What are the generally accepted accounting principles?

Many finance and tax rules change by country, but some accounting principles remain the same. In the United States, companies report under Generally Accepted Accounting Principles, or GAAP. Australia uses its own Australian Accounting Standards, which are built on International Financial Reporting Standards (IFRS). If you deal with US investors, lenders or parent companies, you may also be wondering how GAAP relates to Australian accounting principles.

If you are managing your books, it is important to know what best practices you should follow. Here is how Australian accounting principles and GAAP fit together, and the core principles behind both.

What are generally accepted accounting principles?

Generally accepted accounting principles (GAAP) are the standards and accounting rules US companies use to create their financial statements. US GAAP is set by the Financial Accounting Standards Board (FASB), and US public companies must use it. These standards ensure companies follow similar accounting conventions, giving investors a basic consistency when comparing financial records.

GAAP sets guidelines for a range of topics from financial statements to assets, liabilities, foreign currency, equities, revenue, expenses, and more. One informal summary you may see elsewhere boils its underlying ideas down to a list like this:

• Regularity
• Consistency
• Sincerity
• Permanence of methods
• Non-compensation
• Continuity
• Prudence
• Periodicity
• Utmost good faith
• Materiality

That list is a teaching summary rather than a list set out in the standards themselves, but it captures the intent: apply the rules consistently, report honestly and completely, and don’t net items off against each other to hide them.

What are Australian accounting principles?

US companies adhere to GAAP, but companies in more than 140 jurisdictions are required to use IFRS Accounting Standards, issued by the International Accounting Standards Board.

In Australia, the Australian Accounting Standards Board (AASB), a Commonwealth agency, makes accounting standards under section 334 of the Corporations Act 2001. Australian Accounting Standards apply to the private sector (for-profit and not-for-profit) and the public sector. For for-profit entities, the top tier of Australian Accounting Standards incorporates IFRS, so an Australian listed company that complies with them also complies with IFRS.

Which standards apply depends on the entity. Listed and other publicly accountable entities that must prepare financial statements use Tier 1 (full Australian Accounting Standards). Other entities that prepare general purpose financial statements, such as large proprietary companies, can use Tier 2 (Australian Accounting Standards: Simplified Disclosures), which keeps the same recognition and measurement rules with fewer disclosures. Most small proprietary companies don’t have to lodge financial statements with ASIC at all, although they still need accurate financial records for tax and for their own decisions.

The 10 principles of accounting

To better understand GAAP and Australian accounting principles, here are ten principles of accounting that sit behind both. These are the ideas your bookkeeping should follow, even if your business never prepares formal financial statements under the standards.

1. Accrual principle

The accrual principle requires that you record transactions in the period they happen, regardless of when the cash for the transaction is received or paid. For example, you record sales and expenses when they take place rather than when cash changes hands.

Suppose you are an architect and send an invoice for a project you’ve done. In that case, you should record it in your accounts receivable when you send the invoice, not wait until you receive payment. The accrual principle is behind the accrual accounting method.

Accrual accounting suits business owners who don’t receive payment straight away. It also shows your true financial position by tracking what others owe you and what you owe others. However, it can be more complicated than cash accounting.

2. Conservatism principle

The conservatism principle, called prudence in the accounting standards’ Conceptual Framework, means exercising caution when you make judgements under uncertainty. It stops assets and income being overstated and liabilities and expenses being understated, without being deliberately pessimistic. Individual standards set the recognition tests, for example AASB 137 for provisions and AASB 15 for revenue.

Prudence is not a licence to be pessimistic. The standards require financial statements to be neutral: you should not deliberately understate income or assets, or overstate expenses or losses. If a customer is unlikely to pay, you allow for that doubtful debt; you don’t inflate it.

Applied properly, prudence stops your reports from looking better than reality, so you make decisions on numbers you can rely on.

However, the principle involves judgement, so apply it consistently from period to period and document the estimates you make. Swinging between cautious and optimistic estimates makes your results hard to compare.

3. Economic entity principle

This principle states that business owners should separate the company’s transactions from their personal financial dealings and those of investors.

