1 5: Describe Principles, Assumptions, and Concepts of Accounting and Their Relationship to Financial Statements Business LibreTexts

We can illustrate each account type and its corresponding debit and credit effects in the form of an expanded accounting equation. You will learn more about the expanded accounting equation and use it to analyze transactions in Define and Describe the Expanded Accounting Equation and Its Relationship to Analyzing Transactions. The basic components of even the simplest accounting system are accounts and a general ledger. An account is a record showing increases and decreases to assets, liabilities, and equity—the basic components found in the accounting equation.

• For example, Lynn Sanders purchases two cars; one is used for
  personal use only, and the other is used for business use only.
• Assets are then remain on the balance sheet at their historical without being adjusted for fluctuations in market value.
• When every company follows the same framework and rules, investors, creditors, and other financial statement users will have an easier time understanding the reports and making decisions based on them.
• The International Financial Reporting Standards (IFRS) are used in 110 countries, whereas the Generally Accepted Accounting Principles are used only in the U.S.
• While the original value of an asset on the balance sheet goes unchanged, the difference between the original value and the lower market value is expensed every year over the course of the asset’s life.

This allows companies to accrue expenses in the belief that they will still be in operation when it is time to meet financial obligations. Different financial statements are created in relation to different accounting periods. The Monetary Unit Assumption concept states that if transactions and other activities can be measured and expressed in monetary terms they can be recorded on the balance sheet.

Debits and Credits

This might mean allocating costs
over more than one accounting or reporting period. The primary exceptions to this historical cost treatment, at
this time, are financial instruments, such as stocks and bonds,
which might be recorded at their fair market value. Critics of principles-based accounting systems say they can give companies far too much freedom and do not prescribe transparency. They believe because companies https://personal-accounting.org/ do not have to follow specific rules that have been set out, their reporting may provide an inaccurate picture of their financial health. In the case of rules-based methods like GAAP, complex rules can cause unnecessary complications in the preparation of financial statements. These critics claim having strict rules means that companies must spend an unfair amount of their resources to comply with industry standards.

• For example, banks operate using different accounting and financial reporting methods than those used by retail businesses.
• In the United States, accountants make another assumption regarding money measurement – the
  stable dollar assumption.
• The attorney must earn the income before it
  can be recorded as such, even though he/she received cash for the service at an
  earlier date.
• However, if an influencer is given products in exchange for a social media post – the retail value of those products can be used as the value of that transaction when preparing the accounting records.

There are some important differences in how accounting entries are treated in GAAP as opposed to IFRS. IFRS rules ban the use of last-in, first-out (LIFO) inventory accounting methods, while GAAP rules allow for LIFO. Both systems https://www.wave-accounting.net/ allow for the first-in, first-out method (FIFO) and the weighted average-cost method. In order for companies to record the myriad of transactions they
have each year, there is a need for a simple but detailed system.

IFRS CONNECTION

According to the separate entity concept, Lynn may record the purchase of the car used by the company in the company’s accounting records, but not the car for personal use. The full disclosure principle states that a business must report any business activities that could affect what is reported on the financial statements. The customer did not pay cash for the service at that time and was billed for the service, paying at a later date. When should Lynn recognize the revenue, on August 10 or at the later payment date? She provided the service to the customer, and there is a reasonable expectation that the customer will pay at the later date.

GAAP vs. IFRS

The length of the accounting period must be stated in the financial statements. For instance, so far, the
income statements in this text were for either one month or one year. Revenue and expense recognition timing is critical to transparent financial presentation. Even though GAAP is required only for public companies, to display their financial position most accurately, private companies should manage their financial accounting using its rules. Two principles governed by GAAP are the revenue recognition principle and the matching principle.

Accounting Principles

The economic entity assumption allows the accountant to keep the business transactions of a sole proprietorship separate from the sole proprietor’s personal transactions. Since 1973, US GAAP has been developed and maintained by the Financial Accounting Standards Board (FASB), a non-government, not-for-profit organization. In 2009, the FASB launched the Accounting Standards Codification (ASC or Codification), which it continues to update. This electronic database contains the official accounting standards (the equivalent of many thousands of printed pages) which apply to the financial reporting of U.S companies and not-for-profit organizations. The IASB and the FASB have been working on the convergence of IFRS and GAAP since 2002.

This group of commonly owned corporations is referred to as the economic entity. The set of financial statements that reports the combined activity of the group is referred to as consolidated financial statements. Although it is not required for non-publicly traded companies, GAAP is viewed favorably by lenders and creditors.

Accrual Accounting

Even though Lynn feels the equipment is worth $60,000, she may only record the cost she paid for the equipment of $40,000. Materiality Concept – anything that would change a financial statement user’s mind or decision about the company should be recorded or noted in the financial statements. If a business event occurred that is so insignificant that an investor or creditor wouldn’t care about it, the event need not be recorded. Periodicity Assumption https://accountingcoaching.online/ – simply states that companies should be able to record their financial activities during a certain period of time. Full Disclosure Principle – requires that any knowledge that would materially affect a financial statement user’s decision about the company must be disclosed in the footnotes of the financial statements. This prevents companies from hiding material facts about accounting practices or known contingencies in the future.