Principles Of Financial Accounting (The Key Principle You Should Kow)

Companies need to follow accounting principles and guidelines while reporting financial information. Generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS) provide principles and procedures to guide the preparation of financial statements. IFRSs are standardized accounting principles adopted by countries across the world.

Historically, there have been locally accepted accounting regulations. However, the world is adopting uniform reporting standard IFRS. Let’s discuss the main accounting principles and concepts.

1) Accrual principle

Accrual accounting states that transactions should be recorded in the period during which they occur rather than in the period they produce cash flows. By properly implementing the accrual principle, it is possible to combine all revenues and expense information for an accounting period without the distortions and delays caused by cash flow from that accounting period.

2) Objectivity Principle

Financial performance and position information is important part of financial accounting. As a result, financial accounting statements must contain information about value—the value of the company’s assets and liabilities and the value of transactions conducted by companies.

The objectivity principle states that values to be entered into the accounting system must be backed by evidence. The values should not be based on your wants or feelings.

3) Conservatism principle

Using conservative accounting guidelines, a company can only claim any profit it has earned with a high degree of verification. A firm’s financial future should be viewed in the worst-case scenario. The moment uncertain liabilities are discovered, they must be acknowledged. Contrary to revenues, revenue cannot be recorded until it is certain to be received.

4) Consistency principle

The consistency principle states that you need to continually follow an accounting principle or method once adopted. However, If the new version of the accounting method improves the presentation of financial statements, then it can be changed. Further, the changes should be accompanied by notes that adequately explain the effects of such a change.  

For auditors, consistency is especially important for reporting results from period to period to be comparable. In some audit activities, team members discuss consistency issues. In the case of clear and unwarranted violations of the principle, an auditor may decline to report.

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5) Cost principle

Assets, liabilities, and equity are recorded at their original cost including short-term, long-term, and capital assets. Generally, an asset is recorded at the cash amount purchased or acquired at the time of purchase or acquisition. As per this concept, Inflation or market value increase do not increase the value of the asset, nor additional depreciation is applied.

6) Economic entity principle

A business entity’s record of its activities should be kept apart from the record of the activities of its owner and any other business entities. You will need to keep separate accounting records and bank accounts for each business entity and not intermix the assets and liabilities of the business partners and owners. Furthermore, all business transactions should be associated with a specific business entity.

Various business entities exist, including sole proprietorships, partnerships, corporations, and government agencies. A sole proprietorship is the most troubling business entity in the economic entity principle because a proprietor routinely blends business and personal transactions.

7) Full disclosure principle

Under the full disclosure principle, all information that could affect a reader’s understanding of business should be included in the financial statements of an entity. Due to the massive amount of information that could be provided, the interpretation of this principle is highly judgemental. Generally, only events that are likely to negatively impact a company’s financial position or financial results are disclosed to reduce disclosures.

8) Going concern principle

Going concern refers to the ability of the business to stay afloat or avoid bankruptcy. The business is considered going concerned if it’s expected to remain operational for the foreseeable future as there is no evidence that it may not be able to operate.

If it’s concluded that the business is not going concerned, financial statements are prepared on a break-up basis.

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9) Matching principle

Companies are required to report expenses and revenues together. This is called the matching principle. An income statement matches revenues and expenses for a period of time. Otherwise, calculated profit/loss may not reflect the activities performed during a specific period.

10) Materiality principle

The materiality principle states that guidance of accounting standards can be disregarded if its impact is not expected to mislead a user of the financial statements. As a general principle of generally accepted accounting principles (GAAP), it does not need to be implemented if an item is immaterial.

Although definition does not provide definitive guidance on the distinction between material and immaterial information, deciding whether a transaction is material must be determined by exercising judgment.

11) Monetary unit principle

According to the monetary unit principle, you should only record transactions involving a currency. An organization cannot record non-quantifiable items like employee skill levels or customer service quality. It’s also impossible for a company to estimate the value of its speeches to employees about how to engage in innovative activities.

12) Reliability principle

The reliability principle states that financial records for the accounting system should be verified with objective evidence. Evidence may be in the form of purchase receipts, checks, bank statements, promissory notes, appraisal reports, insurance policies, and contracts.

Further, documents provided by third parties are considered to be more objectively reliable than those created in-house.

13) Revenue recognition principle

Recognizing revenue refers to recognizing revenue when earned. It’s important to note that earning revenue and receiving cash is different. For instance, if the business has sold goods on credit, once goods are delivered, the business has a complete right to record the transaction as sales. Although it’s a fact that cash has not been received but the right to receive the cash has been established. So, a realistic expectation to record revenue is that the customer has received goods or services, but payment will be made later.

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14) Period principle

The time period principle stipulates that businesses should report their financial results after a specified period of time, such as monthly, quarterly, or yearly. Record transactions within each period according to Generally Accepted Accounting Principles or International Financial Reporting Standards guidelines. So, an organization needs to produce financial statements with a high degree of consistency to be compared to their results in previous years.

Conclusion

Financial statements are prepared under the guidance of GAAP and IFRS. Along with these applicable regulations, there are basic accounting principles to be complied with by companies preparing financial statements. These accounting principles are considered building blocks for an accurate and complete financial reporting process.

These principles include accrual, objectivity, conservatism, cost principle, economic entity concept, full disclosure, going concern, matching, materiality, monetary unit, reliability, revenue recognition, time period, etc. Auditors review and analyze financial statements to comply with these principles and other applicable regulations.

Frequently  asked questions

What is a cut-off concept in accounting?

Cut off is the point that creates a boundary between two accounting periods. An accountant needs to sort business activities and record them in their respective accounting periods. It’s extremely helpful in the closing of the accounts and presenting business activities in the right accounting period.

What are the components of a financial statement?

Following are the components of the financial statement.

  1. Statement of financial position.
  2. Statement of profit and loss.
  3. Statement of changes in equity.
  4. Statement of cash flow.
  5. Notes to the financial statement.

What is the purpose of the accounting concept?

The purpose of accounting concepts is to enhance the quality and credibility of the overall financial reporting processes. It aims to bring consistency, maintenance, and comparability. 

What is the revaluation model in accounting?

Revaluation is the process of adjusting the book value of an asset to the market value. However, if the business applies a revaluation model, it’s applied to all the business assets, not selective ones.