Accounting principles are the principle, concepts, basics, guidance, as well as rules that use by the accountant to prepare the financial statements of an entity. They are also used by the standard-setting body to develop accounting standards and frameworks.
You may find out some of the accounting principles have been set out in the qualitative and quantitative characterization of information in IFRS.
Most of the accounting principles are also set in the accounting standard and well as frameworks. Even though those accounting standards (local GAAP) vary from one country to another, the principles set out in the standards are in the same fashion.
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Even if the accounting principles in one financial reporting standard to another are not much different, most investors still do not get comfortable when the investments are moved to a country where different accounting standards are required.
Yet, in the near future, IFRS will replace the local GAAP and be the world-accepted accounting standard. In this article, we will explain the detail of most of the accounting principles that use to prepare financial statements:
List of accounting principles:
1) Accrual Principle:
The accrual accounting concept has required the revenues and expenses to be recorded and recognized in the entity’s financial statements when they are incurred rather than when cash is paid or received.
This principle helps the users of financial statements to get the financial information that really reflected in the current financial status or the economic situation of the entity.
The recognition is not only related to the cash flow like a cash basis where the revenues are recorded and recognized in the financial statements only when the cash is collected from the customers for the services or products that the entity sells to them.
And the expenses are recorded and recognized in the financial statements when the cash is an outflow from the entity.
For example, based on the accrual accounting principle, sales revenues from selling clothes are recognized where the right and obligation are transferred from seller to buyer even if the seller does not receive the payments from the buyer.
Records and recognize the sales based on the accrual basis, the users could see all of the sales that the entity makes during the period for both credit sales and cash sales. It provides a complete picture of sales during the period.
Another example related to accrued expenses is that the maintenance expenses are recognized at the time that services consume by the entity rather than at the time that the entity paid to suppliers.
This recognition will bring the complete picture to the users of financial statements about how much the maintenance expenses incurred during the period rather than just showing how much the payments are made for maintenance expenses during the period on a per cash basis.
2) Conservatism principle:
The conservatism principle is concerned with the reliability of the Financial Statements of an entity for the benefit of users, especially in the areas of overstating the revenue and assets as well as understating the liabilities and expenses.
This accounting principle requires the entity to record and recognize the liabilities and expenses in the financial statements as soon as possible when there is uncertainty about the outcome.
And the entity should not recognize assets or revenue in the financial statements if the outcome is not certain. If it does, the revenues might be overstated and lead users to make the wrong economic decision.
For example, the entity should recognize the expenses immediately in the financial statements if there is a probability that an entity might lose the lawsuit to its customers.
This is to ensure that the liabilities are recognized in the financial statements and it is actually reflecting the current financial situation of the entity that probably makes a loss.
If these expenses are material to the financial statement and they are not recorded, then the potential investors who make their decision make their decision based on the financial statements that off these expenses could potentially make losses.
The entity might come to a situation where it is probably of winning the lawsuit. In this case, and based on this principle, the entity should not recognize the possible revenue from this lawsuit.
In addition, the entity might also come to a situation where inventories or fixed assets that the entity just purchased last month could be purchased now by spending less money.
In this case, the entity should consider writing off the portion that differs into expenses so that assets could be present at the realizable value.
3) Consistency principle:
The consistency Principle is the accounting principle that requires the entity to apply the same accounting method, policies, and standards for reporting its financial statements.
There are many benefits for the stakeholders of financial statements when the consistency principle is correctly and strictly applied.
For example, if different accounting policies or methods are used to measure and recognize the revenues then there will be a significantly different revenue amount present in the income statement while there could be slightly different if the same accounting policies or methods of measurement and recognition are used.
For example, depreciation rates and methods should be applied consistently from one accounting period to period to the same fixed assets. If there is any change in accounting policies, the appropriate standard should be applied.
Normally, if your financial statements are prepared and presented by accounting IFRS, then IAS 8 change in accounting policies, is the standard that you should look for.
This standard guides you on how to deal with such a case that you want to change the accounting policies or accounting estimate.
