Basic Accounting Principles You Need to Know
Before diving into the concepts of basic accounting principles, let us understand accounting principles in general and why they are important.
Accounting principles refer to a set of rules that a company must follow while reporting its accounts and financial information. There are multiple accounting principle frameworks which are adopted differently in different countries.
For example, in the United States, the Financial Accounting Standards Board (FASB) defines a set of accounting principles called the Generally Accepted Accounting Principles (GAAP). All the publicly traded companies must follow these standards, whereas some of the non-publicly traded companies also use it. Similarly, more than 120 countries require or permit the standards set by the International Financial Reporting Standards (IFRS)
Importance of Accounting Principles
The basic accounting principles are used to form accounting standards that most companies within a country must adapt. The importance of these principles are:
When all the companies within a country or a territory follow the same guidelines, there is consistency in financial reporting. This can be used to compare the reports of multiple firms. Companies can rectify their mistakes and improve by comparing them with similar financial reports from other companies.
When there is a standardized set of guidelines, the accounting boards can assert control over the accounting practices. This will prevent unethical practices that companies can use to hide information, evade tax, and carry out fraudulent transactions. Similarly, the companies will always be up to date with their real financial situation, which will prevent sudden bankruptcies.
When the companies present their accounts and financial reports based on guidelines under the basic accounting principles, auditing is easy and accurate. All companies must carry out an internal and external audit to make sure that there is no fraud. Auditors can check if the statements oblige to the standards adopted by the company.
The Basic Accounting Principles
The following is the list of the basic accounting principles that are adopted by companies all over the world.
The accrual principle is one of the most common and basic principles of accounting. This principle defines that you should record the transactions at the period that it occurs, rather than the period when the cash flow occurs for the transaction. It is especially important for preparing financial statements. The financial statements of a company should show what exactly happened during the accounting period, and it should not be affected by cash flows. Basically, there is a match between the revenue generated and the expenses incurred.
The accrual principle is suitable for large companies and shows a more accurate picture of their financial status. However, small businesses can find it difficult to assess their financial performance with this principle.
The conservatism principle is a basic accounting principle that defines the recording of expenses and liabilities as soon as they occur. However, you must only record the assets and revenues when you are sure to receive them. Likewise, when you are not certain of incurring a loss in a transaction, you must tend to record them as losses. In contrast, where there is an uncertainty in incurring profit, you must not record it as profit. When a company reports its financial position using the conservatism principle, it portrays a slightly negative performance than the actual reality.
The conservatism principle is a basic accounting principle which states that you must adopt a consistent principle until a better alternative appears. This is important because it helps you compare your records over a longer period of time. Furthermore, the accountants and managers in your company can better understand your financial reports. Moreover, external auditors will find it easy to assess your reports. You must note that in the case of a change in principle, you must report this information in your financial statements.
According to this basic accounting principle, companies must record the assets, liabilities, and equities at the original cost of purchase or sale. It does not take into account the appreciation and depreciation of assets. Appreciation is the state when the value of an asset increase with time. In contrast, the depreciation of an asset is the decrease in its value over time. The cost principle is easier to adopt as frequent updates in balance sheets need not be carried out. Similarly, auditing is easy because you can calculate the value of an asset straightforwardly. However, this is also one of the most controversial accounting guidelines because it can be highly inaccurate.
Economic Entity Principle
The economic entity principle states that the business transactions must be kept separate from that of the owners, shareholders, partners, and other business entities. The entry-stage businesses, often sole proprietorship type, run into the problem of the owner mixing the company’s transactions with his personal ones.
Full Disclosure Principle
The full disclosure principle is a basic accounting principle that requires all companies to disclose all relevant information required for understanding their financial position. The company must present their accounting policies and state if any changes have been made. This allows managers and audit to accurately assess the records and validate their credibility. Similarly, if there might be a change in the tax policies, you must present this information. Furthermore, the company must state all the details of the accumulated depreciation of assets, plants, and equipment.
The matching principle is a basic accounting principle that requires companies to record all corresponding expenses when recording earned revenues. The matching principle is based on the accrual principle of accounting. For example, a company has to pay a 5% commission to its sales representatives at the end of each month. When the company makes a sales of 40,000 USD in the month of December, it must pay a commission of 2,000 USD to its salesperson in January. However, the matching principle requires the company to record this commission as an expense during the period of December.
Revenue Recognition Principle
The revenue recognition principle states that the company must record its revenues during the time of earning and not necessarily when the cash is collected. Under this principle, there is a more accurate portrayal of the profits and losses of the company. There are some requirements that a company must fulfil while practising this principle. First, there must be an agreement that your customer will pay for the products and services you offered. Secondly, the delivery of the products and services has been completed from your side. Similarly, the final cost has been decided, and both of the parties are aware of it.
How Can We Help?
From this blog, we have learned the basic accounting principles that have been adopted by companies and organizations throughout the world. Similarly, we have also learned the major differences between those basic principles and what kind of flexibility they offer.
3E Accounting has world-class Hong Kong accounting specialists who can offer state-of-the-art services that will help your company with ethical accounting practice. Their unparalleled expertise and decades of experience allow them to understand the accounting climate and how it will evolve in the future.
Even though our services are top-quality, they are affordable. Moreover, our guaranteed satisfaction is backed by thousands of our customers worldwide.