the
matching principle and to expense the entire cost of $150 in the year it is purchased.
The justification is that no one would consider it misleading if $150 is expensed in the
first year instead of $30 being expensed in each of the five years that it is used.
Because of materiality, financial statements usually show amounts rounded to the
nearest dollar, to the nearest thousand, or to the nearest million dollars depending on
the size of the company.

10. Conservatism

If a situation arises where there are two acceptable alternatives for reporting an item,
conservatism directs the accountant to choose the alternative that will result in less net
income and/or less asset amount. Conservatism helps the accountant to "break a tie."
It does not direct accountants to be conservative. Accountants are expected to be
unbiased and objective.

The basic accounting principle of conservatism leads accountants to anticipate or

disclose losses, but it does not allow a similar action for gains. For example, potential
losses from lawsuits will be reported on the financial statements or in the notes, but
potential gains will not be reported. Also, an accountant may write inventory down to
an amount that is lower than the original cost, but will not write inventory up to an
amount higher than the original cost.

Introduction to Accounting
Accounting is the system of recording financial transactions with both numbers and text in the
form of financial statements. It provides an essential tool for billing customers, keeping track of
assets and liabilities (debts), determining profitability, and tracking the flow of cash. The system is
largely self-regulated
and designed for
the users of
financial
information,
who are referred to
as stakeholders:
business
owners,
lenders,
employees,
managers,
customers, and others. Stakeholders utilize financial statements to help make business, lending,
and investment decisions.

Accounting
has several
specialized
fields and roles. Private
(internal) accounting
generally refers to accountants who work within a single business entity. Small business
accountants may assume general roles which require preparing the records (bookkeeping) and
performing bank reconciliations. Accounting professionals are generally divided into three fields:
tax, audit, and advisory. The tax field focuses on federal, state, and local tax filings. Audit roles
test the validity of financial statements and internal controls. Advisory services perform general
financial consulting. Public accounting firms have several different clients, whereas private
accounting refers to working for one specific business entity.
Accounts
There are five different types of accounts: asset, liability, equity, revenue, and
expense. Each account type includes sub-accounts to record transaction details. For
example, cash assets may include several different cash and savings accounts.

-Asset accounts: Cash and cash equivalents, accounts receivable, inventory, allowance
for doubtful accounts (contra account), prepaid expense, investment, property, plant,
and equipment, accumulated depreciation (contra account), intangible assets,
accumulated amortization (contra account) and others

-Liability accounts:
Accounts payable,
notes payable, accrued
expenses, deferred revenue, long-term bonds payable and others

Equity
accounts:
Common stock, additional paid-in capital, retained earnings, treasury stock (contra
account) and others

Revenue accounts: Sales revenue and others

Expense accounts: Selling, general, and administrative, interest, repairs, depreciation

(non-cash), amortization (non-cash) and others

Financial Statements
Financial statements are the end results of the completed accounting record. They
include the balance sheet, income statement, statement of shareholders’ equity,
statement of cash flows, and notes to the financial statements. The information
provides predictive value, feedback, and timely data to stakeholders.

The balance sheet reports business assets, liabilities, and equity up to a specific time
period

The income
statement reports the profit and loss activity for a specified period of time
The statement of shareholders’ equity reports detail of investment received and prior
earnings
The statement of cash flows reports the ins and outs of cash in three categories:
Operating, investing, and financing

The notes to the financial statements disclose information that cannot be understood
with the financial statements alone
Debits and Credits

Debits and credits is the system used for recording accounting transactions. A debit or
credit transaction can increase or decrease balances, depending on the account type
(asset,
liability,
equity,
revenue, and
expense).
This forms
the basis for
double entry
bookkeeping
which
requires equal
debits and
credits. The
underlying
transactions are recorded in detail on the general ledger and are later combined to
form financial statements.

The sum of debits always equals the sum of credits

The sum of debits and credits are represented on opposite sides of the balance sheet

Accounting Standards
Accounting standards set guidelines and rules for financial statement preparation.
These are set via a combination of private industry organizations in cooperation with
government committees. Generally Accepted Accounting Practices in the United
States (US GAAP) largely governs the rules for recording transactions and disclosing
critical business information to stakeholders. International Financial Reporting
Standards (IFRS) governs international standards. Both systems require the use of
double entry accounting. While both sets of standards are similar, there are significant
differences such as allowed inventory methodologies and reporting asset valuation.

Business Types and Entities

Accounting serves diverse entities such as: individuals, companies, trusts,
governments, and charities. These may be legally organized in a variety of ways:
corporation, limited liability company, partnerships, and others. With the exception of
governmental accounting, most accounting systems follow similar double entry,
accrual accounting. Financial statements may have slightly different names,
depending on the entity type. An income statement may also be called a profit and
loss or earnings statement. A balance sheet may be referred to as the statement of
financial condition.
Managerial Accounting and Analysis
Managerial accounting is designed around the needs of managers and not necessarily
regulated. It is for internal purposes and may employ any useful accounting system.
Once the financial statements are compiled, the data may be analyzed using ratios and
financial analysis. Accounting can provide powerful information to all stakeholders
when properly maintained and interpreted.