Principles of Accounting

Basic accounting principles and guidelines are the general rules and concepts that form the groundwork on which more detailed, complicated, and legalistic accounting rules are based. 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.

GAAP has four basic assumptions, four basic principles, and four basic constraints.

Assumptions

	Business Entity: assumes that the business is separate from its owners or other businesses. Revenues and expenses should be kept separate from personal expenses.
	Going Concern: assumes that the business will be in operation indefinitely. This validates the methods of asset capitalization, depreciation, and amortization. Only when liquidation is certain this assumption is not applicable.
	Monetary Unit principle: assumes a stable currency is going to be the unit of record. The FASB accepts the nominal value of the US Dollar as the monetary unit of record unadjusted for inflation.
	The Time-period principle implies that the economic activities of an enterprise can be divided into artificial time periods.

Principles

	Cost principle requires companies to account and report based on acquisition costs rather than fair market value for most assets and liabilities. This principle provides information that is reliable but not very relevant. Thus there is a trend to use fair values. Most debts and securities are now reported at market values.
	Revenue principle requires companies to record when revenue is (1) realized or realizable and (2) earned, not when cash is received. This way of accounting is called accrual basis accounting.
	Matching principle. Expenses have to be matched with revenues as long as it is reasonable to do so. Expenses are recognized not when the work is performed, or when a product is produced, but when the work or the product actually makes its contribution to revenue. Only if no connection with revenue can be established, may cost be charged as expenses to the current period (e.g. office salaries and other administrative expenses). This principle allows greater evaluation of actual profitability and performance (shows how much was spent to earn revenue). Depreciation and Cost of Goods Sold are good examples of application of this principle.

Disclosure principle: Amount and kinds of information disclosed should be decided based on trade-off analysis as a larger amount of information costs more to prepare and use. Information disclosed should be enough to make a

judgment while keeping costs reasonable. Information is presented in the main body of financial statements, in the notes or as supplementary information

Constraints

	Objectivity principle: the company financial statements provided by the accountants should base on objective evidence
	Materiality principle: the significance of an item should be considered when it is reported. An item is considered significant when it would affect the decision of a reasonable individual.
	Consistency principle: It means that the company uses the same accounting principles and methods from year to year.
	Prudent principle: when choosing between two solutions, the one that will be least likely to overstate assets and income should be picked.