ACCOUNTING PRINCIPLES & gUIDELINES
6. TIME PERIOD ASSUMPTION
The ongoing business activities are recorded and published regularly for the management and interested parties in an entity. The intervals in which these business activities are captured and evaluated are known as accounting periods.
Financial statements like Income Statement and Statement of Cash flows are generated considering these accounting periods. It is essential that the period of time is clearly mentioned in the heading of these financial statements. Labeling these statements as “January 31” is not sufficient as the reader might not interpret if the statements cover activities related to one week ending on January 31 or one month, quarter, or a year ending on January 31.
7. CONSERVATISM PRINCIPLE
Conservatism principle states that if an accountant faces a situation where he has to select from two or more acceptable alternatives for reporting a transaction; the preference should be given to a larger number when measuring liabilities and expenses and to a smaller number when reporting assets or revenues. This principle allows accountants to anticipate and report losses early but wait for gains unless they are certain (or actually happen).
Example. If an accountant realizes that the market price of certain inventory items has significantly decreased below cost at which they were procured in the organization, he may chose to write down inventory account to a value which is lower than the original procured amount. This can be done irrespective of expected rise in prices of these items in future.
Similarly, potential losses from an on-going lawsuit must be reported on the financial statements, but gains from a lawsuit cannot be reported until the final verdict is out.
8. REVENUE RECOGNITION PRINCIPLE
Entities can recognize their revenues (or income) either using cash accounting basis or accrual accounting basis.
Under the accrual accounting basis, the revenue for an entity is recognized in the same accounting period in which the product was sold or the service was provided; irrespective of when the cash is actually received. Therefore, using this basis of accounting; an entity can actually report revenue in its very first month of operation even though the cash inflows may be reported 0 in the same period.
An alternative to accrual accounting basis is the cash basis of accounting, in which sales or revenue is not recorded until the period in which cash or revenue is actually received. In practice, “the cash basis of accounting” is rare.
Example. a consulting firm provided its services to a client worth $100,000 in the month of August 2019. Under the accrual basis of accounting; the firm should recognize $100,000 of revenue in the month of August 2019. It doesn’t matter if the customer pays the dues immediately or in the next 30 days.
9. FULL DISCLOSURE PRINCIPLE
Investors, creditors, and other stakeholders are required to understand every minute detail regarding the operations of the company. These details provide them with transparency and confidence when dealing with operational and investment decisions. Thus it becomes extremely important for an accountant to disclose all such details within the financial statements, or in the notes of the statement.
Example. a lawsuit has been filed against an entity demanding a lot of money. Irrespective of the potential outcome, an accountant must disclose such details in the notes section of the financial statements.
10. MATCHING PRINCIPLE
Matching principle is applicable only for entities using accrual basis of accounting and can be summarized under as follows –
- Expenses which can be co-related to revenues directly must be matched with revenues and be reported in the same accounting period in which the revenues are generated (e.g. sales commission, cost of goods sold etc)
- Expenses which can’t be co-related directly to revenues must be reported in the time period in which they were consumed or expired (e.g. utility bills, marketing & advertisements expenses, administrative expenses, income tax etc)
- Amounts spent on purchase of fixed assets (or long term assets) must be expensed off over the entire useful life of the asset under consideration
Example. Mr. John has made a sale in Aug, 2020 and has earned a sales commission of $1000 as per company’s sales policy. But items were not shipped and thus sales not recognized until early 2021. In this case, Mr. John’s sales commission is an expense only to be reported in 2021 (in the same period along with revenue). Therefore, sales commission expense is to be reported in the same accounting period as that of revenue and not to be reported in the period when it’s paid.
Similarly, say a company announced to pay 10% of its revenue generated in the year 2019 to all of its employees as bonus pay. This bonus pay is to be reported as an expense for the year 2019 along with the revenue, irrespective of whether it was paid in early 2020 or late 2019. In case, this bonus was paid in 2020, a liability is to be reported in financial statements as on date 31, December 2019.
Some expenses like marketing & advertisements cannot be tied back directly to revenues and thus are to be reported in the period in which they are made.
11. MATERIALITY
As per this principle, accountants are allowed to use their professional judgment while capturing and reporting financial transactions. There might be business events so insignificant that recording them 100% in-line with above discussed principles may not be justified by the usefulness of the results.
Example. by principle, office stationeries are to be considered as assets as they have useful life beyond the period in which they were purchased. Theoretically, an accountant can track the entire used up inventory of stationery in each period and expense it off accordingly. But practically, there is no usefulness of this activity for the organization. Therefore, most accountants prefer to expense off all the costs related to stationery items in the period in which they are purchased.
Similarly, say a multi-million dollar entity purchased a $200 printer with its useful life of 5 years for managing daily printing needs at office. As per the matching principle, the accountant must expense off this $200 cost over the period of 5 years. However considering the insignificance of this transaction in the overall scenario for the entity; he may also chose to expense it off all at once in the period of its purchase.
Rounding values to nearest dollar in the financial statements is also an example of how materiality principle is implemented in financial accounting.
Table of Contents : Accounting Principles
Accounting Principles & guidelines