Accounting principles are the set of rules and guidelines adopted by organizations for preparing comparable financial statements. Through precise guidelines, the information presented is accurate and precise.
In this article, we will be discussing what is accounting and its different principles.
Table of Contents
- What are principles of accounting?
- Regulatory Bodies
- How do accounting principles work?
- List of Accounting Principles
- Accrual principle
- Consistency principle
- Conservatism principle
- Cost principle
- Economic entity principle
- Matching principle
- Materiality principle
- Full Disclosure Principle
- Going Concern Principle
- Monetary Unit Principle
- Reliability Principle
- Time Period Principle
- Revenue Recognition Principle
- Objectivity Principle
- Limitations of Principle of Accounting
What are the Principles of Accounting?
Accounting principles refer to the rules and guidelines followed by companies while reporting their financial data. Through these rules, experts can examine the financial data by standardizing accounting methods. These principles ensure that the quality of the financial information reported by companies is improved. Let us discuss the concept and principles of accounting in the next section.
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The aim of accounting principles is to compare multiple financial statements on the same level. For this comparability, it is mandatory that these accounting principles have been followed to same set of standards.
Regulatory Bodies For Setting Principles of Accounting
According to this principle, all revenues and expenses can be assigned systematically to consecutive and distinctive accounting time periods. Although, the principle does not require every transaction to be assigned to a specific accounting period. If it is the case, then business transactions and periods should be estimated to a specific time period. Through this principle, accountants can assess the performance of their business. It allows comparison amongst transactions when recorded in different time periods.
How Do Accounting Principles Work?
Principles of accounting work on set standards due to which they minimize irregularities as well as data mismanagement. Since these accounting prinicplesare in line with the international standards, they can help identify cross-border investment opportunities. The principles of accounting are subject to interepretation due to which the inference drawn by different accountants can vary. Not all aspects of a company's functioning are considered by accounting principles. This often poses a limitation.
Importance of Principles of Accounting
The following points explain the importance of accounting principles:
- Accounting principles and concepts determine income, expenses, assets and liabilities for financial reporting.
- Companies implement these principles while preparing financial statements to make them consistent and complete.
- These properly formulated financial statements help investors in analyzing useful information.
- It becomes easier to compare financial information differently.
- Through these principles, transparency in the system is increased and red flags can be identified.
List of Principles of Accounting
Following are the twelve widely adopted principles in accounting:
1. Accrual Principle
It is one of the important accounting concepts and principles that mandate the recording of transactions in the time period in which they occur. It is regardless of the time when actual cash flows for the transactions are received. Through accrual principle, one can gain an accurate insight into the financial status of a business. Most large-scale businesses adopt an accrual system to determine the cash flow of the business operations. Along with this, revenues and related expenses are recorded in the same time period of reporting. Both IFRS and GAAP support this concept. In case, a business has more than $5 million in revenue, then such businesses must adopt this system for the purpose of taxation.
2. Consistency principle
According to this principle, when an organisation adopts a specific accounting method of reporting or documentation, then it should stay consistent with the method. The aim of this basic accounting principle is to make financial statements comparable across industries and companies. This principle has two issues associated with it. First, the principle is not properly followed when many people are recording data and compiling reports. To combat this issue, organizations need to have a set method internally. The second issue is related to switching between the financial reporting methods. Some organizations do this in order to manipulate the data to their advantage.
3. Conservatism Principle
The Conservatism principle gives you a realistic perspective of unexpected situations. According to this principle, one should recognize expenses and liabilities at the early stages even if there is uncertainty about the outcome. However, the principle recognizes revenues and assets when there is an assurance of its receival. This principle can be applied to recognizing the estimates. The conservatism principle is the foundation of lower cost or market rule. As per this rule, one should record inventory at a lower end of its current market value or at its acquisition cost.
4. Cost Principle (historical Cost)
The Historical Cost principle is another name for the cost principle. Whenever a business acquires an asset, its initial value is recorded in its financial reports of the business. This value might not be improved in the market value of inflation. It is also not updated to reflect any depreciation or even appreciation. This value is known as the cost principle. As per the principle, companies keep a record of their tangible assets without reflecting the market value. Through this principle, companies can assess the actual cost of using financial services for calculating the historical cost principles of the assets of the company.
5. Economic Entity Principle
This principle is a basic of accounting that requires businesses to be treated as a separate financial and legal entity. This means that the recorded activities of the business entity must be kept separate from the recorded activities of the owner and other entities. These may include either a sole trader, limited liability partnership, or general partnership.
6. Matching Principle
The matching principle is a concept in accounting that states that companies must report their expenses and revenues simultaneously. The revenues and expenses are matched on income statement for a specific time period. It is a part of the accrual accounting method that provides an accurate representation of operations on the income statement. This principle is quite useful for investors as investors can match revenue and expenses to get a better sense of the finances of a business. Along with the income statement, there is a need to assess the cash flow statement as well.
