Basic Accounting Principles

Accounting principles are the rules that an organization follows when reporting financial information. A number of basic accounting principles have been developed through common usage. They form the basis upon which the complete suite of accounting standards have been built.

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What Are Accounting Principles?

Accounting principles are the rules and guidelines that companies and other bodies must follow when reporting financial data. These rules make it easier to examine financial data by standardizing the terms and methods that accountants must use.

The International Financial Reporting Standards (IFRS) is the most widely used set of accounting principles, with adoption in 167 jurisdictions. The United States uses a separate set of accounting principles, known as generally accepted accounting principles (GAAP).

The Purpose of Accounting Principles

The ultimate goal of any set of accounting principles is to ensure that a company’s financial statements are complete, consistent, and comparable.

This makes it easier for investors to analyze and extract useful information from the company’s financial statements, including trend data over a period of time. It also facilitates the comparison of financial information across different companies. Accounting principles also help mitigate accounting fraud by increasing transparency and allowing red flags to be identified.

Comparability

Comparability is the ability for financial statement users to review multiple companies’ financials side by side with the guarantee that accounting principles have been followed to the same set of standards.

Accounting information is not absolute or concrete, and standards are developed to minimize the negative effects of inconsistent data. Without these rules, comparing financial statements among companies would be extremely difficult, even within the same industry. Inconsistencies and errors also would be harder to spot.

What Are the Basic Accounting Principles?

Some of the most fundamental accounting principles include the following:

• Accrual principle
• Conservatism principle
• Consistency principle
• Cost principle
• Economic entity principle
• Full disclosure principle
• Going concern principle
• Matching principle
• Materiality principle
• Monetary unit principle
• Reliability principle
• Revenue recognition principle
• Time period principle

Accrual principle:

This is the concept that accounting transactions should be recorded in the accounting periods when they actually occur, rather than in the periods when there are cash flows associated with them. This is the foundation of the accrual basis of accounting. It is important for the construction of financial statements that show what actually happened in an accounting period, rather than being artificially delayed or accelerated by the associated cash flows. For example, if you ignored the accrual principle, you would record an expense only when you paid for it, which might incorporate a lengthy delay caused by the payment terms for the associated supplier invoice.

Examples of the Accrual Principle

Examples of the proper usage of the accrual principle are:

• Record revenue when you invoice the customer, rather than when the customer pays you.

• Record an expense when you incur it, rather than when you pay for it.

• Record the estimated amount of bad debt when you invoice a customer, rather than when it becomes apparent that the customer will not pay you.

• Record depreciation for a fixed asset over its useful life, rather than charging it to expense in the period purchased.

• Record a commission in the period when the salesperson earns it, rather than the period in which he or she is paid it.

• Record wages in the period earned, rather than in the period paid.

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Conservatism principle:

The conservatism principle is the general concept of recognizing expenses and liabilities as soon as possible when there is uncertainty about the outcome, but to only recognize revenues and assets when they are assured of being received. Thus, when given a choice between several outcomes where the probabilities of occurrence are equally likely, you should recognize that transaction resulting in the lower amount of profit, or at least the deferral of a profit. Similarly, if a choice of outcomes with similar probabilities of occurrence will impact the value of an asset, recognize the transaction resulting in a lower recorded asset valuation.

Under the conservatism principle, if there is uncertainty about incurring a loss, you should tend toward recording the loss. Conversely, if there is uncertainty about recording a gain, you should not record the gain.

The conservatism principle can also be applied to recognizing estimates. For example, if the collections staff believes that a cluster of receivables will have a 2% bad debt percentage because of historical trend lines, but the sales staff is leaning towards a higher 5% figure because of a sudden drop in industry sales, use the 5% figure when creating an allowance for doubtful accounts, unless there is strong evidence to the contrary.

The conservatism principle is the foundation for the lower of cost or market rule, which states that you should record inventory at the lower of either its acquisition cost or its current market value.

