Many finance and tax rules change by country, but in the world of accounting, some principles remain the same. For example, publicly traded companies in the United States use Generally Accepted Accounting Principles or GAAP. However, many Australian, public companies that operate in the US, and elsewhere may find them useful to know. 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. Let’s dive into Australian accounting principles and GAAP.
What Are Generally Accepted Accounting Principles?
Generally accepted accounting principles (GAAP) are a set of standards and accounting rules U.S companies use to create their financial statements. 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. That said, there are ten GAAP principles:
- Permanence of methods
- Utmost good faith
What Are Australian Accounting Principles?
U.S. companies adhere to GAAP, but firms in other countries follow International Financial Reporting Standards (IFRS). Public companies in the US must meet GAAP accounting standards. While global companies in other countries like the UK must follow IFRS as well as their base country’s standards when creating financial statements.
For Australian companies, the Australian Accounting Standards Board (AASB) establishes generally accepted accounting principles for use by local and state governments. Australian public companies must comply with AASB accounting principles.
The 10 Principles of Accounting
To better understand GAAP and Australian accounting principles, let’s dive deeper into the ten principles of accounting.
1. Accrual Principle
The accrual principle requires that you record transactions in the period they happen, regardless of when the cash flow for the transaction is received. 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 immediately 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 refers to recognizing liabilities and expenses as soon you discover them. Contrastingly, you only record revenue when you are sure you will get it. The idea is to factor in the worst possible outcome in your company’s financial future.
If your business predicts a loss, the conservatism principle suggests that you record the loss and amplify its potential impact. Conversely, if you are uncertain about receiving revenue in your small business, ignore the revenue until you get it.
If you estimate uncertain revenue and loss in your company, you understate revenue and overstate losses. As a result, you become cautious when making decisions since you expect a lower net income.
However, understating and overstating financial periods can complicate tracking finances in your business. Plus, this principle is open to interpretation; businesses can easily be tempted to manipulate it to their advantage.
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 have separate financial statements.
The economic entity principle prevents personal and inter-organisational compounding of assets and liabilities, which would confuse business auditors.
4. Cost Principle
The cost accounting principle is the concept whereby a company records assets, liabilities, and equity investment at the original buying cost. In short, the principle states that you record costs at the actual price you paid for an item. On top of that, the company should not adjust cost-related financial information with depreciation or inflation or market value improvement.
Here’s an example illustrating how the cost principle works.
Business Z bought a property for $275,000 in 2018. In 2020, the property’s market value increased to 350,000. In this case, business Z cannot adjust the property’s cost to reflect the current market value.
However, there are some exceptions to the cost principle. For example, a business should record highly liquid assets (stocks and bonds) at their current market value rather than the original cost.
This principle eliminates the trouble of adjusting your books now and then with the current market prices. However, it can result in an investor undervaluing your business if your assets have increased in value since the initial purchase.
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. 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 essential financial data in their financial records. Your accountant should include all necessary financial information that may influence a person’s or institution’s judgment when deciding to lend or invest in the business.
The full disclosure principle provides external entities with crucial details when evaluating a company’s potential success.
8. Going Concern Principle
The going concern principle applies to businesses that expect to operate for the foreseeable future. It assumes that the businesses can generate revenue, meet their obligation, and don’t plan to liquidate soon.
If you prepare financial statements using the going concern accounting principle, you can defer some prepaid expenses (depreciation) to a later date.
9. Matching Principle
The matching principle requires a company to record expenses and related revenues together in the same reporting period. If an expense doesn’t directly link to revenue (depreciation), the company should record the expense’s effects throughout the years. Here are examples for better clarity.
Example 1: A company acquires a machine for $100,000 with a useful life value of 5 years. In this case, the company should charge the machine’s cost to depreciation expense per year for five years. This ensures the business recognizes the depreciation expense over the machine’s life.
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 as you earn it—not only after collecting cash. In other words, you record revenue when products or services are delivered, not when you receive payment. For example, business X sells products worth $100 on credit.
This principle suggests that the business should immediately record the revenue upon selling the products, 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, the business should recognize the revenue in their statements after it has been delivered.
Navigating various global and Australian accounting principles can be complicated. However, it is essential for every business to prepare financial reports and bookkeeping to meet these standards. If you’d like a bookkeeping expert to help you prepare your business, get started with Visory today. We’ll make sure your books are clean and compliant, so you can focus on running your business.