8 Basic Principles of Accounting
What is Accounting?
Accounting refers to an orderly and comprehensive recording of financial transactions that pertain to business. It is a process of summarizing, analyzing and reporting the financial transactions of the business to oversight agencies, regulators and tax collection units.
The financial statements are the summarization of the operations of the company, its financial position, and cash flow over a particular time period. These statements are concise and specific about all the financial transactions that took place in the organization.
Accounting is a crucial aspect of every business organization. The record of all the transactions of the business must be kept so that a business is able to provide exact financial reports to the shareholders, lenders. Regardless of the kind of business you are running, a complete understanding of the ways to look at the financial needs and accounting principles is commanding for both the owners of the company and the accountants. This further helps to make sure that your fiscal future is safe and secure.
What is Accounting Theory?
It is very important for both the accountants and the business owners to understand and know the basics of accounting concepts. There are many accounting principles that are considered as a part of basic accounting theory.
There are certain rules and concepts that direct the field of accounting. These general rules are referred to as the basic principles and guidelines. These accounting principles form the groundwork, further on which, more detailed, complex, and legalistic accounting rules are based. The standard accounting principles are collectively known as Generally Accepted Accounting Principles. GAAP helps in providing a structural foundation of accounting standards, concepts, objectives, and conventions for the companies, that serve as a guide of how to prepare and represent the financial statements.
Why are Generally Accepted Accounting Principles needed?
GAAP aims at regulating and standardizing the accountancy practices by providing a structural basis to make sure that the companies and organizations are transparent and true in their financial reports.
The accounting principles make sure that the companies and the organizations are following certain standards of recording the way economic events are to be recorded, recognized and presented. These principles are beneficial for the external stakeholders like the investors, banks, agencies etc. as they are able to find whether a company is trustworthy or if exact and relevant information is provided by them.
Following are some of the accounting principles:
1. Economic Entity Assumption
The business transactions of a sole proprietorship are kept separate from that of their personal transactions. This is systematically done by the accountants who have the complete knowledge about the same. For many of the legal purposes, a sole proprietorship and its owners are considered to be a single entity, whereas, for the accounting purposes, they are two different units.
2. Monetary Unit Assumption
The monetary unit concept is an accounting principle that assumes business transactions or events can be expressed in terms of monetary units and these units are stable and dependable. The language of business and finance is used in terms of money. It doesn’t matter that what the currency it is until it is stable, it is easily comparable to other currencies.
3. Time Period Assumption
The time period assumption is also known as the periodicity assumption and accounting time period concept states that the life of a business can be distributed into equal time slots. These time slots are known as the accounting periods for which the organizations prepare their financial reports that are to be used by the various internal and external parties. The nature and requirements and the need of the users of financial reports are the factors on which the length of the accounting period to be used in the preparation of the financial statements depend.
4. Cost Principle
One of the basic fundamental guidelines in accounting is the cost principle, also known as the historical cost principle. The cost accounting guideline wants the actual cost to be recorded in the accounts and in the financial statements rather than the current value. This amount once recorded, doesn’t change due to any of the reasons (inflation or deflation).
5. Full Disclosure Principle
The full disclosure concept is an accounting principle that needs the organization to report all the relevant and useful information about the company’s operations to the creditors and the stakeholders in the financial statements. GAAP requires that the management tell the external users material information about the organization that they can use to make certain decisions. The purpose of the full disclosure principle is to share relevant information with the outside world.
6. Going Concern Principle
The basic principle in accounting that assumes that an organization will continue to function in a foreseeable future. The significance of going concern principle is to become deceptive when the value of an existing principle is compared to the value of the one being liquidated. The moment an organization is declared liquidated, all the arrears instantly become due in full.
7. Materiality Principle
The materiality principle states that an accounting standard can be ignored if the overall effect of doing so has a minor impact on the financial statement that a reader is not misled in any case. Under Generally Accepted Accounting Principles, you don’t need to execute the provisions of an accounting standard, if an item is considered immaterial.
8. Conservatism Principle
The conservatism principle is the general concept of recognizing expenses and liabilities when there is uncertainty about the result, but only to identify the revenues and assets. This principle mainly guides on how the uncertain events and estimates are recorded. In most of the cases, it means that the profits and earnings are to be minimized by keeping a record of uncertain losses or expenses.