Another example is that your entity is currently using FIFO to value your inventories and this method should be used to value your inventories not only in this period but also in the next period. This is also assumed your entity should FIFO was used to value previous inventories.
4) Cost Principle or Historical Cost Principle:
The concept of the historical cost principle is that the assets should be recorded based on the price at the time they are purchased.
And the liabilities should be recorded based on the values that are expected to pay at the original value rather than market value or inflation-adjusted value.
The historical cost principle is also called the cost principle. To avoid incorrect recognition and measurement, it is recommended that the accountant should follow the accounting standards that they are using to prepare the financial statements.
For example, if you are using IFRS to prepare your financial statements, then you should go to each standard under IFRS that is applicable to the items you are dealing with. For example, the recognition of PPE is initially measured at costs and subsequently, the entity could use a costs module or revaluation module to measure.
However, some financial assets and financial liabilities are not applicable to use this principle. The cost principle is a benefit to accountants and other related stakeholders who use the financial statements since the financial transactions are records of the identified costs and verifiable evidence. For example, the costs of fixed assets could be verified with the suppliers’ purchase invoices.
5) Economic Entity Principle:
Business Entity Concept or Business Entity Principle considers the owner of an entity to have different legal liabilities. Under this concept, the entity must record all transactions separately from its owner or owners and other business.
This means that the transactions that record in the entity accounts are only those transactions that belong to the entity.
Any financial transactions, assets, liabilities, and equities that belong to the owner, owners, or other entities should not include in entity accounts.
For example, Sinra shops sell cakes in Bangkok, Thailand. Sinra takes two take-ups for his wife’s birthday. In this case, we need to identify who is the owner and what is the entity. And what transactions happening between Sinra and the entity.
So, Sinra is the owner and Sinra Shop is the entity. Sinra withdraws the cases for this wife. Therefore, by using the business entity concept, the accounting records for the shop are recording decreasing for stoke and increasing owner withdrawal. Or maybe treat it as well as normal customers.
This principle could help to minimize conflict between owners in case there are many owners of the entity. And it also prevents the owner to avoid tax obligations to the government.
It also benefits owners or shareholders to assess the performance of each entity separately and well as to assess the financial position of the entity.
6) Full Disclosure Principle:
Full Disclosure Principle requires the entity to disclose all necessary information in its financial statements. The main idea behind this principle is that the users of the financial statements of entity might depend on the financial information disclosed in the financial statements to make their decision.
Therefore, it is important to make sure that all the information that they should know are available to them.
This is why this principle is introduced to ensure that information that should be disclosed in the entity’s financial statements as per the requirement of accounting standards or frameworks had been disclosed.
In practice, you might follow each accounting standard whether the situation that happens in your entity should be disclosed or not as per standard.
The information to be disclosed is only financial information but also non-financial information such as new law and regulations that come into effect soon and the entity’s business might get hurt by that law and regulations. The subsequent adversely affects the revenues or the going concern of the entity.
For example, the government of the country where the entity runs its business just amount that numbers of the tax rate will increase and it will come to effect next year. The entity’s business and specifically profits will get hurt.
The going concern of the entity is questionable. In this case, based on the full disclosure principle, this revision and how it is affected the entity should be fully disclosed in the entity’s financial statements.
7) Going Concern Principle:
Going concerned is the concept that assumes the entity will remain the business in the foreseeable period which is normally twelve months from the operating date. If the financial statements are prepared based on the going concern basis.
In other words, if the entity does not face going concern problems, then the users of financial statements could their reliance on the entity’s financial information that they are valued by considering the entity could survive in the period of twelve months.
There are many factors that indicate an entity might face a going concern problem. Or the entity might stop its business in the period of twelve months from the reporting date of financial statements.
For example, the entity’s main services or products are no longer needed in the markets and sales dramatically drop also most to zero. This situation indicates that an entity probably liquidates its assets to support its operation in a period of less than twelve months.
And, we could say that it will go into solvency in a period of fewer than twelve months. In this case, the financial statements should not prepare by using the going concern problem. For example, there is no accrual of expenses recognized in the balance sheet and income statement. Prepayments should not also recognize.
