The rules that make up acceptable accounting practices are referred to as, Generally Accepted
Accounting Principles (GAAP). The responsibility for setting for setting accounting principles is
determined by many individuals and groups.
The primary purpose of the GAAP, is to make information in financial statements relevant, reliable,
consistent, and comparable.
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Information that has relevance can affect the types of decisions made by users.
Information must have reliability for decision makers to depend on it.
Consistency ensures that information is prepared using the same accounting procedures form
one accounting period to the next.
If companies use similar practices, users are able to compare companies and their information
comparably.
The Fundamental Principles of Accounting
1. Business Entity Principle
Each economic entity or business of the owner must keep accounting records and reports that are
separate from those of the owner and any other economic entity of the owner. Users want information
about the performance of a specific entity or business. If information is mixed between two or more
entities, its usefulness is decreased.
Example: Looking at Finlay Interiors, Carol Finaly must not include personal expenses, such as
clothing and the cost of going to the movies as an expense of her business.
2. Cost Principle
All transactions are recorded based on the actual cash amount received or paid. In the absence of cash,
the cash equivalent amount of the exchange is recorded.
Example: If Finlay Interiors purchased used furniture for $5000.00 cash, it is recorded in the
accounting records at $5000.00. It makes no difference if Carol Finlay thinks that the value of
the furniture is $7000.00.
3. Going Concern Principle
Financial statement users assume that the statements reflect a business that is going to continue its
operations instead of being closed or sold. Therfore, assets are maintained in the accounting records at
cost and not reduced to a liquidation value as if the business were being sold or bought. If a company is
to be bought or sold, buyers and sellers are advised to obtain additional information, such as estimated
market value, from other sources.
Example: It is assumed from a review of Finaly Interiors’s financial statements that the business
is continuing its operations because information to the contrary is not included.
4. Monetary Unit Principle
Transactions are expressed using units of money as the common denominator. It is assumed that the
monetary unit is stable; therefore, a transaction is left as originally recorded and is not later adjusted
for changes in currency, value or inflation.; The greater the changes in currency value and inflation, the
more difficult it is to use and interpret financial statements across time.
Example: Assume that in August 2005 Finlay interiors purchased furniture from a supplier in the
US at a total cost of $1000.00 (US) or $1489 (Cdn). Even if the exchange rate changes over time,
the amount that was paid at the original time of purchase is the amount that will remain in the
accounting records.
5. Revenue Recognition Principle
Revenue is recorded at the time that it is earned regardless of whether cash or another asset has been
exchanged. The amount of revenue to be recorded is measured by the cash plus the cash equivalent
value of any other asset received.
Example: Assume that on April 3, Finlay interiors performed work for a client in the amount of
$600.00. The client did not pay $600.00 until May 15. Revenue is recorded when actually
earned on April 3 in the amount of $600. The value of the non – cash asset received by Finlay
Interiors . Alternatively , if Finaly received $1000 on April 15 for work to be done in May. The
revenue will not be recorded until May.
6. Time Period Principle
Assumes that an organizations activity can be divided into specific time periods such as month, a three
month, a three month quarter or a year.
Examples:
 Monthly ( Jan, Feb, Mar, Apr, May, June, July, August, September, October, November,
December.
 Quarterly (Quarter 1 – Ending March, Quarter 2 – Ending June, Quarter 3- Ending
September, Quarter 4- Ending December)
 Semi Annually( Ending in June and December)
 Annaual ( Ending December)
7. Matching Principle
This aims to report or match expenses in the same accounting period as the revenues they helped to
earn.
Example: Assume that a as a part of a $500.00 consulting service contract Finlay Interiors is to
provide a detailed written pan to one of its consumers in March. In the process of earning this
$500.00 in revenue, Finlay interiors will use $150.00 of office supplies purchased and paid for in
February. The $150.00 of supplies used in March is an expense that will be reported on the
March income statement even though the supplies were purchased and paid for in February. The
$150.00 of office supplies used in March must be matched against the $500.00 of March revenue
in accordance with the matching principle.
8. Materiality Principle
This principle states that an amount may not be ignored if its effect on the financial statements is
important to their users.
Example: The materiality principle is used by some companies not to assign incidental costs of
acquiring merchandise to inventory. These companies argue that incidental costs are
immaterial or that the effort in these costs to inventory outweighs the benefits. Such
companies price inventory using invoice prices only. When this is done the incidental cost are
allocated to cost of goods sold in the period when they incurred.
9. Full Disclosure Principle
This principle requires financial statements to report all relevant information about the operation and
financial position of an entity.
10. Consistency Principle
The consistency principle requires a company to use the same accounting methods period after period
so that the financial statements are comparable across periods.
11. Conservatism Principle
When faced with a choice of two or more equally like amounts, the least optimistic value should be
selected.
Example: The December 31, 2005 inventory of a music store included eight –track tapes that
cost the merchandiser a total of $100 000 but had a market value on that date of $500 and we know
that eight tracks are obsolete, the least optimistic and most realistic value is that of $500.00.