The principle runs counter to the needs of taxing authorities, since the amount of taxable income reported tends to be lower when this concept is actively employed; the result is less reported taxable income, and therefore lower tax receipts.

The conservatism principle is only a guideline. As an accountant, use your best judgment to evaluate a situation and to record a transaction in relation to the information you have at that time. Do not use the principle to consistently record the lowest possible profits for a company.

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Consistency principle:

The consistency principle states that, once you adopt an accounting principle or method, continue to follow it consistently in future accounting periods. Only change an accounting principle or method if the new version in some way improves reported financial results. if such a change is made, fully document its effects and include this documentation in the notes accompanying the financial statements.

Auditors are especially concerned that their clients follow the consistency principle, so that the results reported from period to period are comparable. This means that some audit activities will include discussions of consistency issues with the management team. An auditor may refuse to provide an opinion on a client’s financial statements if there are clear and unwarranted violations of the principle.

The consistency principle is most frequently ignored when the managers of a business are trying to report more revenue or profits than would be allowed through a strict interpretation of the accounting standards. A telling indicator of such a situation is when the underlying company operational activity levels do not change, but profits suddenly increase.

Cost principle:

The cost principle requires one to initially record an asset, liability, or equity investment at its original acquisition cost. The principle is widely used to record transactions, partially because it is easiest to use the original purchase price as objective and verifiable evidence of value. A variation on the concept is to allow the recorded cost of an asset to be lower than its original cost, if the market value of the asset is lower than the original cost. However, this variation does not allow the reverse – to revalue an asset upward. Thus, this lower of cost or market concept is a crushingly conservative view of the cost principle.

Applicability of the Cost Principle

How the cost principle is applied depends on the situation, as noted below.

Cost Principle for Short-Term Assets and Liabilities

Using the cost principle for short-term assets and short-term liabilities is the most justifiable, since an entity will not have possession of them long enough for their values to change markedly prior to their liquidation or settlement.

Cost Principle for Securities

The cost principle is not applicable to financial investments, where accountants are required to adjust the recorded amounts of these investments to their fair values at the end of each reporting period.

Economic entity principle:

 This is the concept that the transactions of a business should be kept separate from those of its owners and other businesses. This prevents intermingling of assets and liabilities among multiple entities, which can cause considerable difficulties when the financial statements of a fledgling business are first audited.

The economic entity principle states that the recorded activities of a business entity should be kept separate from the recorded activities of its owner(s) and any other business entities. This means that you must maintain separate accounting records and bank accounts for each entity, and not intermix with them the assets and liabilities of its owners or business partners. Also, you must specifically associate every business transaction with an entity.

A business entity can take a variety of forms, such as a sole proprietorship, partnership, corporation, or government agency. The business entity that experiences the most trouble with the economic entity principle is the sole proprietorship, where an owner routinely mixes business transactions with his or her own personal transactions.

It is customary to consider a commonly-owned group of business entities to be a single entity for the purposes of creating consolidated financial statements for the group, so the principle could be considered to apply to the entire group as though it were a single unit.

The economic entity principle is a particular concern when businesses are just being started, for that is when the owners are most likely to commingle their funds with those of the business. A typical outcome is that a trained accountant must be brought in after a business begins to grow, in order to sort through earlier transactions and remove those that should be more appropriately linked to the owners.

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Full disclosure principle :

 This is the concept that you should include in or alongside the financial statements of a business all of the information that may impact a reader’s understanding of those statements. The accounting standards have greatly amplified upon this concept in specifying an enormous number of informational disclosures.

The full disclosure principle states that all information should be included in an entity’s financial statements that would affect a reader’s understanding of those statements. The interpretation of this principle is highly judgmental, since the amount of information that can be provided is potentially massive. To reduce the amount of disclosure, it is customary to only disclose information about events that are likely to have a material impact on the entity’s financial position or financial results.

