Basic Principles of Accounting are important guidelines that ensure that all businesses have financial statements prepared similarly.
In this regard, it is rudimentary to understand that these guidelines are mostly unanimously applied across accounting bodies of all countries, which follow the IFRS (International Financial Reporting Standards).
What is meant by Accounting Principles?
Accounting Principles are rules that an organization is supposed to follow to ensure compliance regarding financial reporting and respective standards that are followed.
These principles are regarded as the foundations on which accounting standards are duly created.
They are supposed to be followed and implemented across all organizational steps, primarily to facilitate better accounting frameworks.
What Are the Principles of Accounting?
Several different accounting principles are used and implied within an organization. Definition and explanation of all these principles are given below:
- Accrual Principle: Accrual Principle mostly relates to accountants recording transactions in the periods where these accounting transactions occur, compared to when they are paid for. This implies that the accounting period, when the transactions take place, is considered highly important, and all transactions are supposed to be recorded in the respective accounting period only. This means that companies are supposed to follow the Accrual basis of accounting instead of the cash basis of accounting.
Under the cash basis of accounting, expenses and revenues are recorded as they are paid. However, an accrual basis requires organizations to record expenses and revenues when they are incurred, and not when they are paid for.
- Conservatism Principle: Under the conservatism principle of accounting, organizations are supposed to record expenses and liabilities even when there is a significant probability that they will, in actuality, be incurred. However, revenues are only supposed to be recorded when there is complete and total certainty that the sale has actually been confirmed. The main premise of this principle is to record losses and expenses at an earlier date, and assets and profits once they have taken place.
- Consistency Principle: The consistency Principle talks about consistency in terms of business practice. It implies that businesses should adopt a standardized approach across all years. For example, organizations cannot change their bookkeeping policies from one year to another. They are supposed to stay consistent across the years. For example, they cannot randomly capitalize expenses expensed until the last year. This means that accounting treatments should not fluctuate from one year to another.
- Cost Principle: Using the Cost Principle, organizations should record all economic instruments (including assets, liabilities, and equity-related investments) at the original cost price. However, in the case of inventory, and other fixed assets, the principle of ‘lower of cost of net realizable value is used.
- Economic Entity Principle: The economic entity principle states that business transactions should be kept separate for both the business owner and the business entity. This implies that these transactions should not be mixed, and should be recorded separately. The business account should not be treated as a business owner’s account.
- Going-Concern Principle: Under the going-concern concept, financial statements are prepared with the context that businesses will continue to remain operational for the foreseeable future. In other words, the company’s financial statements should be prepared to bear in mind that the business continues to remain operational for the coming few years. This principle then creates a justification for deferring expenses till later periods, as to when they will be covered.
- Materiality Principle: The materiality principle requires accountants to gauge all material transactions, and record transactions to an extent where they are significant enough to impact the decision-making ability of the user of the financial statements. This implies that all the transactions that are significant enough to influence the decision-making ability of the end user are supposed to be disclosed in the financial statement. On the contrary, all other transactions that are not as material or significant can be missed out upon, since including all the immaterial transactions might prove to be unfavorable to the efficiency of the accounting process.
- Monetary Unit Principle: This principle mainly requires all financial transactions to be recorded in the form of a certain currency. All purchases and sales should be recorded in the applicable financial currency, which in most cases, tends to be the prevalent economic currency of the country. Additionally, all financial units must also be recorded in a singular currency, which does not require the end user of financial statements to do any translations or currency conversions. However, companies might choose to issue their financial statements in several other forms of currencies for separate users.
- Revenue Recognition Principle: This principle mostly entails that revenue should be recorded as revenue in the financial statements only when earned. In the case of advance payments received by customers for orders not yet processed, the received payment is supposed to be recorded as ‘unearned revenue’ (a current liability). Only when the order has been processed, the company can record it as earned revenue. Before that, the company could not record it as revenue under the Revenue Recognition Principle.
- Full Disclosure Principle: Under the full-disclosure principle, companies are also required to record all transactions and other information that the company requires. The rationale behind applying full disclosure is to ensure that stakeholders of the company are fully aware of the company’s operations and any red flags they should consider before investing in the company. The reason why this principle is in place mostly lies in the realm of ensuring that companies can communicate everything regarding their operations to the general public. Informational disclosures help companies to grow and progress over time.
- Matching Principle: Matching Principle requires companies to record expenses corresponding to revenues and vice versa. Similar to the accrual principle, the matching principle ensures that revenues and expenses are recorded for a given accounting year only. Organizations should not record revenues for one year, and expenses for some other time duration because that is likely to falsify the financial statements, similar to a material misstatement.
- Reliability Principle: As per the Reliability Principle, organizations are supposed to record transactions reliably. This means all transactions recorded should be backed with the respective evidence. If all steps of reliability are accounted for from the initial recording process, this would mean that the financial statements are also reliable, and can be relied upon for decision making.
Importance of Accounting Principles
Accounting Principles tend to provide a much-needed discipline for organizations and accountants. It is important to consider that accounting principles need to be properly followed so that greater compliance can be achieved in terms of the standards put forth by accounting bodies.
The framework these accounting bodies provide helps organizations prepare accounting records that are viable for an internal understanding and from the perspective of external stakeholders.
Hence, accounting principles tend to work in favor of the company and its external stakeholders to ensure better performance and, eventually, better transparency with the external stakeholders.