Accounting Principles: Types, GAAP and IFRS Explained

Accounting is the core language of any business, and like any language, it has its own rules. These rules, known as Accounting Principles, shape how companies record, present and interpret their finances. They are the foundation of reliable reporting as they ensure accuracy and build trust among shareholders, creditors, and other interested parties.

This blog explores the major Accounting Principles that shape financial reporting from foundational concepts to global standards like GAAP and IFRS. So read on, be fluent in the language of business and become a master at decoding the financial health of any organisation!

Table of Contents

1) What are Accounting Principles?

2) Importance of Accounting Principles

3) Major Types of Accounting Principles

4) Generally Accepted Accounting Principles (GAAP)

5) International Financial Reporting Standards (IFRS)

6) Limitations of Accounting Principles

7) Conclusion

What are Accounting Principles?

Accounting Principles are rules that guide how companies record and report their financial activities. They ensure financial statements are consistent and clear, making it harder for businesses to hide details or exaggerate results. This consistency also helps people understand a company’s financial health and compare it with others across different time periods.

These principles explain how transactions like sales, purchases, and payments should be reported. Before they existed, companies could present financial data however they wanted, which made comparisons difficult and allowed numbers to be easily distorted. For investors and regulators, this created major problems.

Importance of Accounting Principles

Accounting Principles play a vital role in business for several reasons:

1) Ensure Accuracy and Reliability: They ensure financial statements are accurate and reliable.

2) Standardise Financial Reporting: They define how expenses, income, assets, liabilities, profits, and losses should be reported.

3) Enable Comparability: They make it easier to compare financial data across companies and time periods.

4) Promote Transparency and Fraud Detection: They promote transparency and help in detecting financial fraud effectively.

5) Support Investor Decision-making: They provide investors with clear information to analyse and make sound financial decisions.

Major Types of Accounting Principles

There are several basic Accounting Principles that investors and Accountants follow to implement appropriate financial processes. Here are the types of Accounting Principles that'll help you make informed decisions:

1) Matching Principle

Based on this principle, all expenses pertaining to earning revenue must be recorded at the same time that the revenue is recognised. This prevents the company from overstating its profits by recording income in one period and delaying the related costs to another.

2) Accrual Principle

The accrual principle in Accounting records the expenses and income when they are earned or incurred, not when cash changes hands. This ensures that a company’s financial performance is shown accurately in its financial statements at any given time.

3) Objectivity Principle

This is one of the most important Accounting Principles. It states that all financial information must be based on unbiased evidence and not influenced by personal opinions. It highlights the importance of using verifiable documents such as invoices, receipts, contracts, and bank statements to support Accounting records.

4) Cost Principle

Under the cost principle, assets are initially recorded at their original purchase price. This ensures the accuracy and fairness in financial reporting. While later adjustments may be made for depreciation, the focus remains on reflecting the asset’s actual transaction value.

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5) Economic Entity Principle

The economic entity principle requires that a company’s financial activities be kept separate from those of its owners. This means the company must maintain its own Accounting records, bank accounts, and financial statements, independent of personal transactions.

6) Revenue Recognition Principle

This principle states that revenue must be recorded only when it has been both earned and can be reasonably measured. In other words, a company must recognise revenue when it has delivered goods or services, and payment is either received or assured.

7) Full Disclosure Principle

This principle requires companies to share all relevant information in their financial statements. This means any details that could impact a user’s understanding must be clearly reported. This includes major write-downs or the method used to calculate depreciation.

8) Time Period Principle

This principle in financial reporting ensures that businesses present their performance over consistent time frames. It’s about giving a clear and accurate picture of a company’s financial health. This principle helps businesses of all sizes, from small firms to global corporations, produce reliable financial statements. These can be compared across different periods.

9) The Conservatism Principle

The principle of conservatism helps businesses, especially small ones, manage their finances wisely. It encourages companies to be cautious by recognising expenses and liabilities as soon as they are likely to occur. For small businesses, this approach can prevent risky decision-making and make balance sheets more reliable.
 

10) The Principle of Consistency

This principle is essential for making financial information reliable and easy to compare. It applies to all businesses, whether private or public, and ensures financial statements are prepared in the same way over time. Once a company chooses an Accounting method, such as cash basis or accrual, it should use it consistently across reporting periods.

11) Materiality Principle

One of the most crucial principles of Accounting, the materiality principle requires companies to include all information in their financial statements that could influence the decisions of investors, creditors or other stakeholders. If a piece of financial data is important enough to affect how someone evaluates the company’s performance, it must be disclosed clearly.

12) Going Concern Principle

This principle assumes that a business will keep running for the foreseeable future unless there’s clear evidence it won’t. This approach lets companies value their assets and liabilities as if operations will continue. It helps create accurate and realistic financial reports.

13) Reliability Principle

The reliability principle states that only transactions backed by verifiable evidence should be recorded in the financial statements. This evidence could include receipts, invoices, contracts, bank statements, or other official documents that prove the transaction actually took place.

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Generally Accepted Accounting Principles (GAAP)

In the UK, companies follow a set of rules called Generally Accepted Accounting Principles in the United Kingdom (UK GAAP) to keep financial reporting clear and consistent. These rules are created by the Financial Reporting Council (FRC). Although there isn’t one fixed list, these principles form the basis of UK GAAP:
 

International Financial Reporting Standards (IFRS)

IFRS is a set of global Accounting rules adopted in 169 jurisdictions, including the UK, EU, Canada, India, South Korea, and South Africa. They are created and maintained by the International Accounting Standards Board (IASB). Currently, there are 17 IFRS standards that cover many areas such as how companies should record revenue from contracts, handle insurance agreements, or account for leases. 

 These rules are built on four main Accounting Principles: 

1) Clarity

2) Relevance

3) Reliability

4) Comparability

The types of organisations required to follow IFRS vary by country. In the EU, all companies must comply, while in some other regions, only certain businesses (banks or large companies) are required to use them.

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Limitations of Accounting Principles

While Accounting Principles are essential for bookkeeping, they do have certain drawbacks. These can affect how a company’s finances are shown. Some key limitations include:

1) Records are only measured in monetary terms. Events that impact a business but cannot be expressed in money are not included.

2) These principles follow the “time value of money” and record assets at historical cost. They ignore current market changes, which may not reflect the true financial position.

3) Only past transactions are recorded. Standards like GAAP do not account for future events that could influence finances.

4) More focus is placed on forms and tables rather than explaining important details. This can reduce the depth of financial information.

Conclusion

In the field of Finance, Accounting Principles are the foundation of transparency, trust and consistency. By understanding their types and global frameworks like GAAP and IFRS, businesses and investors gain greater clarity. Whether local or international, these principles ensure financial information speaks the same language.

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