What is Accounting Principles

Accounting principles

What is Accounting Principles

In this article we will be looking into accounting principles and generally accepted accounting principles.

First we should start with what is accounting principles? 

Accounting principles are the principles that govern the rules of accounting and reflect the latest accounting methodologies. The professional world of accounting is governed by general rules and concepts referred to as basic accounting principles and guidelines. Together, they form the groundwork for the more complicated, detailed and legalistic rules of accounting.

Accounting principles are the building blocks for GAAP. All of the concepts and standards in GAAP can be traced back to the underlying accounting principles. Some accounting principles come from long-used accounting practices where as others come from ruling making bodies like the FASB.

It’s important to have a basic understanding of these main accounting principles as you learn accounting. This isn’t just memorizing some accounting information for a test and then forgetting it two days later. These principles show up all over the place in the study of accounting.

Accounting principles govern how accountants calculate and present the details of a company’s financial operations, such as net earnings, gross income, and net cash provided by operating activities.

Accounting principles designate at the most fundamental level how both companies should record those revenues and expenses. For example, the accrual and matching principles require companies to match revenues and expenses with the period in which they are incurred, regardless of whether any cash changes hands.

List of Accounting Principles

Accounting principles

Below are some of the basic accounting principles;

Historical Cost Principle

The historical cost principle states that businesses must record and account for most assets and liabilities at their purchase or acquisition price. In other words, businesses have to record an asset on their balance sheet for the amount paid for the asset. The asset cost or price is then never adjusted for changes in the market or economy and changes due to inflation.

The historical cost principle is a trade off between reliability and usefulness. The historical cost of an asset is completely reliable. After all, that’s how much the company paid for the asset. It might not be very useful however. Knowing that a company purchased a piece of land in 1950 for $10,000 does not really tell financial statement users how much the land is currently worth.

In this case a fair market value would be more useful. Since fair market values and replacement costs are left up to estimates and opinions, the FASB has decided to stick with the historical cost principle because it is reliable and objective. In current years, the FASB as well as the IASB has become more open to fair value information.

Liabilities are also accounted for using the historical cost principle. When bonds or other debts are issued or received, they are recorded on the balance sheet at the original acquisition price.

Revenue Recognition Principle

The revenue recognition principle states that revenue should be recognized and recorded when it is realized or realizable and when it is earned. In other words, companies shouldn’t wait until revenue is actually collected to record it in their books. Revenue should be recorded when the business has earned the revenue. This is a key concept in the accrual basis of accounting because revenue can be recorded without actually being received.

Revenues are realized or realizable when a company exchanges goods or services for cash or other assets. So if a company enters into a transaction to sell inventory to a customer, the revenue is realizable. A specific amount of cash is identified in the transaction. The revenue is not recorded, however, until it is earned. In this case, the retailer would not earn the revenue until it transfers the ownership of the inventory to the customer.

There are three main exceptions to the revenue recognition principle. Some manufacturers may recognize revenue during the production process. This is common in long-term construction and defense contracts that take years to complete. The revenue in these cases is considered earned at various stages of job completion.

Some companies recognize revenue after the manufacturing process but before the sale actually takes place. Mining, oil, and agricultural companies use this system because the goods are marketable and effectively sold as soon as they are mined.

The last exception to the revenue recognition principle is companies that recognize revenue when the cash is actually received. This is a form of cash basis accounting and is most commonly found in installment sales.

Matching Principle

The matching principle states that expenses should be recognized and recorded when those expenses can be matched with the revenues those expenses helped to generate. In other words, expenses shouldn’t be recorded when they are paid. Expenses should be recorded as the corresponding revenues are recorded. This matches the revenues and expenses in a period. In this sense, the matching principle recognizes expenses as the revenue recognition principle recognizes income.

In general, there are two types of costs: product and period costs. Product costs can be tied directly to products and in turn revenues. Period costs, on the other hand, cannot.

Period costs do not have corresponding revenues. Administrative salaries, for example, cannot be matched to any specific revenue stream. These expenses are recorded in the current period.

The matching principle also states that expenses should be recognized in a “rational and systematic” manner. This is the key concept behind depreciation where an asset’s cost is recognized over many periods.

In short, the matching principle states that where expenses can be matched with revenues, we should do so because the benefits of an asset or revenue should be linked to the costs of that asset or revenue.

Conservatism Principle

The principle of conservatism gives guidance on how to record uncertain events and estimates. The principle of conservatism states that you should always error on the most conservative side of any transaction. Most of the time this means minimizing profits by recording uncertain losses or expenses and not recording uncertain or estimated gains.

