The main accounting principles use general guidelines and rules to manage the world of accounting.
These standards are known as Generally Accepted Accounting Principles or GAAP. They try to synchronise and standardise accounting assumptions, definitions and methods.
What is GAAP?
GAAP stands for Generally Accepted Accounting Principles.
There are several different accounting principles. Some of the most noteworthy are the consistency principle, the materiality principle, the matching principle and the revenue recognition principle.
Having standard accounting principles provides more peace of mind for people that read an organisation’s financial statements.
The readers can rest easy knowing that the financial reports are comparable, consistent and complete.
The accrual principle states that all transactions should be recorded during the period that they occur. Accountants don’t have to wait until when the cash flows associated with these activities happen.
Here are a few examples of when and how the accrual principle should be used:
- Revenue should be recorded when the customer is invoiced, not when the customer pays that invoice.
- Expenses should be recorded when they are charged instead of when they are actually paid.
- Bad debt amounts should be estimated once the respective customer has been properly invoiced. You shouldn’t wait until you realise that the bill will go unpaid.
- Fixed asset deprecation should be recorded over the useful life of that asset. Depreciation should not be recorded as an expense in the period in which the particular item was acquired.
- All commissions should be recorded in the period that your salespeople earned them. Commissions shouldn’t be recorded in the period that the salespeople were paid for them.
Wages should also be recorded in the period that they were earned, instead of the period in which they were paid.
You can accumulate all of your expense and revenue data for each period when the accrual principle is used. The best part is that you don’t have to deal with any delays or interruptions created each accounting period’s cash flows.
This principle tells an accountant to select the option that will result in a lower asset amount and/or lower net income.
The principle is used in situations where there are two ways that an item can be recorded.
Accountants using this principle can usually expect to see some losses that should be disclosed as necessary.
However, the same is not true for any potential gains. For instance, financial statements or the notes therein will include information about possible losses from lawsuits.
There won’t be any information in those notes or statements about possible gains. Conservatism allows accountants to reduce inventory to a dollar amount that’s lower than the initial purchase price.
Inventory dollar amounts can’t be increased to a figure that’s more what those items were purchased at.
Accountants should be consistent in using and applying accounting practices, procedures and principles.
If an organisation uses the first-in, first-out (or FIFO) cost flow assumption method, it’s reasonable for the people who read their financial statements expect that the business would keep using that same method.
If the company decides to change to a last-in, first-out (LIFO) accounting method, the change should be disclosed plainly.
That change should also be consistent throughout the entire firm’s accounting practices.
This principle states that any goods or services purchased should be recorded at the price that was originally paid for them or their historical cost. They should not be recorded at their fair market value.
If your business currently owns vehicles, property or other forms of real estate, those assets should be recorded at their historical prices.
Current market values should not be recorded for those assets.
Economic entity principle.
The logic behind the economic entity principle is that a company’s transactions should be kept apart from the transactions conducted by other businesses and the business owner.
This helps companies avoid the hassles involved when assets are combined across different organisations under the same umbrella.
This can be especially complicated when auditing a new company that doesn’t abide by this principle.
Full disclosure principle.
This principle explains why there are often several pages of footnotes in a company’s financial statements.
Businesses that follow this principle include such information either in the footnotes of the statements or the statements themselves.
This is usually included if it is something that could be important to potential lenders or investors who use those statements.
The first note in a company’s financial statements often includes its major accounting policies.
Going concern principle.
This concept operates under the assumption that the business will operate indefinitely.
They intend to fulfil their obligations and have no plans to close or cease operations in the near future.
Companies are required to list an assessment of their condition if their accountant feels that their financial situation will prevent the business from continuing to operate in the long run.
Accountants may also use the going concern principle to postpone some of its prepaid expenses to future accounting periods when those charges can reasonably be paid.
The logic behind the matching principle is that each expense item should be matched to a revenue item and vice versa.
For instance, taco stand owners should count the expense of the taco toppings, shell and meat when a customer buys a taco.
The revenue earned from the sale should be matched with the expense of all the ingredients that went into making the taco.
Companies work under the accrual accounting method when they apply, expense, revenue and matching principles.
If the amount of a specific transaction is deemed unimportant, this concept may allow accountants to disregard another accounting principle.
It may be up to a person or organisation’s professional judgment to decide if an amount should be considered insignificant.
Financial statements are often rounded due to materiality. Depending on the company, financial records may be rounded to the nearest dollar, thousand dollars or million dollars.
Monetary unit principle.
The monetary unit principle says that the only type of business transactions that should be recorded are the ones that can be conveyed using currency.
The principle also assumes that the value of the currency unit used in those transactions won’t fluctuate too much over extended periods of time.
This principle states that you should only record transactions that can be proven. A supplier’s invoice is an example of a proven expense that has been incurred.
The reliability principle is especially important to auditors, as they are regularly looking for documentation that supports the facts that certain transactions have taken place.
Revenue recognition principle.
Revenue recognition acknowledges that revenue should be recorded when it’s actually earned, regardless of how long it may take a company to receive the actual funds associated with the particular transaction.
The revenue principle, or revenue recognition principle as it is also known, is one of the more generally accepted accounting principles.
According to this logic, revenue happens when the buyer legally takes possession of the services performed or the items that were purchased.
You don’t have to wait to record revenue until the seller accepts cash for the transaction in question.
Time period principle.
This principle says that companies should report details of their operating activities for a predetermined time period.
It may seem like one of the most obvious accounting procedures to follow.
This principle was designed to develop uniform time periods that can be used for trend analysis and other important functions.
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