Accounting principles to follow
In the subject of accounting, there are some overarching principles and guidelines that must be followed. These are referred to as fundamental accounting principles and guidelines, and they serve as the foundation upon which more specific, technical, and legally-oriented accounting standards are built. The Australian Accounting Standards Board (AASB) in Australia uses the basic accounting principles and guidelines as a basis for developing their very own complete and comprehensive set of accounting rules and standards. These rules and standards are based on the Australian Accounting Standards.
Through the process of common usage, a number of fundamental accounting principles have been formed. They serve as the foundation upon which the entire body of accounting standards has been constructed, making them an essential component. The following are some of the most well-known of these principles:
Accrual principle
This refers to the idea that transactions in accounting should be reported in the accounting period in which they actually take place, as opposed to recording them in the period in which the cash flows related with those transactions occur.
This serves as the basis for accounting that is done on an accrual basis. It is essential for the compilation of financial statements that indicate what occurred during an accounting period, rather than being unduly delayed or accelerated by the accompanying cash flows.
This is because it allows the statements to accurately reflect the state of the business. If you chose to disregard the accrual principle, for instance, you wouldn't be able to record an expense until you had actually paid for it. This could result in a protracted delay due to the fact that the payment terms for the related supplier invoice are quite stringent.
Conservatism principle
This refers to the idea that you should keep track of your expenditures and liabilities as soon as it is humanly possible, but that you should wait to record your revenues and assets until you are certain that they will materialise.
This gives the financial statements a more cautious tilt, which may result in lower reported profits due to the possibility that the recognition of income and assets would be delayed for some period of time.
On the other hand, this theory tends to favour the earlier recording of losses rather than the later recording of those losses.
This idea has the potential to be taken to an extreme, which would be the case if a company consistently misstated its results to be worse than what was actually the case.
When faced with a scenario in which there are two valid options for reporting an item, a prudent accountant will follow the advice of the conservative school of thought and select the one that will provide a lower amount of nett income and/or a lower asset number. The accountant is able to "break a tie" with the help of conservatism. It does not instruct accountants to adhere to a cautious approach. It is expected of accountants that they will be impartial and neutral.
The fundamental principle of conservatism in accounting requires accountants to estimate or disclose losses, but it does not permit a comparable action to be taken in the case of gains. For instance, possible losses from lawsuits will be mentioned on the financial statements or in the notes, but prospective gains will not be declared at all. This applies even if the potential losses exceed the potential gains. Additionally, an accountant may write inventory down to a value that is less than the original cost, but an accountant will not write inventory up to a value that is greater than the original cost.
Consistency principle
When you've settled on a particular accounting principle or approach, you should stick with it until you find one that's demonstrably superior to the one you've chosen. This is the idea behind the "continuous usage" principle. If a company does not adhere to the principle of consistency, then it is possible that it will frequently switch between various accounting treatments of its transactions. As a result, the company's long-term financial performance will be very difficult to understand.
Cost principle
This relates to the idea that a corporation should only record its assets, liabilities, and equity interests at the prices at which they were initially obtained. This is known as the "purchase-price accounting" theory. The applicability of this principle is decreasing as an increasing number of accounting standards are heading in the direction of calculating an asset's and liability's "fair value" and modifying the balance sheet accordingly. This is causing the applicability of this principle to become less widespread.
The phrase "cost" refers to the amount of money (or the cash equivalent) that was spent at the time that an item was first acquired, despite the fact that this transaction may have taken place as recently as the previous year or as far back as thirty years ago, when speaking from the perspective of an accountant, the phrase "cost" refers to the amount of money that was spent at the time that an item was originally purchased. The amounts that are reported on financial statements are known as historical cost amounts because of this reason.
Because of this fundamental principle of accounting, asset values are not increased to account for the effects of inflation. In point of fact, as a matter of standard practice, asset amounts are not revised to take into account any rise in value. As a consequence of this, the amount of an asset does not correlate to the amount of money that a company would receive if it were to sell the asset at the value that it is currently fetching on the market. (An exception to this rule would be a purchase of stocks or bonds that are being actively traded on a stock exchange.) If you are looking for information about the current value of a company's long-term assets, you will not find it in the company's financial statements. These statements do not include this type of information. You will, however, be required to seek assistance elsewhere, most likely from an impartial evaluator.