Since accounting standards and GAAP are always concerned with the usefulness of financial data to financial statement users, you can understand why the FASB doesn’t want financial information to over estimated or error on the high side. This could sway users’ decisions.

The principle of conservatism also applies to estimates. Generally, a more conservative estimate should always be used. When estimating allowance for doubtful accounts, casualty losses, or other unknown future events you should always error on the side of conservatism. In other words, you should tend to take the position that is records the most expenses and least income. This is the main principle behind the lower of cost or market concept for recording inventory.

Remember when there is a event with an uncertain outcome, you want to recognize revenues when they are actually earned and recognize expenses when they are reasonably probable.

Cost Benefit Principle

The cost benefit principle or cost benefit relationship states that the cost of providing financial information in the financial statements must not outweigh the benefit of that information to the users. In other words, financial information is not free. Companies spend millions of dollars every year gathering and organizing financial information to assemble into financial statements.

Ideally, investors and creditors would like to know every piece of information about a company as possible. Unfortunately, this level of disclosure would place a huge financial burden on the company. Some financial information external users don’t receive a large benefit from knowing such as how much money Apple spends giving the public tours of its headquarters. Other information would be far too costly to obtain like audit, potential litigation, and competitor’s information.

Essentially, the cost benefit principle is a common sense rule. Management can ask, “does it make sense to gather this financial information to put it in financial statement? Do the costs of gathering this information outweigh the benefit to the users?” Essentially, do users need this information enough to spend this money getting it? If the answer is yes, the company can leave the information out of the financial statements.

The cost benefit principle also applies to internal company processes.

Full Disclosure Principle

The full disclosure principle states that information that would “make a difference” to financial statement users or would be useful in decision-making should be disclosed in the financial statements. This way investors or creditors can see a total picture of the company before they choose to take any action.

Companies use the full disclosure principle as a guide to understand what financial and non-financial information should be included in their financial statements. The full disclosure principle states that disclosed information should make a difference as well as be understandable to the financial statement users.

This information is either disclosed in the footnotes of the financial statements or the supplemental information. The financial statement footnotes usually explain the information presented in the body of the financial statements. If an item on the balance sheet is unclear, the notes can be used to explain it. For instance explanations of lawsuits and contingencies might be mentioned in the notes as well as accounting methods used for inventory.

Supplemental information, on the other hand, is extra information that companies may want to show potential investors. This information is usually relevant but is often not very reliable. For instance, management might include its own analysis of the financial statements and the company’s financial position in the supplemental information.

As you can see, these disclosures would be essential for investors, creditors, and other readers of the financial statements to properly view a company’s overall financial position; although, no amount of disclosures can make up for bad accounting. Companies cannot be negligent with their records and disclose everything.

Consistency Principle

The consistency principle states that companies should use the same accounting treatment for similar events and transactions over time. In other words, companies shouldn’t use one accounting method today, use another tomorrow, and switch back the day after that. Similar transactions should be accounted for using the same accounting method over time. This creates consistency in the financial information given to creditors and investors.

The consistency principle does not state that businesses always have to use the same accounting method forever. Companies are allowed to switch accounting methods if the company can demonstrate why the new method is better than the old method. The company then must disclose the change in its financial statement notes along with the effect of the change, date when the change occurred, and the justification for the accounting method change.

As you can see, the consistency principle is intended to keep financial statements similar and comparable. If companies changed accounting methods for valuing inventory every single year, investors and creditors wouldn’t be able to compare the company’s financial performance or financial position year after year. They would have to recalculate everything to make the financial statements equivalent to each other.

Objecivity Principle

The objectivity principle states that accounting information and financial reporting should be independent and supported with unbiased evidence. This means that accounting information must be based on research and facts, not merely a preparer’s opinion. The objectivity principle is aimed at making financial statements more relevant and reliable.

The concept of relevance implies that financial statements can have predictive value and feedback value. This means the financial statements are accurate and can be used to predict future company performance.

The concept of reliability implies that financial information can be verified by many sources with evidence and that all financial information is presented. In other words, the favorable and unfavorable financial information is presented in the financial statements.

The two concepts of relevance and reliability encompass the objectivity principle. By making financial statements more relevant and reliable, the objectivity principle makes the financial information more usable for investors and creditors.

The objectivity principle extends to internal auditors and CPA firms as well. Although auditors must adhere to GAAS, auditors must be independent of the company they are auditing. This helps ensure that the financial reporting and audits are done objectively. Since investors and creditors rely on auditor’s reports, the reports should be independent. If management or current shareholders wrote reports and audits, they would tend to be too optimistic and not rely on pure facts.

These are the accounting Principles that i know, you can also add yours through the comment box below thanks.

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