Accounting principles refer to a list of rules that focus on how an organisation prepares its financial statements. All practising accountants must obey certain principles when performing their duties in their specific workplace, to maintain consistency and transparency across the department. While some countries follow different principles, many businesses around the world accept and implement the most common accounting rules. In this article, we focus on the most commonly used accounting principles.
What are accounting principles?
Accounting principles are the practices that accountants must follow when preparing financial statements for a publicly traded organisation. Developed through regular practice by accountants around the world, in Australia, the Australian Accounting Standards Board built their own comprehensive set of accounting standards based on these principles. It's important for an organisation to obey the accounting rules that apply to its industry for multiple reasons, including external audits, which is a regular necessity for investors and lenders.
Therefore, it's crucial for anyone in the accounting sector to understand and obey these rules, which are also known worldwide as the Generally Accepted Accounting Principles (GAAP). The principles incorporate several topics, like presentation, assets, liabilities, revenue, equity, and expenses. Organisations in specific industries may also have additional rules, so to avoid errors it's important for accountants to review general and industry-specific provisions.
12 commonly used accounting principles
Here are 12 of the most commonly used accounting principles worldwide and how they apply to an accountant's role and duties:
1. Accrual principle
The foundation of the accrual basis of accounting is that businesses should record all transactions in the periods during which they actually take place, rather than when there are cash flows associated with them. It's important for the construction of more transparent financial statements that specifically show what happened during a particular period.
If an organisation chooses not to obey the accrual principle, it may cause an artificial hurrying or delay in the transaction because of the associated cash flow. For example, an accountant may enter an expense when someone makes the payment, which could cause a delay based on the vendor's payment terms.
2. Conservatism principle
The conservatism principle relates to the notion that organisations should record all debts and expenses as early as possible, while accountants should only record assets and revenues when they are certain they'll occur. Implementing this principle can introduce a conservative slant to financial documents, resulting in lower recorded profits because of delays in asset and revenue identification. Conversely, this rule may encourage businesses to record losses earlier than needed, so it's important to not take this concept too far and misrepresent your business' finances.
3. Consistency principle
Applying the consistency principle means an organisation will continue to use its chosen systems and accounting standards until their industry introduces a clearly improved method. Following this principle ensures that those evaluating an organisation's financial statements fully comprehend how they reported specific numbers and data and how its accountants prepared the documents. Without consistency, an organisation may confusingly alternate between varying accounting rules.
4. Cost principle
The cost accounting principle refers to the concept that an organisation records all equity investments, assets and liabilities at the original purchased cost. Another aspect of this rule is that accountants shouldn't adjust the recorded numbers for market value improvements or inflation. The only exception to the rule is if a short-term investment (actively trading on the major stock exchanges) in a corporation's capital stock experiences a shift in its market value. The cost principle may not be in effect on a long-term basis as more organisations move towards fair value regulations, which produce more consistent financial documents.
5. Economic entity principle
An organisation's transactions should remain separate from any transaction of other organisations or business owners. Known as the economic entity principle, this rule helps prevent the inter-organisational compounding of liabilities and assets, which is imperative during audits. Including different transactions from multiple businesses in a single financial statement can create confusion and make it challenging for auditors to identify financial data about a particular organisation.
Business entities subsist in many forms, including government agencies, corporations, sole proprietorships and partnerships. Entrepreneurs and new business owners encounter the greatest amount of issues with the economic entity principle, as the individuals who operate them may not have the right training or understand the importance of separating business and personal transactions. Therefore, to adhere to the economic entity principle, it's beneficial to hire an accountant or bookkeeper to help with financials.
6. Full disclosure principle
The full disclosure accounting principle ensures accountants incorporate all essential data in an organisation's financial documents. Necessary information refers to all pertinent details about how the business functions and manages its financial records and any additional information that could influence a receiver's judgment when deciding to invest or lend to the organisation.
The full disclosure principle's primary purpose is to ensure that any external entity that has an interest in the organisation can examine material data that outlines its potential for success. Particularly, it's an important principle in international business transactions.
7. Going concern principle
The going concern principle refers to a business continuing to operate for the foreseeable future, barring any unexpected circumstances. It also suggests the business entity will not have to liquidate its assets or stop operating in the recent future. When making this assumption and following this accounting principle, an accountant can delay recognising specific payments until later, as it's presumed the business will continue to operate and will recognise and handle those expenses soon.
This principle justifies an organisation to delay the acceptance of some of its expenses until a later time, such as depreciation. Alternatively, if an organisation decides not to practice the going concern principle, it will have to recognise all of its expenses immediately without delay. If no significant data exists that shows the business faces impending closure, it can (and should) observe the going concern principle.
8. Matching principle
The matching principle means a business must record all expenses with their associated revenue. Applying this principle enables a business to charge inventory to the cost of goods sold when recording the revenue that arises from the sale of each item. If an expense doesn't have a direct link to an organisation's profits, it's included in the statement from the period in which the organisation used it. When a business cannot decide the future benefit of a certain cost, it needs to charge that cost to the expense section of its financials immediately.
The accrual basis of accounting relies on this rule as one of its cornerstones, while cash basis accounting does not apply the matching principle. When every expense and cost doesn't have a cause-and-effect relationship with the organisation's revenue, a business can systematically allocate them to the accounting periods in which they used them.
9. Monetary unit principle
An organisation should only record transactions it can state in terms of a unit of currency when practising the monetary unit principle. While this rule makes it easy to report specific purchases, such as fixed assets that are bought for a certain price, it also makes it more difficult to record items that have estimated costs. Applying this principle ensures that businesses outline all transactions in a dependable way, as the values of the currency or monetary unit are simpler to quantify.
10. Reliability principle
Businesses should only record proven transactions under the reliability principle. Examples of validated evidence to record include purchase receipts, bank statements, appraisal reports and cancelled checks, as they're each generated by third parties. The reliability principle holds records supplied by vendors, customers and other external entities at a greater value, compared to those the business generates. Auditors are especially interested in the reliability principle, as they're tasked to find evidence that supports every recorded business transaction.
11. Revenue recognition principle
The revenue recognition principle acknowledges that an organisation should only recognise revenue when it's completed the earnings process and can verify the completion. A business recognises the revenue upon its earning, rather than its collection. Because of fraud concerns, various accounting regulation boards have released additional information that details what makes up the proper recognition of revenue. The accrual basis of accounting also includes the revenue recognition principle.
12. Time period principle
The time period principle relates to the concept that a business should report all of its financial data within a fixed period and that the organisation can arrange all of its ventures into defined time periods. Common time periods—referred to as reporting and accounting time periods—are weekly, monthly, semi-annually and annually, although an organisation can create its own periods as needed.
The goal of the time period accounting principle is to ensure that all established periods deliver uniform and dependable information that is used for comparison. Producing frequent and consistent records is imperative when an organisation intends to go public and is seeking investors or getting business loans.