#6
This post attempts to help you remember the 10 principles of accounting.
1. Separate Legal Entity Assumption
Accountant keeps all of the business transactions of a sole proprietorship separate from the business owner's personal transactions.
Note:
For legal purposes, a sole proprietorship and its owner are considered to be one entity, but for accounting purposes, they are considered to be two separate entities.
2. Monetary Unit Assumption
Generic version:
Money itself is treated as a unit of measurement and all transactions or economic events recorded in the accounts of a business can be expressed and measured in monetary terms by a currency.
Specific version:
Economic activity is measured in U.S. dollars, and only transactions that can be expressed in U.S. dollars are recorded.
Note:
It is assumed that the dollar's purchasing power has not changed over time. As a result, accountants ignore the effect of inflation on recorded amounts. For example, dollars from a 1960 transaction are combined (or shown) with dollars from a 2019 transaction.
3. Time Period Assumption
This principle assumes that it is possible to report the complex and ongoing activities of a business in relatively short, distinct time intervals such as the five months ended May 31, 2019, or the 5 weeks ended May 1, 2019. The shorter the time interval, the more likely the need for the accountant to estimate amounts relevant to that period. For example, the property tax bill is received on December 15 of each year. On the income statement for the year ended December 31, 2018, the amount is known; but for the income statement for the three months ended March 31, 2019, the amount was not known and an estimate had to be used.
Note:
It is imperative that the time interval (or period of time) be shown in the heading of each income statement, statement of stockholders' equity, and statement of cash flows. Labelling one of these financial statements with "December 31" is not good enough–the reader needs to know if the statement covers the one week ended December 31, 2019, the month ended December 31, 2019, the three months ended December 31, 2019, or the year ended December 31, 2019.
4. Cost Principle
"Cost" refers to the amount spent (cash or the cash equivalent) when an item was originally obtained, whether that purchase happened last year or thirty years ago. For this reason, the amounts shown on financial statements are referred to as historical cost amounts.
Note:
Asset amounts are not adjusted upward for inflation. In fact, as a general rule, asset amounts are not adjusted to reflect any type of increase in value. If you want to know the current value of a company's long-term assets, you will not get this information from a company's financial statements–you need to look elsewhere, perhaps to a third-party appraiser.
5. Full Disclosure Principle
If certain information is important to an investor or lender using the financial statements, that information should be disclosed within the statement or in the notes to the statement.
Example:
A company is named in a lawsuit that demands a significant amount of money. When the financial statements are prepared, it is not clear whether the company will be able to defend itself or lose the lawsuit. As a result of these conditions and the full disclosure principle, the lawsuit will be described in the notes to the financial statements.
Note:
A company usually lists its significant accounting policies as the first note to its financial statements.
6. Going Concern Principle
This accounting principle assumes that a company will continue to exist long enough to carry out its objectives and commitments and will not liquidate in the foreseeable future. If the company's financial situation is such that the accountant believes the company will not be able to continue, the accountant is required to disclose this assessment.
Note:
The going concern principle allows the company to defer some of its prepaid expenses until future accounting periods.
7. Matching Principle
This accounting principle requires companies to use the accrual basis of accounting to match expenses with revenues.
Example:
Sales commissions expense should be reported in the period when the sales were made (and not reported in the period when the commissions were paid).
Wages to employees are reported as an expense in the week when the employees worked and not in the week when the employees are paid. If a company agrees to give its employees 1% of its 2019 revenues as a bonus on January 15, 2020, the company should report the bonus as an expense in 2019 and the amount unpaid at December 31, 2019, as a liability.
Note:
Since we cannot measure the future economic benefit of things such as advertisements and thereby not be able to match the ad expense with related future revenues, the accountant charges the ad amount to the expense in the period the ad is run.
8. Revenue Recognition Principle
Under the accrual basis of accounting, revenues are recognized as soon as a product has been sold or a service has been performed, regardless of when the money is actually received. Under this basic accounting principle, a company could earn and report $20,000 of revenue in its first month of operation but receive $0 in actual cash in that month.
Example:
ABC Consulting completes its service at an agreed price of $1,000.
ABC should recognize $1,000 of revenue as soon as its work is done. It does not matter whether the client pays the $1,000 immediately or in 30 days.
Note:
Do not confuse revenue with a cash receipt.
9. Materiality
An accountant can violate another accounting principle if the amount is insignificant. Professional judgement is needed to decide whether an amount is insignificant or immaterial.
Example:
Purchase of a $150 printer by a highly profitable multi-million dollar company. Since the printer will be used for five years, the matching principle directs the accountant to expense the cost over the five-year period. The materiality guideline allows this company to violate the matching principle and to expense the entire cost of $150 in the year it is purchased. The justification is that no one would consider it misleading if $150 is expensed in the first year instead of $30 being expensed in each of the five years that it is used.
Note:
This principle allows financial statements to show amounts rounded to the nearest dollar, to the nearest thousand, or to the nearest million dollars depending on the size of the company.
10. Conservatism
If a situation arises where there are two acceptable alternatives for reporting an item, conservatism directs the accountant to choose the alternative that will result in less net income and/or less asset amount. Conservatism helps the accountant to "break a tie." It does not direct accountants to be conservative. Accountants are expected to be unbiased and objective.
Example:
Potential losses from lawsuits will be reported on the financial statements or in the notes, but potential gains will not be reported.
Also, an accountant may write inventory down to an amount that is lower than the original cost, but will not write inventory up to an amount higher than the original cost.
Note:
The basic accounting principle of conservatism leads accountants to anticipate or disclose losses, but it does not allow a similar action for gains.
Here's an interesting
tutorial explaining the fundamental principles.