The financial records of each entity should also be distinct. For example, if you own businesses A and B (or a parent company with several subsidiaries), each entity should keep its own records. A parent company may also need to prepare consolidated statements for the group.

The economic entity principle prevents personal and business assets and liabilities from being mixed together, which would make your records unreliable for you, your advisers and the ATO.

4. Cost principle

The cost principle (also called historical cost) means you initially record an asset at the price you actually paid for it, including costs needed to get it ready for use.

After that, the asset is usually carried at cost less depreciation. Under Australian Accounting Standards (AASB 116), an entity can choose either the cost model or the revaluation model for each class of property, plant and equipment. Here’s an example illustrating how the cost model works.

Business Z bought a property for $275,000 in 2018. In 2020, the property’s market value increased to $350,000. If business Z uses the cost model, its books continue to show the property at its original cost (less any depreciation of the building), not the $350,000 market value.

However, there are exceptions to the cost principle. For example, listed shares held as an investment are generally measured at fair value (their current market value) rather than their original cost, and investment property can be carried at fair value.

The cost model avoids constantly adjusting your books to market prices. However, it can mean your balance sheet understates assets that have increased in value since you bought them.

5. Monetary unit principle

The monetary unit principle states that you only record transactions that are expressible in terms of a currency. That means you can’t record non-quantifiable items like employee talent and customer service quality.

While the monetary unit principle simplifies quantifying business transactions, it has one big drawback. It doesn’t consider inflation and a currency’s purchasing power.

For example, the dollar’s purchasing power could increase or decrease in the future, depending on inflation. The monetary unit principle assumes that the currency you use to record transactions remains stable over time.

6. Time period principle

The time period principle states that a company should report its finances over a specific period, usually annually, quarterly, or monthly. In Australia, most businesses use a financial year ending 30 June. The goal of the time period principle is consistency.

Consistent reporting for similar periods simplifies comparing your current financial status with those of the previous years. Hence, investors and lenders can make financial decisions faster.

7. Full disclosure principle

As the name suggests, the full disclosure principle requires businesses to include all material financial information in their financial reports. That means any information that could reasonably influence a lender’s or investor’s decision about the business.

The full disclosure principle provides external parties with the details they need when evaluating a company’s performance and prospects.

8. Going concern principle

The going concern principle assumes that a business will keep operating for the foreseeable future: that it can meet its obligations as they fall due and has no intention or need to liquidate or stop trading.

This assumption is why you can spread the cost of a long-lived asset over its useful life through depreciation, and carry prepaid expenses as assets until they are used. If a business is not a going concern, its assets and liabilities may need to be measured differently, and the uncertainty must be disclosed.

9. Matching principle

The matching principle requires a company to record expenses in the same reporting period as the revenue they help earn. If an expense doesn’t link directly to particular revenue, such as the cost of equipment, the company spreads it over the periods that benefit. Here are examples for better clarity.

Example 1: A company acquires a machine for $100,000 with a useful life of 5 years and no residual value. Using straight-line depreciation, the company records a depreciation expense of $20,000 a year for five years. This spreads the machine’s cost over the years it is used. (Tax depreciation can follow different rules, so check with a registered tax agent.)

Example 2: A salesperson earned a 5% commission on sales a company shipped and recorded in February. The commission is to be paid in March. The company should record the commission expense in February. That way, the company records the expense in the same month as the associated sales.

The matching principle applies to businesses that use accrual accounting.

10. Revenue recognition principle

This accounting principle states that you should record revenue when you earn it, not only after collecting cash. Under AASB 15, revenue is recognised when (or as) you satisfy your promise to the customer by transferring control of the goods or services. For example, business X sells products worth $100 on credit.

Business X records the revenue when the customer receives the products (when control passes), even if it doesn’t expect payment for several days or weeks.

Suppose business X received payment in advance before delivering the goods. In that case, it records the payment as a liability (a contract liability, often called unearned revenue) and recognises the revenue once the goods have been delivered.

Navigating global and Australian accounting principles can be complicated, and which standards apply to your business depends on its structure and size. A registered tax agent or qualified accountant can confirm the reporting requirements for your entity. Whatever they are, they start with well-kept books. If you’d like a team to keep your books clean and compliant, book a discovery call with Visory.