This disclosure may include items that cannot yet be precisely quantified, such as the presence of a dispute with a government entity over a tax position, or the outcome of an existing lawsuit. Full disclosure also means that you should always report existing accounting policies, as well as any changes to those policies (such as changing an asset valuation method) from the policies stated in the financials for a prior period.

You can include this information in a variety of places in the financial statements, such as within the line item descriptions in the income statement or balance sheet, or in the accompanying footnotes. More substantial disclosures are always included in the footnotes.

When the Full Disclosure Principle Does Not Apply

The full disclosure concept is not usually followed for internally-generated financial statements, where management may only want to read the “bare bones” financial statements. In this situation, management is assumed to already have full knowledge of the items that would otherwise have been disclosed.

Examples of the Full Disclosure Principle

Several examples of full disclosure involve the following items:

• The nature and justification of a change in accounting principle

• The nature of a non-monetary transaction

• The nature of a relationship with a related party with which the business has significant transaction volume

• The amount of encumbered assets

• The amount of material losses caused by the lower of cost or market rule

• A description of any asset retirement obligations

• The facts and circumstances causing goodwill impairment

Going concern principle :

 This is the concept that a business will remain in operation for the foreseeable future. This means that you would be justified in deferring the recognition of some expenses, such as depreciation, until later periods. Otherwise, you would have to recognize all expenses at once and not defer any of them.

The going concern principle is the assumption that an entity will remain in business for the foreseeable future. Conversely, this means the entity will not be forced to halt operations and liquidate its assets in the near term at what may be very low fire-sale prices. By making this assumption, the accountant is justified in deferring the recognition of certain expenses until a later period, when the entity will presumably still be in business and using its assets in the most effective manner possible.

An entity is assumed to be a going concern in the absence of significant information to the contrary. An example of such contrary information is an entity’s inability to meet its obligations as they come due without substantial asset sales or debt restructurings. If such were not the case, an entity would essentially be acquiring assets with the intention of closing its operations and reselling the assets to another party.

If the accountant believes that an entity may no longer be a going concern, then this brings up the issue of whether its assets are impaired, which may call for the write-down of their carrying amount to their liquidation value. Thus, the value of an entity that is assumed to be a going concern is higher than its breakup value, since a going concern can potentially continue to earn profits.

The going concern concept is not clearly defined anywhere in generally accepted accounting principles, and so is subject to a considerable amount of interpretation regarding when an entity should report it. However, generally accepted auditing standards (GAAS) do instruct an auditor regarding the consideration of an entity’s ability to continue as a going concern.

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Matching principle :

This is the concept that, when you record revenue, you should record all related expenses at the same time. Thus, you charge inventory to the cost of goods sold at the same time that you record revenue from the sale of those inventory items. This is a cornerstone of the accrual basis of accounting. The cash basis of accounting does not use the matching the principle.

The matching principle  requires that revenues and any related expenses be recognized together in the same reporting period. Thus, if there is a cause-and-effect relationship between revenue and certain expenses, then record them at the same time. In some cases, it will be necessary to conduct a systematic allocation of a cost across multiple reporting periods, such as when the purchase cost of a fixed asset is depreciated over several years. If there is no cause-and-effect relationship, then charge the cost to expense at once.

This is one of the most essential concepts in accrual basis accounting, since it mandates that the entire effect of a transaction be recorded within the same reporting period. Doing so ensures that the reporting of profits is not artificially accelerated or delayed in any reporting period. Instead, when revenues are reported, all associated expenses are also reported at the same time.

Examples of the Matching Principle

Several examples of the matching principle are noted below, for commissions, depreciation, bonus payments, wages, and the cost of goods sold.

Matching Principle for Commissions

A salesman earns a 5% commission on sales shipped and recorded in January. The commission of $5,000 is paid in February. You should record the commission expense in January, so that the expense is recognized in the same month as the associated sale.

