13
Top Accounting Principles
Definition:
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 those accounting standards (local GAAP) vary from one
country to another, but the principles that set out in the standards are in the
same fashion.
For example, GAAP or IFRS is different in many areas but the
principles that use in those standards are very much the same.
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Even
the accounting principles in one financial reporting standard to another is not
much different, most investors still not get comfort when the investments are
moved to the country where different accounting standards are required.
Yet,
soon, 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:
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
then 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 recordings 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 of
cloths are recognized where the right and obligations are transferred from the seller to the buyer even 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
recognizing 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 as per cash basis.
2)
Conservatism principle:
Conservatism
principle concern about the reliability of 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 the 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 it probably makes a loss.
If
these expenses are material to the financial statement and they are not recording,
then the potential investors who make their decision make their decision based
on the financial statements that off these expenses could potentially make
loses.
The entity might come to the situation where it is probably of winning the lawsuit.
In this case, and base on this principle, the entity should not recognize the
possible revenue from this lawsuit.
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In
addition, the entity might also come to the situation where inventories or
fixed assets that entity just purchased last month could be purchase now by
spending less money.
In this case, the entity should consider writing off the portion that different into
expenses so that assets could be present at the realizable value.
3)
Consistency principle:
Consistency The principle is the accounting principle that requires the entity to
apply the same accounting method, policies, and standard 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 a significant different revenue amount
present in the income statement while there could be slightly differenced if
the same accounting policies or methods of measurement and recognition are
used.
For example, depreciation rates and methods should be applying 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 applying.
Normally,
if your financial statements are prepared and present 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 base
on the price at the time they are purchased.
And
the liabilities should be recorded based on the values that 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 incorrectly
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, you are using IFRS to prepare your financial statements, then you
should go to each standard under IFRS that is applicable for the items you are
dealing with. For example, the recognition of PPE is initially measured at
costs and subsequently, the entity could use 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 at the identify 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
has 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 entity should not include in entity accounts.
Example,
Sintra shop sells cake in Bangkok, Thailand. Sintra 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 Sintra and the entity.
So,
Sintra is the owner and Sintra Shop is the entity. Sintra 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 as sell to 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 to owners or shareholders to assess the performance of each
entity separately and well as to assess the financial position of the entity.
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6)
Full Disclosure Principle:
Full The 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 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 is
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 the financial information but also
non-financial information such as new law and regulation that come into effect
soon and the entity’s business might get hurt from that law and regulation. The
subsequent adversely affect 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. Entity’s business and specific profits will get hurt.
Going a concern of entity is questionable. 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 the concern 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, the entity does not face going concern problem, then the users of
financial statements could their reliance on 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 the entity might face going concern problem. Or
entity might stop its business in the period of twelve months from the reporting
date of financial statements.
For
examples, the entity’s main services or products are no longer need 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 the
period of fewer 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 recognize
in both the balance sheet and income statement. Prepayments should not also
recognize.
The entity should conduct going concern assessments annually to see if it is in the
going concern problems. The assessment should not only focus on financial
factors but also non-financial factors that might affect the entity to shut
down its business.
8)
Matching principle:
Matching The principle is the accounting principle that uses to records and recognizes
expenses and revenues in the financial statements.
This
principle wants to make sure that the incomes and expenses in the income
statement are 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 finished 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 the 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 the 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.
Related article Accrual Basis in Accounting:
Definition | Example | Explanation
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
concern about 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 material to one entity’s financial statements but might not
material to another.
For Example, the wrong recognition of revenues amount USD 50k of ABC is not
material if we compare to its total revenues of 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. These unadjusted
transactions or amounts are part of auditors’ evidence to support their opinions.
10)
Monetary unit principle:
Monetary Unit The assumption is the accounting principle that concerns the
valuation of transactions and events 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 the 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 an accident, and the entity pays for the costs of the 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 The principle is the accounting principle that concerns the
reliability of financial information that presents 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 the 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
13) Time
period 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 the regulatory requirement.
Here
is the detail of the Time
Period Principle or Periodicity Principle
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