Accounting principles and guidelines form the basic framework upon which more detailed standards and rules are developed.
The generally accounting principles (GAAP) and International Financial Accounting Standards (IFRS) are actually fruits of fundamental accounting principles.
The fundamental accounting principles include the following:
1. Accrual Concept
The concept of accrual states that income should be recognized when earned regardless of when collected; and expenses should be recognized when incurred regardless of when paid. It means that the recognition of income does not depend upon cash collection or payment, but upon occurrence.
For example, if we made a sale to a customer on credit on May 20 of the current year, it is proper to recognize the income on that day regardless of when the customer pays for it. Remember, from the time the sale was made, we already earned the income, even if it is still to be collected.
Another example: unpaid rent. Should it be expensed even if not yet paid? Based on the accrual concept, yes. Company XYZ has 3 months of unpaid rent from January to March. The rent should be recognized as expense for those months even of it was paid, let’s say, on April. Why? Because the company incurred such rental expense in those months.
Other alternatives to the accrual basis accounting, such as cash basis and percentage-of-completion method, are allowed in certain cases.
2. Going Concern
Going concern means that a business will continue to exist in the future. The financial statements are prepared and analyzed with the assumption that the company will still be there in the next years.
This is the main reason assets are generally carried at cost rather that fair value Also, fixed assets are depreciated with the assumption that they will be used for a long period of time. The going concern primarily affects the balance sheet.
If a company will not be able to continue as a going concern, it is required that the matter be disclosed in the notes to financial statements.
3. Periodicity or Time Period
The assumed unlimited life of a business is divided into several accounting periods. In these periods, financial statements are prepared to be used by interested users. Financial statements are generally prepared monthly, quarterly, and annually.
4. Accounting / Economic / Separate Entity Concept
The transactions of a business should be kept separate from the transactions of the owner/s, and vice versa. For example, Mr. C purchased a personal house. That transaction should not be recorded as a transaction of his mini-mart. In the same case, the rent of the mini-mart space should not be treated as an expense of Mr. C but should be recorded separately as expense of the mini-mart.
What if the space is used both by the owner for personal use and by the business? Then the rent should be split according to a rational basis such as floor area occupied or some other logical ratio.
5. Monetary unit
Business transactions are recorded in terms of money, in U.S. Dollar, Euro, Peso, whatever would be most relevant as the case maybe. It also states that the purchasing power of the currency is stable. Hence, the effect of inflation is ignored in the financial statements.
6. Full Disclosure
All important information should be disclosed. This does not mean that all information must be included in the financial statements. We’re talking about important or material information, those that could influence the decision of the users. This is why the notes to financial statements exist. The notes to financial statements contain other information (mostly qualitative) not seen and cannot be placed in the face of the financial statements.
For example: the continuity of a business. As stated earlier, if the company is believed not to exist in the near future, the users should know about it. It should be disclosed in the notes to financial statements.
7. Historical Cost
The amounts shown in the financial statements are measured at cost. Historical cost refers to the amount incurred to acquire the item. Any appreciation or increase in the value of that item is ignored.
For example, Company XYZ acquired 100 bags of cement. The purchase price at that time was $10 per bag. Now, it has gone up to $12. The cements should stay at $10 per bag, the historical price.
Fixed assets are carried at carrying value, i.e. historical cost minus accumulated depreciation. There are, however, exceptions where items are measured at bases other than historical cost. Nonetheless, the general measurement base used is historical cost.
8. Revenue Recognition Principle
Generally, revenue (or income) is recognized when earned regardless of when received. This is in accordance with the accrual concept discussed above. Income is considered earned when the sale is made or the service is performed.
Materiality is relative. It depends upon the natured and size of the item. $10,000 may be immaterial (insignificant) to one company but may be material to another. Materiality allows accountants to ignore items that are useless or immaterial to users. At times, this allows violation of some accounting standards. But in any case, accountants should apply due care and professional judgment in deciding over cases involving materiality.
10. Prudence or conservatism
In cases when there are two or more acceptable accounting standards, the principle of conservatism directs accountants to choose the one that will result in lower net income or lower net assets. This principle is the basis for standards on recognition of probable gains and losses, lower of cost or net realizable value, and other similar standards.
11. Matching principle
The matching principle aims to align revenues and expenses. Expenses should be recognized in the period the revenues from them were earned. In the same way, revenues should be recorded in the period the expenses incurred to earn them were recognized. The matching principle is actually a result of the application of the accrual concept.
Accounting methods and procedures adopted by a company should be applied consistently in future periods, unless there is a reasonable ground to shift to other methods. For example, ABC Company uses the straight-line method in depreciating its delivery equipment. This method should be maintained in the next years, unless there is reasonable explanation to change to let’s say, declining balance method.
The above principles are the building blocks upon which detailed accounting rules and standards such as GAAP and IFRS are based. It will be much easier to comprehend and apply accounting standards no matter how complex they are if the above principles are understood.