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 table below lists the
ten main accounting principles and guidelines together with a highly condensed
explanation of each.

Basic Accounting Principle What It Means in Relationship to a Financial Statement

1. Economic The accountant keeps all of the business transactions of a sole

Entity proprietorship separate from the business owner's personal transactions.
Assumption 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 Economic activity is measured in U.S. dollars, and only transactions
Assumption 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
2008 transaction.
3. Time Period This accounting principle assumes that it is possible to report the
Assumption complex and ongoing activities of a business in relatively short, distinct
time intervals such as the five months ended May 31, 2008, or the 5
weeks ended May 1, 2008. 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, 2008,
the amount is known; but for the income statement for the three months
ended March 31, 2008, 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 ending December 31,
2008 the month ending December 31, 2008 the three months ending
December 31, 2008 or the year ended December 31, 2008.
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 If certain information is important to an investor or lender using the
Disclosure financial statements, that information should be disclosed within the
Principle 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 This accounting principle assumes that a company will continue to exist
Concern long enough to carry out its objectives and commitments and will not
Principle 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 This accounting principle requires companies to use the accrual basis
Principle 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 2007 revenues as a bonus on
January 15, 2008, the company should report the bonus as an expense
in 2007 and the amount unpaid at December 31, 2007 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 Drills for Adjusting Entries.)
8. Revenue Under the accrual basis of accounting (as opposed to the cash basis of
Recognition accounting), revenues are recognized as soon as a product has been
Principle 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. If a situation arises where there are two acceptable alternatives for
Conservatism 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.