What Are The Fundamental Of Accounting Principles

Matilda Simpsons For accountants, accounting is a form of art and it’s important to obtain the right tools in order to make your masterpiece. These tools are better known as the ten major accounting principles and that’s what we’re going to discuss– what these basic principles are together with their respective uses.

The Fundamental Principles of Accounting

1) Economic Entity Assumption
An account should keep all the business transactions of a sole proprietorship separated from the business owner’s personal transactions. Which only implies that for accounting purposes, the owner and sole proprietorship are considered to be separate entities, but for legal purposes they’re merged as one.

2) Cost Principle
From an accountant’s POV, the term “cost” describes the amount spent when an item was obtained– it doesn’t matter if the purchases happened last year or three decades ago. With this, the amounts shown on financial statements are classified as the “historical cost amounts.” Considering this accounting principle, the asset amounts are never adjusted upward even during inflation. To support that, as a general rule, asset amounts should never be adjusted, so that it could serve as a reflection of the amount of money a company would receive when it sells the asset at today’s market value.

3) Time Period Assumption
This principle follows the assumption that there’s a possibility to report the ongoing and complex activities of a business in a relatively short time intervals, such as the five months ended on March 31, 2014, or it could be the 5 weeks ended on March 1, 2015. Which only implies that the shorter the time interval is, the more chances that the account must estimate the amounts relevant to the given period. Furthermore, the time interval should be shown in the heading of every income statement, statement of cash flows, and statement of stockholders’ equity.

4) Monetary Unit Assumption
As a rule of thumb, the economic activity should be measured in dollars and only the transactions expressed in US dollars could be recorded. With this basic accounting principle, it’s a given that the dollar’s purchasing power remained constant throughout the years. Considering that, accountant ignores the effect of inflation on recorded amounts. For instance, from a 1970 transaction transaction are combined with dollars from a 2015 transaction.

5) Full Disclosure Principle
In case that there’s a certain information that’s relevant to a lender or investor, that information should be disclosed within the statement. This is the reason why the basic accounting principles have a number of pages of “footnotes” that are often attached to the original financial statements. For instance, if a company is experiencing a lawsuit that demands a certain amount of cash. If the financial statements prepared are vague, the company would have a hard time defending itself and there’s a great chance that it’ll lose in the law suit.

A company should always have a list of its important accounting policies as the first note of the financial statements.
6) Matching Principle
A company should use the accrual basis of accounting at all cost. Likewise, the matching principle requires that expenses should go with the revenues.

For instance, as much as possible, the sales commission expense should be reported the moment the sales were made.
Likewise, considering the fact that it’s impossible to measure the future economic benefits of things, such as advertisements, the accountant often charges the ad amount to expense in the period where the advertisement was made visible to the public.

7) Going Concern Principle
This accounting principle observes the assumption that a company would continue to exist long enough that it’ll have the capacity to carry out its commitments and objectives. Likewise, it wouldn’t liquidate in the foreseeable future if properly maintained. On the other hand, if the company’s financial situation seems to be unbalanced and the account believes that the company would have a hard time going further, the accountant must disclose the statement.

This principle allows the company to hold over some of its prepaid expenses until the upcoming accounting periods.

8) Conservatism
In case that a situation where there are two acceptable alternatives arise, conservatism would be used. This would allow the accountant to pick an alternative that would result in less net income. Aside from that, conservatism also helps the accountant to “break a tie.” Though this wouldn’t direct accountants to be conservative. Likewise, as a rule of thumb, the accountants are expected to be objective and unbiased and objective. Also, this principle encourages the accountants to disclose or anticipate loses, but this isn’t applicable to probable gains. For instance, potential losses from lawsuits should be reported on the financial statements, but the gains shouldn’t be reported.

9) Revenue Recognition Principle
Following the accrual basis of accounting, the revenues are often recognized the moment a product has been sold or a service has been given to the customer, and it doesn’t matter when the payment was actually received. Under this accounting principle, a company has the ability to earn and report $25,000 of revenue during its first month of operation, but would only receive $0 in actual cash during that month. To explain this even more, if ABC Consulting managed to complete its service at an agreed price of $2,000, ABC should have a $1,000 worth of revenue as soon as the work is completed. It doesn’t matter whether or not the client would pay the $1,000 immediately or within a month. Aside from that, the cash receipt should never be confused with the revenue.

10) Materiality
Based on the accounting principles, an accountant has the privilege to violate another accounting principle, especially if the amount at risk is insignificant. Likewise, professional judgment is crucial, because it’ll be the basis of deciding whether the amount is really insignificant or not. For instance, an obviously immaterial item was purchased by a highly profitable multi-million industry. If the equipment wouldn’t be used within 5 years, the matching principle would ask the accountant to record the expense within a five-year period. This guideline allows the company to violate the matching principle, because the equipment has never been used or essential in the business. Due to materiality, financial statements often show the amounts rounded to the nearest dollar, to the nearest hundred, and so on. This would depend on the size of the company.