Matching Principle for Depreciation

A company acquires production equipment for $100,000 that has a projected useful life of 10 years. It should charge the cost of the equipment to depreciation expense at the rate of $10,000 per year for ten years, so that the expense is recognized over the entirety of its useful life.

Matching Principle for Employee Bonuses

Under a bonus plan, an employee earns a $50,000 bonus based on measurable aspects of her performance within a year. The bonus is paid in the following year. You should record the bonus expense within the year when the employee earned it.

Matching Principle for Wages

The pay period for hourly employees ends on March 28, but employees continue to earn wages through March 31, which are paid to them on April 4. The employer should record an expense in March for those wages earned from March 29 to March 31.

Matching Principle for the Cost of Goods Sold

A company sells 50 units of a product for $5,000. The cost of the goods sold for these units is $2,000. The company should recognize the entire $2,000 cost as expense in the same reporting period as the sale, since the recognition of revenue and the cost of goods sold are tightly linked.

Materiality principle :

 This is the concept that you should record a transaction in the accounting records if not doing so might have altered the decision making process of someone reading the company’s financial statements. This is quite a vague concept that is difficult to quantify, which has led some of the more picayune controllers to record even the smallest transactions.

The materiality principle states that an accounting standard can be ignored if the net impact of doing so has such a small impact on the financial statements that a user of the statements would not be misled. Under generally accepted accounting principles (GAAP), you do not have to implement the provisions of an accounting standard if an item is immaterial. This definition does not provide definitive guidance in distinguishing material information from immaterial information, so it is necessary to exercise judgment in deciding if a transaction is material.

The Securities and Exchange Commission has suggested for presentation purposes that an item representing at least 5% of total assets should be separately disclosed in the balance sheet. However, much smaller items may be considered material. For example, if a minor item would have changed a net profit to a net loss, then it could be considered material, no matter how small it might be. Similarly, a transaction would be considered material if its inclusion in the financial statements would change a ratio sufficiently to bring an entity out of compliance with its lender covenants.

The materiality concept varies based on the size of the entity. A massive multi-national company may consider a $1 million transaction to be immaterial in proportion to its total activity, but $1 million could exceed the revenues of a small local firm, and so would be very material for that smaller company.

The materiality principle is especially important when deciding whether a transaction should be recorded as part of the closing process, since eliminating some transactions can significantly reduce the amount of time required to issue financial statements. It is useful to discuss with the company’s auditors what constitutes a material item, so that there will be no issues with these items when the financial statements are audited.

Example of the Materiality Principle

As an example of a clearly immaterial item, you may have prepaid $100 of rent on a post office box that covers the next six months; under the matching principle, you should charge the rent to expense over six months. However, the amount of the expense is so small that no reader of the financial statements will be misled if the entire $100 is charged to expense in the current period, rather than spreading it over the usage period. In fact, if the financial statements are rounded to the nearest thousand or million dollars, this transaction would not alter the financial statements at all.

Monetary unit principle :

This is the concept that a business should only record transactions that can be stated in terms of a unit of currency. Thus, it is easy enough to record the purchase of a fixed asset, since it was bought for a specific price, whereas the value of the quality control system of a business is not recorded. This concept keeps a business from engaging in an excessive level of estimation in deriving the value of its assets and liabilities.

The monetary unit principle states that you only record business transactions that can be expressed in terms of a currency. Thus, a company cannot record such non-quantifiable items as employee skill levels, the quality of customer service, or the ingenuity of the engineering staff. Or, a business cannot record the monetary value of a valuable speech given to employees about how to engage in innovative activities.

The monetary unit principle also assumes that the value of the unit of currency in which you record transactions remains relatively stable over time. However, given the amount of persistent currency inflation in most economies, this assumption is not correct – for example, a dollar invested to buy an asset 20 years ago is worth considerably more than a dollar invested today, because the purchasing power of the dollar has declined during the intervening years. The assumption fails completely if an entity records transactions in the currency of a hyperinflationary economy. When there is hyperinflation, it is necessary to restate a company’s financial statements on a regular basis.