7. Materiality Principle
As per the materiality principle, any item that may impact the decision-making process of an investor must be recorded. These details must be recorded in length in the financial statements using Generally Accepted Accounting Principles (GAAP). The material principle states that the accounting standard can be ignored if the end result is small. It is an important principle for deciding if a transaction should be recorded as a part of closing process.
Do check out our article on IFRS vs. GAAP
8. Full Disclosure Principle
In the Full Disclosure principle, each piece of information should be included in the financial statement of an entity. This is necessary since it might affect the reader’s perspective of understanding the statement. It is important to only disclose information about events that have a material impact on the financial position of an entity. As per the full disclosure principle, it may also include those items that cannot be quantified. Businesses are also liable to report existing accounting policies and any changes in them as well.
9. Going Concern Principle
According to this accounting principle, a company will complete its recent plans, meet its financial obligations and use its existing assets. This process of continuing operations indefinitely must go on until the company has any evidence on the contrary. Through this principle, the company continues to make money to avoid going bankrupt. In case, the company is unable to adopt this principle properly, the chance of liquidation and bankruptcy increases.
Going concern concept is also known as the continuing concern concept. A company continues to be a going concern till the time the sale of assets does not hamper its operations. If a company is no longer a continuing concern, it needs to start reporting specific information on financial statements. Through this principle, accountants can make decisions related to which information should be reported on financial statements.
10. Monetary Unit Principle
According to this principle, business transactions should be recorded only when they can be expressed as currency. Accountants should avoid recording non-quantifiable entities in the financial accounts. Whenever a transaction or an event occurs, it is first converted into money. After that, it is recorded into financial accounts of a business. It ensures that every accounting record is measurable in monetary terms by currencies.
11. Reliability Principle
This principle ensures that every transaction, business activity, event, etc is reliable when presented in the financial statement. Information should be associated with objective evidence and it can be checked, reviewed, and verified. This makes the information more reliable. Along with this, the information should be accurate and have a transparent representation. This makes the information reliable for its users. This principle ensures every financial statement and business accounting records are accurate.
12. Time Period Principle
There are two main regulatory bodies that develop the principles based on accounting concepts. GAAP and IFRS develop these principles. US-based companies follow GAAP principles whereas, outside the US, most countries follow IFRS guidelines. GAAP is static in comparison with the IFRS. IFRS builds principles to address the evolving financial condition in the world.
13. Revenue Recognition Principle
Revenue recognition is a part of GAAP that identifies certain conditions in which the revenue is recognized. The revenue is recognized when a critical event has occurred. This principle uses the accrual method of accounting. According to this, revenues are recognized when realised and earned. It is a straightforward principle when revenue is recognized when customers make payments. Whenever the production takes longer, the accounting for revenue becomes more complicated. This is one of the standard accounting principles in the industry.
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14. Objectivity Principle
It refers to the concept of considering financial statements as solid evidence. These statements should not be biased or opinionated. While constructing financial statements, these statements should be helpful in evaluating the financial results, financial position and cash flow of an entity. This principle of accounting must be from the viewpoint of an auditor as well. In case an auditor is auditing a business that he has worked with, then the audit report might not be free from bias as per the relationship with the business owner.
Limitations of Principle of Accounting
Accounting principles has certain limitations including the following:
- These financial recordings are measured in monetary value due to which the significant events that are not monetary in nature, are not accounted for.
- Accounting principles are maintained as per the historical cost and are treated as per 'time value of money'
- Only past records are accounted for leaving no scope for recording any future events that might affect business finance.
- In case of accounting principles, form is given importance over substance. Explanations of substantial information is not given any importance.
Hope that this article has been able to explain the principles of accounting in detail. These Accounting principles are necessary for enhancing the significance of financial statements. Through the implementation of these principles, there is a uniformity in the process of preparing financial statements. These principles ensure that stakeholders and investors get a standardized accounting system to compare business performance on a global level.
What is a T-account?
T-account refers to the set of financial records that use the system of double-entry bookkeeping. Here, the bookkeeping entries are laid in a T-shape which leads to the name of this account.
Define books of original entry.
Books of original entry is an accounting journal in which every transaction is recorded initially. To keep a track of day-to-day transactions, these are recorded on a timely basis along with their descriptions and details.
Is petty cash debit or credit?
It can be considered as both. The petty cash journal entry is 'debit' to the petty cash account and 'credit' to cash account.
What is the limit of petty cash?
The petty cash limit varies from organization to organization. Usually, it ranges up to 20,000 rupees.
Who is the father of accounting?
Luca Pacioli is the father of accounting.
Explain the golden rules of accounting?
There are three golden rules of accounting. These include: Debit all expenses and losses; Credit all incomes and gains; Debit the receiver, Credit the Giver; Debit what comes in, Credit what goes out.
Explain contra entry.
It is an entry recorded when credit and debit affect the account of the same person. This results in the impact being net zero to the account.
What is a cash book?
A cash book is both ledger and a journal that is used for every cash transaction required by the company. It is of three types, including single-column, double column, and triple-column cash books.