Accounting Principles

Accounting Principles

Introduction
Accounting has developed a number of rules which must be applied by everyone who is involved with the recording of financial information. If every accountant or bookkeeper followed their own rules it would be impossible for others to fully understand the financial position of a business. In the same way, it would be impossible to make a comparison between the financial results of two or more businesses if they had each applied their own rules in the preparation of their accounting statements.

Accounting Principles
Accounting principles are sometimes referred to as concepts and conventions. A concept is a rule which sets down how the financial activities of a business are recorded. A convention is an acceptable method by which the rule is applied to a given situation.
There are a number of accounting concepts and principles based on which we prepare our accounts. These generally accepted accounting principles lay down accepted assumptions and guidelines. The main accounting principles are explained below.

1. Business Entity
This is also known as the accounting entity principle. This means that the business is treated as being completely separate from the owner of the business. The personal assets of the owner, the personal spending of the owner etc. do not appear in the accounting records of the business.
If there is a transaction concerning both the business and its owner then it is recorded in the accounting records of the business. When the owner introduces capital into the business, it is credited to the capital account. When the owner makes drawings from the business a debit entry will be made in the drawings account which reduces the amount owed by the business to the owner.
Examples: Insurance premiums for the owner’s house should be excluded from the expense of the business. The owner’s property should not be included in the premises account of the business. Any payments for the owner’s personal expenses by the business will be treated as drawings and reduced the owner’s capital contribution in the business.

2. Money Measurement
This accounting principle means that only information which can be expressed in terms of money can be recorded in the accounting records. Money provides a common unit of measurement.
Examples: There are many aspects of a business which cannot be measured in terms of money and, therefore, do not appear in the accounting records. The morale of the workforce, the effectiveness of a good manager, market conditions, technological changes, the benefits of a staff training course all play an important part in the success of the business, but they will not appear in the accounting records as their value cannot be expressed in monetary terms.

3. Going Concern
The accounting records of a business are always maintained on the basis of assumed continuity. This means the business will continue in operational existence for the foreseeable future. This continuity means that the fixed assets shown in a balance sheet will appear at their book value, which is the original cost less depreciation, and stock will appear at the lower of cost or net realizable value.
If it is expected that the business will cease to operate in the near future the asset values in the balance sheet will be adjusted. Assets will be shown at their expected sale values which are more meaningful than their book value in this situation.
Financial statements should be prepared on a going concern basis unless management either intends to liquidate the enterprise or to cease trading, or has no realistic alternative but to do so
Example: Possible losses from the closure of business will not be anticipated in the accounts.
Fixed assets are recorded at historical cost.

4. Historical Cost
This principle requires that all assets and expenses are recorded in the ledger accounts at their actual cost. It is closely linked to the money measurement principle.
Example: The cost of fixed assets is recorded at the date of acquisition cost. The acquisition cost includes all expenditure made to prepare the asset for its intended use. It included the invoice price of the assets, freight charges, insurance or installation costs.

5. Accounting Period
The principle of going concern assumes that a business will continue to operate for an indefinite period of time. It is clearly not sensible or practical to wait until a business ceases trading before a report on its progress is made. Because reports are required at regular intervals, the life of the business is divided into accounting periods – usually years. This allows meaningful comparisons to be made between different periods for the same business and between one business and another business.
Example: The balance of the ledger accounts at the end of one trading period will be carried down to become the opening balance for the next accounting period. The expenses for the period will also be totaled and transferred to the profit and loss account for the period.

6. Matching
This is also referred to as the accruals principle. The revenue of the accounting period is matched against the cost of the same period (the timing of the actual receipts and payments is ignored). Revenues are recognized when they are earned, but not when cash is received. Expenses are recognized as they are incurred, but not when cash is paid. And the net income for the period is determined by subtracting expenses incurred from revenues earned.
Example: The figures shown in a trading and profit and loss account must relate to the period of time covered by that account, whether or not any money has changed hands.
Expenses incurred but not yet paid in current period should be treated as accrual/accrued expenses under current liabilities.
Expenses incurred in the following period but paid for in advance should be treated as prepayment expenses under current asset.
Depreciation should be charged as part of the cost of a fixed asset consumed during the period of use.

7. Prudence
This is also known as the principle of conservatism. This principle ensures that the accounting records present a realistic picture of the position of the business. Accountants should ensure that profits and assets are not overstated and that liabilities are not understated. The phrase “never anticipate a profit, but provide for all possible losses” is often used to describe the principle of prudence. Profits should only be recognized when it is reasonably certain that such a profit has been realized and all possible losses should be provided for.
Example: Stock valuation sticks to rule of the lower of cost and net realizable value.
The provision for doubtful debts should be made.
Fixed assets must be depreciated over their useful economic lives.

8. Materiality
This principle applies to items of very low value (items which are not “material”) which are not worth recording as separate items. Immaterial amounts may be aggregated with the amounts of a similar nature or function and need not be presented separately. Materiality depends on the size and nature of the item. Classes of similar items are to be presented separately in the financial statements. This would apply to a grouping such as current assets.
Example:What is material for one business may not be so for another business. A lap top computer may be regarded as immaterial for a large multi-national business, but would be material for a small sole trader.
A large business may decide that fixed assets costing less than $1000 will be regarded as immaterial and be charged as expenses. A small business may have a much lower figure.
The cost of small-valued assets such as pencil sharpeners and paper clips should be written off to the profit and loss account as revenue expenditures, although they can last for more than one accounting period.
Small payments such as postage, stationery and cleaning expenses should not be disclosed separately. They should be grouped together as sundry expenses.

9. Consistency
There are some areas of accounting where a choice of method is available. For example, there are several different ways to calculate the depreciation of a fixed asset. Where a choice of method is available, the one with the most realistic outcome should be selected. Once a method has been selected, the method must be used consistently from one period to the next. If this is not done, a comparison of the financial results from year to ear is impossible, and the profit of a particular year can be distorted.
Companies should choose the most suitable accounting methods and treatments, and consistently apply them in every period. Changes are permitted only when the new method is considered better and can reflect the true and fair view of the financial position of the company. The change and its effect on profits should be disclosed in the financial statements.
Examples: If a company adopts straight line method and should not be changed to adopt reducing balance method in other period.

10. Duality
This is also referred to as the dual aspect principle. Every transaction has two aspects – a giving and a receiving. The term double entry is used to describe how these two aspects of a transaction are recorded in the accounting records.