INTRODUCTION TO ACCOUNTING PRINCIPLES
Accounting principles were created to bring in standardization in the field of accounting. They ensure that financial statements as published by various companies follow the same guidelines and are comprehensible by their investors and other stakeholders. These rules dictate the field of financial accounting and are commonly known as Generally Accepted Accounting Principles (GAAP).
ACCOUNTING PRINCIPLES & gUIDELINES
The following section captures description for a few of these principles in a highly condensed format.
1. MONEY MEASUREMENT
Transactions or economic activities that can be measured or converted in monetary terms are the only ones considered for accounting purposes. The monetary value of transactions provides a common denominator for the comparison of several heterogeneous facts as undertaken by a business entity.
Example. Consider a company that owns $50,000 of cash, 10,000 square feet of land, 2,000 pounds of inventory, 3 trucks, and so on; these units cannot be added together to provide real insight of what actually business owns. Also, these are not quite useful for comparing two or more such entities.
However, expressing these items in monetary terms makes addition possible and thus true ownership of the company can be studied and compared to an extent.
Measuring financial transactions using their monetary values often comes with a few limitations on the scope of the accounting reports. Transactions or business events captured in terms of their monetary values assume that the dollar’s purchasing power has not changed over time; thus ignoring the effect of inflation on the recorded amounts. So theoretically, a dollar from the 1980 transaction carries the same value as a dollar from the 2020 transaction.
2. ECONOMIC ENTITY ASSUMPTION
Transactions are recorded and accounting reports are prepared for business entities. These entities are considered different and distinguished from their owners, executives and persons who are associated with them for accounting purposes.
Business entities can either be incorporated (registered) or unincorporated (un-registered). For corporations, the distinction between owners and the businesses is often quite easily made as corporations themselves are registered as a separate legal entity. However, in case of un-incorporated businesses, it often becomes difficult to identify the entity for which a set of accounts is defined.
Example. consider a family who owns and operates an unincorporated clothing store. For legal purposes, the store and its owners are considered to be a single entity and a creditor of the store can sue owners in case of a default payment. But for sake of accounting, they are considered as two different entities. The non-business transactions of the owners must not be captured in the store’s set of accounts.
3. THE GOING CONCERN PRINCIPLE
The Going concern principle assumes that a business entity will continue to operate for infinitely long periods and will not liquidate in the near future. Thus, the resources currently available to the entity will be available for future use and there is no use to continually estimate an entity’s total worth for prospective buyers. This principle allows entities to spread its prepaid expenses to several future accounting periods.
However, considering the financial situation if the accountant feels that an entity is going to be liquidated in the near future; he is required to disclose this assessment and report the entity’s resources at their liquidation value.
Example. a shirt manufacturer might have various stages of production and at any point in time; it may have several partially completed shirts. Accounting does not attempt to value these partially completed shirts for regular reporting. The on-going principle presumes that the manufacturing of these shirts will proceed to completion, and thus the value at which these unfinished items could be sold, if the entity were liquidated today is immaterial.
4. THE COST PRINCIPLE
The cost principle states that an entity should record the value of all its assets (such as land, machinery, equipments, buildings, etc) at the cost of their purchase. This amount once captured remains unaffected by the depreciation or appreciation in the value of the asset in future. Therefore the values shown on financial statements are actually historical costs of purchase and under no circumstances reflect the true market value of these assets. (Exception to this principle is investments related to stocks, bonds and other marketable securities that are actively traded on stock markets).
Example. an entity purchases a piece of land for $500,000; this transaction would be recorded in the accounts of the entity as an asset worth $500,000. This value would remain unaltered in books even if the value of land appreciates to $600,000 or depreciates to $400,000 next year.
At the time of liquidation or acquisition; the true worth of an entity’s long term assets is mostly derived by third party appraisers and is altogether a very different activity.
5. THE DUAL ASPECT PRINCIPLE
Each entity has economic resources called assets. These assets are claimed by various parties called equities. There are two types of Equities – 1) Owner’s equity (claims by business owners) 2) Liabilities (claims by creditors). For an incorporated business; term stockholders’ equity is used instead of owners’ equity.
Basis above explanation, the financial accounting equation can be summarized as below –
Assets = Owners’ Equity + liabilities
Accounting records for all business transactions are generated considering the above equation. As an example, if an entity decides to increase one of its assets, it will be automatically followed by either a decrease in another asset or an increase in one of its equities (liability or owners’ equity) in order to bind accounting entry as per the above equation. This phenomenon is called the dual impact of accounting records.
Dual aspect principle ensures that every transaction recorded in the accounting books of an entity affects at-least two accounts and it is not possible to record a transaction resulting in change of only one account.
Example. To illustrate the dual aspect of accounting records, consider Mr. Jane has just started a business and has infused capital of $55,000 into the entity’s bank account.
The new entity now has an asset (cash) of $55,000 which is claimed by Mr. Jane (owner’s equity); thus accounting records generated would be –
Cash $55,000 Owner’s Equity $55,000
Table of Contents : Accounting Principles
Accounting Principles & guidelines