Economic entity principle
The idea behind this is that a company's financial dealings should be kept entirely distinct from those of its owners as well as those of any other company. This prevents the intermingling of assets and liabilities among several entities, which can create significant challenges during the initial audit of the financial statements of a nascent company.
When it comes to a sole proprietorship, the accountant ensures that all of the business transactions are kept distinct from the personal dealings of the business owner. When it comes to accounting, a sole proprietorship and its owner are considered to be two independent entities, despite the fact that the former is deemed to be a single entity for legal purposes.
The full transparency rule
All of the information that might have an impact on how a reader understands a company's financial statements should be included in or presented alongside those statements whenever possible, according to this school of thought. You should do this so that the reader will be able to evaluate the statements and come to an educated conclusion. This concept has been developed further as a result of the accounting rules, which mandate the disclosure of a very wide variety of factual information in a very specific format.
If a particular piece of information is going to be helpful to an investor or a lender who is going to be using the financial statements, then that information needs to be given either within the statement itself or in the notes that accompany the statement. This is the case whether the information is going to be useful or not. Due to the fact that this is one of the most important principles of accounting, financial statements typically carry a substantial amount of "footnotes" on multiple pages.
Take the following example as an illustration: a company finds itself the target of a legal action that demands a significant amount of money as compensation for its wrongdoing. While the financial statements are being prepared, it is not known whether or not the company will be able to successfully defend itself against the lawsuit or whether or not it will end up being found guilty of all allegations.
The impending legal action will be described in the notes to the financial statements as a consequence of these considerations, as well as in compliance with the notion of full transparency.
Typically, a corporation will include a description of its primary accounting policies in the introductory note that it attaches to its financial statements.
Going-concern theory
This refers to the idea that a company will continue to run its operations for at least the next many years. This indicates that you would be within your rights to delay the recognition of certain expenses, such as depreciation, until later periods of time. In that case, you would be required to record all of your expenses immediately and not postpone any of them.
This accounting principle operates under the presumption that a firm will remain operational for an amount of time sufficient to fulfil its goals and promises and that it will not go out of business in the near future. It is necessary for the accountant to reveal this evaluation if the current state of the company's finances leads the accountant to assume that the business will not be able to continue operations in the foreseeable future.
The corporation is able to postpone the payment of part of its prepaid expenses into subsequent accounting periods because of the going concern principle.
Matching principle
When you record your revenue, you should also record all of the expenses that are related to that revenue at the same time. This is an important step in maintaining accurate financial records. This is the idea behind it. Consequently, at the same time that you are recording revenue from the sale of those inventory items, you will also be charging inventory to the total cost of goods sold. This is because you will be doing both of these things simultaneously. This is a key principle that underlies the accrual method of accounting, and it is one of the most important ones. Because of this, the cash basis of accounting does not make use of the matching idea.
This accounting concept requires companies to use the accrual basis of accounting, which is the procedure that forms the basis of this accounting system.
According to the matching principle, the ratio of a company's expenditures to its income should be as close to 1:1 as possible. For example, the cost of sales commissions should be included in the report for the time period in which the corresponding sales were really made (and not reported in the period when the commissions were paid).
It is not the week in which wages are paid to employees that is regarded as an expense; rather, it is the week in which wages are documented as having been paid to employees that is regarded as having been an expense. If a company has an agreement with its employees that the company will give the employees a bonus on January 15, 2020, equal to 1 percent of the company's revenues in 2019, then the company should report the bonus as an expense in 2019, and the amount that is still owed to the employees as a liability as of December 31, 2019. The agreement between the company and its employees should be reported as an expense in 2019. (At the same time that revenue is being generated via sales, expenses are also being racked up.)
Because it is impossible to estimate the future economic benefit of activities such as advertisements (and because of this, it is also impossible to match the cost of advertisements with related future revenues), an accountant will deduct the cost of the advertisement from the cost of the goods that are sold during the time period in which the advertisement is being displayed.
Objectivity Principle
The accounting information must always be accurate and clear of any traces of the accountant's personal viewpoint. Check to see that the data are backed up by documentation as well, which may include vouchers, receipts, and invoices.
