What are Accounting Principals?
Accounting principles refer to the set of guidelines and standards that companies follow when preparing their financial statements. These principles provide a common basis for how financial information should be recorded, summarized, and presented. The purpose of accounting principles is to ensure that financial information is reliable, consistent, and comparable, and to provide a framework for making informed business decisions.
Accounting is a process of recording, classifying, and summarizing financial transactions in order to provide relevant and useful information to various stakeholders. It is an essential tool for managing businesses and making informed decisions. Accounting is governed by certain principles that ensure the accuracy, consistency, and reliability of financial information.
The following are the basic principles of accounting:
Economic Entity Principle: This principle states that a business should be considered as a separate entity from its owners and other entities. The transactions and financial statements of a business should not be mixed with the personal transactions and financial statements of its owners. This principle helps in maintaining the integrity of financial information and making it easier to analyze and understand.
Example: If a business owner uses the company’s funds to pay for personal expenses, it should be recorded as a draw or a loan to the owner and not as an expense of the business.
Materiality Principle: This principle states that transactions should be recorded if they are material, meaning they are significant enough to affect the financial statements of the business. Material transactions should be recorded accurately, even if they are small in value.
Example: If a business buys a pen for $1, it should still be recorded as an expense in the financial statements, as it is material to the business and it might affect in decision making in small businesses. But if this is a larger business $1 pen may not affect any decision so that won’t be material.
Going Concern Principle: This principle states that a business should be considered a going concern, meaning that it is expected to continue operating into the future. This principle assumes that a business will have the resources and ability to continue operating for the foreseeable future.
Example: If a business is closing down and has no plans to continue operating, this should be reflected in the financial statements.
Matching Principle: This principle states that expenses should be matched with the revenue they helped to generate. This means that expenses should be recorded in the same accounting period as the related revenue.
Example: If a business incurs advertising expenses in January to generate sales in February, the advertising expenses should be recorded in January and the related sales in February.
Full Disclosure Principle: This principle states that all relevant information that could affect the understanding of the financial statements should be disclosed. This includes disclosing any contingencies, commitments, and off-balance sheet arrangements.
Example: If a business has a loan that is due in the next accounting period, this should be disclosed in the financial statements as a liability.
Accrual Principle: This principle states that transactions should be recorded when they occur, not when payment is made or received. This means that expenses should be recorded when incurred and revenue should be recorded when earned, regardless of when payment is received.
Example: If a business provides services in January but receives payment in February, the revenue should be recorded in January as earned.
Conservatism Principle: This principle states that in case of uncertainty, financial statements should reflect a cautious or conservative approach. This means that when there are two equally likely outcomes, the outcome that results in a lower net income should be recorded.
Example: If a business has a doubtful debt, the amount should be recorded as a loss, even if there is a chance that it may be recovered in the future.
Consistency Principle: This principle states that a business should use the same accounting methods and principles from one accounting period to the next. This helps ensure the comparability of financial information from one period to another.
Example: If a business uses the straight-line method of depreciation in the first accounting period, it should continue to use the same method in subsequent periods.
Cost Principle: This principle states that assets should be recorded at their cost, not at their market value. Cost includes all expenses incurred to acquire the asset and make it ready for use. This principle helps ensure that assets are recorded at a consistent and objective value.
Example: If a business buys a piece of equipment for $10,000, including shipping and installation costs, the equipment should be recorded in the financial statements at a cost of $10,000.
Monetary Unit Principle: This principle states that financial transactions should be recorded in the currency of the country in which the business operates. This helps ensure the comparability of financial information and reduces the impact of changes in exchange rates.
Example: If a business operates in the United States, all financial transactions should be recorded in U.S. dollars.
Reliability Principle: This principle states that financial information should be reliable and trustworthy. This means that financial information should be based on accurate and complete data, and it should be free from material errors and bias.
Example: If a business discovers a mistake in its financial statements, it should correct the mistake and provide reliable information to its stakeholders.
Revenue Recognition Principle: This principle states that revenue should be recognized when it is earned, regardless of when payment is received. This means that revenue should be recorded when the goods are sold or the services are provided, and not when payment is received.
Example: If a business sells goods on credit, the revenue should be recognized when the goods are sold, not when payment is received.
Time Period Principle: This principle states that financial information should be presented on a periodic basis, such as monthly, quarterly, or annually. This helps ensure that financial information is up-to-date and relevant, and it allows stakeholders to monitor the performance of the business over time.
Example: If a business operates on a calendar year basis, its financial statements should be prepared and presented annually, as of December 31st.
In conclusion, the basic principles of accounting provide a foundation for accurate and reliable financial information. Adhering to these principles helps ensure that financial information is consistent, trustworthy, and useful for making informed decisions. It is important for businesses to understand and follow these principles to ensure the integrity of their financial information.