Earnings reports tell us if a company spent more than it earned or vice versa. Balance sheet, a close cousin, shows what a firm owns and owes. Both adhere to a set of accounting principles that firms follow to record, process, and report financial information.
Accounting principles are the foundational principles of financial reporting as they provide a frame of reference for understanding and analyzing financial statements, helping firms make informed decisions about business operations. Proper accounting ensures that businesses operate responsibly and transparently.
Why are accounting principles important?
Accounting principles are important because they provide a framework for understanding and managing financial transactions. They can help businesses make efficient decisions, manage risk, and optimize resources. They also play an essential role in auditing a company’s finances.
Accounting principles help us understand how a company performs financially, identify potential problems, and make necessary adjustments. They also provide guidelines for recording revenue, expenses, and other financial information.
Without accounting principles, it would be difficult to determine whether a company complied with laws or regulations governing the reporting of financial data. Additionally, it would be impossible to make informed investments or business decisions without accurate financial information.
Types of accounting principles
There are several accounting principles that businesses must adhere to maintain accurate records and track their financial progress. Some common principles include revenue recognition, the going concern principle, the materiality principle, the monetary unit principle, etc. Each has its own set of rules to ensure that firms present numbers accurately in quarterly or annual reports.
Accrual accounting principle
This method records expenses when they are incurred and credits revenues to accounts receivable when payment is received. It makes it easier to track finances and manage cash flow. The accrual principle states that expenses should be recorded when they are incurred rather than when money is received. Thus, transactions, if tracked accurately, can lead to better planning and management.
Revenue recognition principle
When a company sells goods or services, it must determine the fair market value (FMV) of those items. The firm can record FMV as revenue on an Income Statement. This helps companies stay consistent with their financial statements and avoid disputes over prices with customers.
Simply put, businesses must determine when sales occur (in which period), what is being sold (be specific), and who is making the payment (the supplier or customer). A firm should verify all three items before receiving money in its account.
Expenses should be kept as low as possible while meeting all obligations. It holds that new funds should enter a business only if they generate revenue or offset losses already existing in the accounts receivable department.
Accounts and records should be consistently updated and maintained to ensure accuracy. All financial statements should reflect the same set of accounting principles used to prepare them to minimize potential discrepancies between reports.
Identifying the costs associated with providing goods or services is important to determine whether those costs are reasonable for the business to survive and grow. The cost principle advises companies to account for actual expenses associated with their products or services rather than using estimates or standard pricing schedules. This helps ensure fair treatment for customers and employees alike.
Economic entity principle
Businesses must account for themselves as separate economic units to measure performance and make strategic decisions based on results. The economic entity principle stipulates that business entities are classified according to the nature of their primary activity. For example, sole proprietorships vs. partnerships.
Full disclosure principle
All relevant information regarding the business should be disclosed in financial reports so that investors know what they are investing in. Also known as the “truthful statement” principle, this guideline encourages businesses to disclose all relevant information so people can make informed decisions about their investments.
Going concern principle
Whenever there is any uncertainty surrounding a company’s future, it is prudent to apply the going concern standard, also known as full value at risk. This rule requires companies to continue operating even if it appears likely they will not meet their debts due to a lack of available capital or an uncertain market environment.
Under this, an enterprise should operate normally so that proper management functioning is not affected. For this, firms should ensure that they allocate all necessary resources toward sustaining operations rather than wasting funds on short-term projects or expenditures. It also requires managers to assess how long a business can survive without certain services or products and act accordingly.
The materiality principle dictates how much evidence needs to exist before a firm classifies assets as “material.” This may include equipment, accounts receivable, and contracts since damaged or destroyed assets may impact future profitability. Examples of information that typically fall under this category would include the amount owed by shareholders or contractual agreements between companies involved in cross-selling activities.
The monetary unit principle
It stipulates that all financial statements should reflect transactions using standard units of currency (e.g., dollars), even if actual amounts involved fall within different ranges. According to the principle, a monetary value assigned at face value is always considered representative of economic reality.
To balance correctly, expenses must correspond to revenues received for accounts payable (or claims) liabilities and equity (owners’ equity) balances. Otherwise, an adjustment will need to take place to make them tally.
An enterprise should use accounting principles that are reliable and consistent from period to period.
Time period principle
Enterprises should use accounting principles that reflect the underlying reality of their business. This means using financial statements, cash flow reports, and other information in a way that is accurate and meaningful for investors, creditors, employees, and other stakeholders.
Examples of accounting principles
In a global context, there are two sets of popular accounting principles. Most of the world—read 167 countries—use the International Financial Reporting Standards (IFRS), while the US follows a different accounting standard called generally accepted accounting principles (GAAP or US GAAP). America’s securities regulator SEC has said it plans to eventually shift from GAAP to IFRS, but the transition has been slow.
Conditions of accounting principles
A few important conditions must be met for an entity to use the accounting principles described in Generally Accepted Accounting Principles (GAAP). Conditions of accounting principles (CoAP) are a set of guidelines that accountants use to determine and report the financial condition of an entity.
The International Accounting Standards Board (IASB) developed the CoAP framework in response to changing global business environments and requirements. The goal of the CoAP is to provide clarity and consistency across various national GAAP frameworks. It also allows entities greater flexibility in preparing their financial statements in accordance with local legal requirements or commercial considerations.
The following are some of the broad areas covered under the Conditions of Accounting Principles:
Financial reporting framework
All businesses must report their financial information under Generally Accepted Accounting Principles (GAAP). These guidelines state how to record and report revenue and expenses for a fiscal year. GAAP also establishes standards for preparing balance sheets and income statements.
Property, plant, and equipment
Every business needs some equipment or property to function properly. These include buildings, machinery, computer systems, etc. When assets are acquired or disposed of, they must be recorded in the company’s books.
Conservation of resources
Businesses must always try to conserve resources where possible to keep costs down and stay competitive in the long term. This includes using recycled materials to plan in advance so that a firm does not have to undertake non-essential work at peak times.
Income statement preparation and analysis
The Income Statement tells investors what happened during a given period on the financial front. It shows gross profits (revenue minus cost of goods sold) and net income (profit after taxes).
Equity holders’ rights
Under this comes dividend payments, voting rights, and liquidation preferences—which are important for equity holders to maximize their return on investment.
We have touched upon the main principles of accounting. It can be a bit overwhelming when you begin analyzing the financial statements of a business. But there’s no need to panic. Simply implementing a few of the principles listed above will help you understand what is going on in a company’s books.
A business can analyze financial statements easily using accounting principles. Thus, a firm can make well-informed decisions to guard against fraud and other such illegal acts.