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Reliability principle :

This is the concept that only those transactions that can be proven should be recorded. For example, a supplier invoice is solid evidence that an expense has been recorded. This concept is of prime interest to auditors, who are constantly in search of the evidence supporting transactions.

The reliability principle is the concept of only recording those transactions in the accounting system that you can verify with objective evidence. Examples of objective evidence are purchase receipts, cancelled checks, bank statements, promissory notes, and appraisal reports. Note that the examples shown here are of documents generated by other entities (customers, suppliers, valuation experts, and banks). Since they are third parties, documents supplied by them are considered to be of higher value as objective evidence than documents created internally.

The reliability principle is particularly difficult to meet when you are recording a reserve, such as an inventory obsolescence reserve, a sales returns reserve, or an allowance for doubtful accounts, since these reserves are essentially opinion-based. In these cases, it is particularly important to justify your actions with a detailed analysis of the reasons for the reserve. This is frequently based on verifiable historical experience with similar transactions, and which you expect to be repeated in the future.

From a practical perspective, only record those transactions that an auditor could reasonably be expected to verify through normal audit procedures.

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Revenue recognition principle :

This is the concept that you should only recognize revenue when the business has substantially completed the earnings process. So many people have skirted around the fringes of this concept to commit reporting fraud that a variety of standard-setting bodies have developed a massive amount of information about what constitutes proper revenue recognition.

The revenue recognition principle states that you should only record revenue when it has been earned, not when the related cash is collected. For example, a snow plowing service completes the plowing of a company’s parking lot for its standard fee of $100. It can recognize the revenue immediately upon completion of the plowing, even if it does not expect payment from the customer for several weeks. This concept is incorporated into the accrual basis of accounting.

A variation on the example is when the same snow plowing service is paid $1,000 in advance to plow a customer’s parking lot over a four-month period. In this case, the service should recognize an increment of the advance payment in each of the four months covered by the agreement, to reflect the pace at which it is earning the payment.

Accounting for Revenue Recognition

If there is doubt in regard to whether payment will be received from a customer, then the seller should recognize an allowance for doubtful accounts in the amount by which it is expected that the customer will renege on its payment. If there is substantial doubt that any payment will be received, then the company should not recognize any revenue until a payment has been received.

Also under the accrual basis of accounting, if an entity receives payment in advance from a customer, then the entity records this payment as a liability, not as revenue. Only after it has completed all work under the arrangement with the customer can it recognize the payment as revenue.

Under the cash basis of accounting, you should record revenue when a cash payment has been received. For example, using the preceding scenario, the snow plowing service will not recognize revenue until it has received payment from its customer, even though this may be a number of weeks after the plowing service completes all work.

Time period principle:

This is the concept that a business should report the results of its operations over a standard period of time. This may qualify as the most glaringly obvious of all accounting principles, but is intended to create a standard set of comparable periods, which is useful for trend analysis.

The time period principle is the concept that a business should report the financial results of its activities over a standard time period, which is usually monthly, quarterly, or annually. Once the duration of each reporting period is established, use the guidelines of Generally Accepted Accounting Principles or International Financial Reporting Standards to record transactions within each period. A high degree of consistency in reporting for the same time periods is needed, so that an organization can produce financial statements that can be compared to the results reported for prior years.

Accounting principles: Why are they so important for any business?

As an accountant, you know that accounting principles are rules for reporting financial information. But you also know that these principles aren’t just arbitrary checklists. They’ve been developed over decades as part of a system of checks and balances designed to provide investors with trustworthy information about companies.

Accounting principles have an essential impact on businesses and their profitability. Without adherence to these standards, financial statements would be completely unreliable and useless to anyone. In short, accounting principles matter a lot.

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