Financial accounting principles can be defined as the rules that govern the practice of accounting or the preparation of financial accounting statements. These principles are part of the rules which form what are referred to as the Generally Accepted Accounting Principles (GAAP). GAAP also comprises of, besides the basic accounting principles and guidelines, generally accepted industry practices and detailed standards and rules. The standards and rules are issued by the Financial Accounting Standards Board (FASB). GAAP accounting is used for ensuring that there is some level of consistency in the preparation of financial accounting statements. The consistency in the preparation ensures that statements from different companies or even different countries can be compared and understood.
There are a number of basic financial accounting principles that are followed in the preparation of financial statements.
- Economic entity assumption – This can be taken to be the first accounting principle. It holds that the business is a distinct body separate from its owners and should be treated as such for accounting purposes.
- Going concern principle – This is the assumption that the financial entity will continue its operations in the foreseeable future.
- Cost principle – Goods or services should be recorded in the books of accounting at their actual purchase price. Assets should also be recorded at their historical cost and not at their current market value.
- Full disclosure principle – This holds that all material information about the company should be disclosed in the financial statements.
- Materiality – This principle allows for omission of certain information or transactions if the magnitude of the omission is not significant. This is a threshold principle and an item is deemed to be immaterial if its omission does not alter the judgment of the reader of the financial statements.
- Revenue recognition principle – This is the principle that holds that revenue should be recognized as soon as it is earned, irrespective of when cash is received.
- Matching principle – This is related to the revenue recognition principle. These two principles are the basis for accrual accounting. The matching principle, like the revenue recognition principle determines when revenues and expenses are recognized. It holds that revenues should be matched with the expenses that were incurred to generate them.
- Prudence principle – This principle requires that financial statements show the most conservative position of the company. However, assets should not be overstated or liabilities understated.
Other principles are objectivity principle, monetary unit assumption and the time period assumption.