In this situation, having an objective viewpoint is helpful in order to trust on the financial results. If you have a history of working for the same firm for which you are now an auditor, for instance, your perspective could not be considered objective because of the potential influence that your relationship with the company's client has on your work.
Materiality principle
This is the notion that a transaction ought to be recorded in the accounting records even if it might not have had an effect on the decision-making process of an individual who was viewing the company's financial statements had it been recorded. This is the case even though it is possible that it would not have had an effect on the decision-making process had it been recorded. Some of the most minute controllers have begun logging even the most small transactions as a result of the fact that this concept is fairly hazy and difficult to measure. This is because of the fact that it is tricky to measure.
If a sum is minor, then an accountant may be allowed to break another accounting requirement because of this fundamental accounting concept or guideline. Because of the connection that exists between the two, this is the result. The exercise of one's professional judgement is required in order to assess whether or not a particular amount is minor or irrelevant.
The purchase of a printer costing $150 by a highly prosperous corporation that is worth multiple millions of dollars is an illustration of an obviously inconsequential item. According to the matching principle, the accountant needs to write off the cost of the printer during its expected lifetime of five years because it will be used during that time.
Due to the fact that the materiality rule gives them permission to do so, this company can violate the matching principle and deduct the entire sum of $150 in the same year that it was purchased.
The reasoning behind this is because no one would consider it dishonest if $150 were to be deducted as an expense in the first year rather than $30 being deducted as a cost in each of the five years that it is utilised. This is the argument for why this is the case. This is due to the fact that everyone would consider it to be deceptive if $150 were to be spent on expenses in the first year.
Depending on the size of the company, the values that are reported in financial statements are often rounded to the nearest dollar, to the nearest thousand, or to the nearest million dollars. This is done because rounding takes into account the significance of the data.
Monetary unit principle
This refers to the principle that a company's books should only reflect financial dealings that may be expressed in terms of a certain monetary denomination. As a result, the acquisition of a fixed asset may be reported with relative ease given that it was purchased for a predetermined sum, however, the worth of a company's quality control system is not shown in financial statements.
A company can benefit from this concept by avoiding the need to engage in an excessive amount of estimation when calculating the value of an organization's assets and liabilities.
As a result of this fundamental accounting concept, it is an accepted assumption that the purchase power of the dollar has not changed over the course of time. As a consequence of this assumption, accountants ignore the impact that inflation has had on the amounts that have been recorded. For example, monetary quantities from a transaction that took place in 1960 are combined with monetary amounts from a transaction that took place in 2019, and the results are analysed.
Reliability principle.
This refers to the idea that the books should be kept only of the dealings that can be substantiated in some way. For instance, a supplier invoice is strong evidence that an expense has been recorded in the appropriate place. Auditors are always looking for documentation to back up transactions, therefore this idea is of the utmost importance to them.
Revenue recognition principle.
The idea behind this is that you shouldn't recognise revenue until the company in question has earned a significant amount of money for the period in question.
As a result of the large number of persons who have committed reporting fraud by going about this concept's periphery in search of loopholes, a variety of standard-setting bodies have accumulated an enormous amount of knowledge regarding what constitutes appropriate revenue recognition.
When using the accrual basis of accounting rather than the cash basis of accounting, revenues are recognised as soon as a product has been sold or a service has been performed, regardless of when the money is actually received. This is in contrast to the cash basis of accounting, which recognises revenues only when the cash is actually received. According to this fundamental accounting principle, a business could earn and report $20,000 in revenue during its first month of existence, even if the business might have received no cash during that time period.
Time period principle.
The concept that a company should report the results of its operations over a predetermined amount of time is known as the accounting cycle. The purpose of this accounting concept, which may be considered the most self-evident of all accounting principles, is to establish a standard set of comparable periods, which is helpful for doing trend analysis.
These concepts are incorporated into a number of different accounting frameworks. Accounting standards are derived from these frameworks, and they control how business transactions should be treated and reported.
Any company worth its salt has to have a firm grasp on the fundamentals of accounting to provide the most precise depiction of its financial status. Because it is essential for your customers and other stakeholders to maintain trust in your business, documenting information that is credible and validated is essential.