“Accounting is the language of business efficiently communicated by well-organised and honest professionals called accountants.”
Accounting not only records financial transactions and conveys the financial position of a business enterprise; it also analyses and reports the information in documents called “financial statements.”
Recording every financial transaction is important to a business organisation and its creditors and investors. Accounting uses a formalised and regulated system that follows standardised principles and procedures.
Obviously, if each business organisation conveys its information in its own way, we will have a babble of unusable financial data. Therefore, accounting principles based on certain concepts, convention, and tradition have been evolved by accounting authorities and regulators and are followed internationally.
Here are 8 accounting principles every graduate must know:
BUSINESS ENTITY CONCEPT
Business entity and its owners should be treated as two different entities as they are distinct from one other. Personal transactions of the owner are to be kept separate from the business transactions. Similarly, the assets and the liabilities of the business should solely be used for business purposes. The underlying reason for this is that if these transactions are mixed together then the true picture of the business will not be visible.
Illustration 1: The auditor of the company A while analysing the balance sheet found an increase in expenses which was mainly recorded for travelling expenses. After digging deeper and looking at the expenses of the trip the auditor discovered that these expenses were not for business purpose but personal expense. This is a wrong practise and is against the business entity concept which separates entity from the businessman/person running the business.
MONEY MEASUREMENT CONCEPT
Business transactions that can be expressed in terms of money can only be recorded in accounting. The records of other transactions should be dealt with separately. In fact, if there is reasonable doubt amount of regarding the monetary value of a transaction or event, it is better not to capture it in the financial reporting, but rather disclose it in the supplementary notes.
Illustration 2: Let us take the example of employee skills and their salaries. Although employee skill is an important factor for any company, it can’t be quantified in terms of monetary value and as such can’t be captured in the financial reporting. On the other hand, the salary of an employee which is a reflection of his skill set can be quantified in terms of money and as such forms part of the financial reporting of a company. The difference between employee skill and their salary is one of the examples of money measurement concept.
DUAL ASPECT CONCEPT
This is the heart of the entire accounting process – for every debit, there is a credit. The dual concept works in such a way that a transaction is said to be completed only when the above-mentioned condition is fulfilled. To put in other words, it helps us in determining the source of the wealth and where it is used or the form it takes. There are four possible entries that will help you to equate the source with the use. They are:
- Both the sources and the uses increase by the same amount
- Both the sources and the uses decrease by the same amount
- The sources remain constant while some of the uses of wealth increase and the others decrease
- The uses remain constant while some of the sources of wealth increases and the others decrease.
Illustration 3: A grocery store owner has identified the below transactions for the Month of March and wants to record this data and create financial statements –
- Payment of electricity expense: $5,000
- Sale of goods for cash: $1,000
- Sale of goods on credit: $15,000
Under the double-entry system, the above transactions will be accounted for as follows:
|Electricity Expense||Increase in expenses||$5,000||–|
|Cash at Bank||Decrease in assets||–||$5,000|
|Cash in hand||Increase in assets||$1,000||–|
|Sales Revenue||Increase in income||–||$1,000|
|Receivables||Increase in assets||$15,000||–|
|Sales Revenue||Increase in Income||–||$15,000|
The baseline of this principle is that for every entry of revenue there should be an equal expense recorded for correctly matching the profits and the losses for a given period of time. The profit is determined by tallying the expenses during that period. This mainly focuses on which item of costs is a part of the expense in the accounting period. Costs are reported in that period in which revenue in relation to that expense is also reported. Costs are matched with revenues and the process can’t be used the other way around. The matching principle, therefore, requires cost allocation and is significant in historical accounting.
Illustration 4: The accounting period for ABC Limited ends on 31st December of each year. During FY2018, the company has taken a loan for which the first interest payment will be due on 3rd January 2019. Now, let us look at the recording of the interest payment transactions in FY2018 and FY2019.
ABC will recognize the interest payment of $5,000 in its financial statements for FY2018 even though the interest is actually paid in the preceding year FY2019 as the expense is related to the current period i.e. 2018. Accounting entry as of 31st December 2018 will be as follows.
|Debit||Interest expense||$ 5,000|
|Credit||Interest payable||$ 5,000|
On the day when the actual payment has to be done (3rd January 2019) in the following year the below-accounting entry will be recorded.
|Debit||Interest payable||$ 5,000|
ACCOUNTING YEAR CONCEPT
Every business chooses a discrete-time period for completing a cycle of accounting process and the books of accounts are maintained for that period. It can be according to the fiscal year or calendar year. Most companies in India follow the fiscal year while in the US companies follow the calendar year. Based on the accounting year, the total income and expenses are calculated. It can also be identified in the financial statements. The time period is usually of twelve months but some companies also issue half-yearly and even quarterly statements. These half-yearly and quarterly statements are known as interim statements and are different from the annual statements. Statements for shorter periods, such as weekly or monthly, can also be prepared at the desecration of the management.
This concept assumes that profit is realized only when it is earned. If your firm has received an advance fee, then it will not be considered as a profit until the goods have been provided or the service has been offered. The underlying logic behind this is that the profit can only be when all the risk and reward-related to this have been transferred.
This is also linked to another important principle of conservatism. This principle intends to anticipate no profits and accounts for possible losses. One point to note here is that there is no intention of deflating the value of assets, it is only used in those places where there is a reasonable amount of doubt. For example, whenever inventory is valued it is always done at lower costs or market value. This leads to recognizing all the losses in the income statement and accounting for profits only when they are realized.
Illustration 5: Consider a company which receives an advance fee of $1,000 for conducting the credit rating exercise of a borrower. However, the company is unable to complete the task by the end of the accounting year. The company will record $1,000 as deferred revenue under the liability side and increase cash by $1,000 on the asset side. This is in line with conservatism concept that the profit will not be booked until the service is completed.
In accounts, it is assumed that a business can go on for a very long time and carry out its obligations and commitments effectively. This also assumes that business will not be forced to stop functioning and liquidate its assets at a very low valuation. Keeping this in mind all the transactions are accounted. For example, all the fixed assets like plant and machinery are recorded at cost price in balance sheet based on the assumption that business will go on forever and there is no intention of selling these assets. These assets are depreciated and amortized over the useful life of these assets and not on the basis of short term liquidation.
This principle requires that once an organization has decided on a certain method, then they have to follow the same method for all the other transactions and can change only if they have a sound reason to do that. The idea behind this concept is that if changes are made very frequently, then it will be very difficult to compare two statements over different periods. In fact, consistent changes in policies can be seen as a red flag because there might be a possibility that the manipulation of statements and balance sheet is an act of felony. In fact, investors see consistency as an important aspect to make investment decisions.
Illustration 6: Let us take the example of Company A that has been using the FIFO method for inventory valuation. However, in the current, the company is planning to switch to LIFO method. According to the consistency principle, the company can only switch from FIFO to LIFO if there is a justifiable reason. But in the absence of a valid reason, it will be treated as a violation of the consistency principle.
All these concepts go hand in hand like the realization concept is the base for conservatism and accrual concept of accounting. This is also related to the dual concept of accounting. Therefore, it is important to understand each individual concept clearly. These are only the basic principles, however, to dive deep into accounts it is important to start from these and then move ahead. Please bear in mind that building a proper balance sheet and income statement completely depends on these concepts.