Accounting principles are the guidelines and rules that the business needs to follow while reporting financial data/information. These rules are standard procedures and a common set of principles that provide the basis for the financial accounting policies adopted by the business.
These principles apply to the whole set of the financial statement, including assets, liabilities, revenue, expenses, and notes to the financial statements.
Further, different stakeholders of the business-like banks, regulatory agencies, taxation authorities, and investors, expect the company to comply with the set of accounting principles to ensure the accuracy and relevancy of the information presented to them.
The purpose of implementing these principles is to enhance comparability, understandability, and ease of using financial statements for a decision-making purpose. Let’s understand seven types of accounting principles used in accounting.
This concept is that the business should recognize expenses and liabilities in books of accounts even when there is uncertainty. On the other hand, assets and revenue can only be recognized when there is a certainty, or the business will receive economic benefits.
The concept’s impact is that the financial statement user must have confidence in the resources owned and controlled by the business. This should also lead to enhanced confidence in the profitability reported by the business.
Example of prudence/conservatism with perspective
An example of the prudence/conservatism principle can be seen in the ASC-330 that requires businesses to value the inventory at lower cost and NRV – Net Realizable Value.
NRV is sales proceeds less cost to sales. It means we need to deduct the cost of modification/changes in the products before they come into the sale condition. So, we can write the following formula for the NRV.
NRV = Expected sales price – cost of selling.
The standard for inventory valuation supports the prudence concept because it decides between a lower purchase cost and NRV. So, opting for the lower valuation results in a lower value for the assets and a lower value of the profit.
Hence, the standard has been designed for businesses to comply with the basic principle of prudence/conservatism.
Similarly, let’s assume that the sales manager of the business is of the view that provision for the accounts receivable should be 5%, and the marketing manager is of the view that provision for the accounts receivable should be 10%.
So, as per the prudence concept, 10% provision should be recorded in the books of accounts that lead to conservative business profitability.
This principle states that an accounting policy, once adopted, should be continued in the future as well. It helps to bring consistency between the financial reports presented by the business. So, the users of the financial statement can easily compare between these statements and track the performance.
This principle is implemented to create ease as investors want to assess the performance of the business by comparing it with the previous performance. Similarly, auditors want to perform analytical procedures on a set of accounts.
If different accounting policies have been followed, there will be a need to make adjustments that might consume more time and resources. Hence, to create ease for the user of financial statements, the consistency principle is adopted.
Example of consistency principle
The businesses can adopt FIFO and AVCO methods of accounting valuation. However, if in year-1 the business had adopted the FIFO method, it must continue to use the FIFO method in year-2.
Although, the standard allows the business to switch an accounting policy. However, the business must disclose in the notes to the accounts and provide a reasonable explanation of how a change of the accounting policy seems to enhance financial reporting.
Going concern principle
The going concern principle is an assumption that the business will remain operational for the foreseeable future. It means that the business does not seem to halt its operations, liquidate its assets or go out of operations.
Going concern assumption enables us to record a deferred liability, deferred assets, and many more items that are expected to be settled in the future.
Similarly, the valuation of assets can be carried based on the value in use. On the contrary, if the business is expected to be liquidated in the foreseeable future, the valuation of assets needs to be done based on breakup value.
Following are some of the symptoms that reflect the company may not be going concerned. (Please note given list is not conclusive/exhaustive).
- Serious losses on a consistent basis, negative retained earnings in some cases.
- The inability of the company to meet loan installments.
- Active legal proceeding against the business.
- Denial of credit from suppliers.
- New Government regulations seriously affecting the main product of the business.
Example of going concern principle
Suppose the main product of the national chemical company is naphthol. The State Government restricts the import, manufacturing, and marketing of the naphthol.
Hence, the business no more seems to be going concerned because they cannot continue their operations in the country, and the financial statement needs to be prepared on a break up basis.
This principle states that revenue earned by the business must be recognized in the same period as related expenses. In simple words, if the business earns revenue by performing an activity and incurs the cost, the cost of an activity and revenue earned from the performance of the activity must be reported in the same accounting period.
This principle intends to enhance the accuracy of the financial reporting by setting the relevancy of the accounting period. It’s based on the principle of cause and effect and implied to enhance the relevancy of the financial figures.
Example of matching concept
Suppose the business pays a 1% commission on gross sales and sales in January amount to $100,000. However, the commission is payable on the 15th of next month, which is February.
So, we need to understand that sales were generated in January. Hence, related expenses (commission) must be recorded in January, irrespective of actual cash being paid in February.
Economic entity principle
This principle is that the business is a separate entity from the owner, and the accounting record of the business and owner must be kept separately. The implementation of the accounting principle intends to prevent the intermingling of the company’s assets and liabilities with that of the owner.
It helps to obtain a clear picture of the company’s financial figures, which can be used in different tax and financial analysis calculations.
Example of economic entity concept
Suppose a sole trader faces cash flow problems and decides to add $25,000 to the business. The business needs to record this receipt as a liability in their books. Hence, recording of the liability makes it clear that business is separate from owners.
Cost principle of accounting
The cost principle states that an asset needs to be recorded at purchase price/cost; the value of an asset does not change with inflation/market trends. Instead, the cost of an asset remains the same in the books of accounts.
Example of the cost principle
Suppose the business purchased land amounting to $40,000 ten years ago. In the current year, the market value of the land increases to $70,000. However, the value of the land remains $40,000 in the books of accounts. So, it complies with the cost principle of accounting.
Full disclosure principle
The full disclosure principle states that all information that impacts user understanding of the financial statement should be disclosed in the notes to the financial statement. The interpretation of the principle may be judgmental and lead to massive information in the financial statement. So, as a custom, only material and important events are disclosed in the financial statement.
Example of full disclosure principles
Suppose there is litigation on the company as they had to breach the contract, the legal counsel concludes that they are confident that they won’t have to pay damages. So, in this case, the company does not need to record a liability, but they must disclose the fact in notes to the financial statements.
Frequently asked questions
What is a contingent liability, and how it’s connected to the full disclosure principle?
The contingent liability is the expected loss of the business due to some uncertain event. This type of liability needs to be recorded in the balance sheet if it’s likely that the business will have to pay damages. The amount can also be estimated reasonably. However, if these conditions are not fulfilled, contingent liability needs to be disclosed.
The full disclosure principle requires businesses to disclose the current status of the litigation in the notes to the accounts. Further, analysis of contingencies is one of the important areas when due diligence is performed.
What is the main goal of GAAP in accounting?
The main role of GAAP in accounting is to ensure transparency, consistency, and accuracy of financial reporting.
Who is responsible for enforcing GAAP on the companies?
In the United States, GAAPS are enforced by Security Exchange Commission and Financial Accounting Standard Board – FASB.