The entity should conduct going concern assessment annually to see if it is in the going concern problems. The assessment should not only focus on financial factors but also on non-financial factors that might affect the entity to shut down its business.
8) Matching principle:
The matching Principle is the accounting principle that uses to record and recognizes expenses and revenues in financial statements.
This principle wants to make sure that the incomes and expenses in the income statement really reflected in the period that they actually incurred.
When this principle is correctly applied, net income is truly and fairly present in the income statement. It is not the result of overstatement or understatement of revenues or expenses.
For example, when the entity sells goods to its customers, the entity will generate revenues and at the same time, the entity also has to spend its finish goods to its customers.
In this case, sales revenues are recognized in the income statement and the cost of goods sold is also recognized in the same period. Revenues are matched with cost of goods sold in the income statement.
If either revenue or costs of goods sold are deferred to the next period because of whatever reason, then net income will not arrive as it should be. Then the users’ decision could when wrong if it is depending on this information.
The entity might come into a situation where customers pay for the goods they have not received. In this case, the entity could not recognize the payments that they received from customers as revenue. This is because goods are not delivered to customers yet.
The entity should recognize the payment received from customers as unearned revenues under liabilities accounts.
Subsequently, the entity delivers the goods to customers then the entity could move from unearned revenues to revenues in the income statement. At the same time, the costs of goods sold are also recognized.
9) Materiality principle:
Materiality Principle or materiality concept is the accounting principle that is concerned with the relevance of information, and the size and nature of transactions that report in the financial statements.
Based on this concept, financial information is material if its omission and addition could be misleading the users’ decision. The same size and nature of financial information might be material to one entity’s financial statements but might not be material to another.
For example, the wrong recognition of revenues amounts USD 50k of ABC is not material if we compare to its total revenues USD 500,000K. However, 50K is material to financial statements of DEF and especially it could be misleading to the users’ decision if it is over or under recognize when the total revenues are just USD 100K.
This principle is not only used by the accountant to prepare the financial statements as the basis to decide the financial transaction and event that is material to financial statements, but it is also used by the auditor as to calculate the tolerable error, performance materiality as well as planning materiality.
These materiality use as the matrix or tools for auditors to decide if unadjusted transactions or amounts are material to financial statements. This unadjusted transactions or amounts is part of auditors’ evident to support their opinions.
10) Monetary unit principle:
Monetary Unit Assumption is the accounting principle that concern about the valuation of transactions and event that entity records in its financial statements. In monetary unit assumption, transactions or even could records in the Financial Statements only if they could measure in monetary.
There are many transactions that occur in and by entity every day. Not all of those transactions are recording in the financial statements. For example, sales staff got accident and the entity pay for the costs of accident and hospital.
The entity could record these costs in the income statement but the entity could not record the costs that sales staff’s performance becomes low as the result of an accident.
Entity’s financial transactions and events use a monetary unit to records in the financial statements due to many reasons. Some of those including:
- Simple and easy to use. Money is very simple to use and easy to understand therefore it is easy to use to records business transactions. It is easy to understand by users.
- Universally recognized and communicated. Money is generally and globally used in a normal business transaction.
- The monetary unit that is used to records the financial statements should be stable like USD currency. The currency that is not stable is not applicable for use as a unit to record financial statements.
- The entity uses a monetary unit to record financial transactions and events The value of assets that record in the financial statements is changed due to inflation.
11) Reliability principle:
Reliability Principle is the accounting principle that is concerned with the reliability of financial information that present in the financial statements of an entity. This accounting concept is quite important for the users of financial information. If the information is not reliable, then the decision-making will be unlikely correct.
12) Revenue Recognition Principle:
There are many principles that use to recognize revenue in Financial Statements. For example, Accrual Basis or Cash Basis. In the accrual accounting Principle, Revenue should be recognized when risks and rewards are transferred.
Here is the detail of Revenue Recognition Principle
Time Period Principle or Periodicity Principle, Financial Statements of an entity could be prepared in an artificial period of time. They are no need to be prepared based on regulatory requirements.
Here is the detail of the Time Period Principle or Periodicity Principle
Written by Sinra