5.1.1. Accounting Principles
Stakeholders relying on financial statements require a basic comprehension of the principles guiding their preparation to ensure accurate interpretation. These principles, known as Generally Accepted Accounting Principles (GAAP), provide consistency to the financial statement preparation.
Business Entity Concept
This concept underscores that a business entity is separate from its owners, requiring separate financial records. Failure to uphold this separation compromises the business’s integrity and accurate assessment of its performance. For instance, personal withdrawals from business funds without proper documentation blur this distinction and undermine financial transparency.
The Fundamental Equation
Expressed as “assets equal liabilities plus owner’s equity,” it delineates the relationship among resources, debts, and ownership interests. This equation ensures accounting records’ balance, with any asset increase being offset by corresponding liabilities or owner’s equity adjustments.
Going-Concern Concept
This concept posits that an organization will continue operating indefinitely, with asset value determined by revenue generation potential rather than liquidation value.
Money as a Unit of Measure
Money serves as the standard unit of measurement in business transactions, enabling uniform financial data representation. Using this concept, only information that can be stated in monetary terms is included on a company’s financial statement. Furthermore, other information, such as the value of good employees, is not included in financial statements because it cannot be expressed in monetary terms.
Cost Principle
The cost principle involves recording transactions at their dollar value at the time of occurrence, reflecting costs incurred for goods or services. Cost is the amount expended for goods or services.
Cash Versus Accrual Bases of Accounting
Accounting methods, such as cash basis and accrual basis, determine transaction recording timing. While the cash basis records transactions upon cash inflow or outflow, the accrual basis recognizes revenue upon earning and expenses upon incurring, regardless of cash movements.
Matching Revenues and Expenses
The matching concept aligns revenue with associated expenses during the accounting period to accurately represent profit. Failure to apply this concept could misrepresent financial performance. For example, consider a scenario where a restaurant owner purchase food supplies in one accounting period but sells them in the subsequent period. Without adhering to the matching concept, the cost of the food would be registered in the accounting period preceding the sale, leading to an inflation of costs in the initial period and profits in the subsequent one.
Depreciation
Depreciation, an essential part of accrual accounting, involves systematically spreading the costs linked to acquiring and installing a fixed asset over its estimated useful lifespan. Several depreciation methods exist, with one common approach being the straight-line method. Under this method, the asset’s cost is evenly distributed over its entire useful life. The formula to calculate the annual depreciation using the straight-line method is:
Annual Depreciation= (Cost of the asset−Salvage value)/Years of useful life
However, certain assets tend to depreciate more rapidly in their initial years, prompting the utilization of accelerated depreciation techniques. These methods allocate higher depreciation expenses in the early stages of the asset’s life and lower amounts in subsequent years.
Adequate Disclosure
Adequate Disclosure specifies that financial statements, along with their accompanying footnotes or supplementary materials, must provide comprehensive information essential for the reader’s comprehension. This entails detailing accounting methodologies employed, any modifications in these methodologies, and addressing any exceptional or nonrecurring matters crucial for an accurate interpretation of the financial statement.
Consistency Principle
The Consistency Principle states that upon selecting an accounting method, an organization should maintain its use across consecutive periods to ensure the comparability of financial data. Deviating from consistent methods may lead to misinterpretations of financial statements. For instance, altering depreciation methods would influence depreciation expenses, thereby impacting net income from one period to the next.
Materiality Principle
Absolute accuracy and complete full disclosure may not always be practical or economically feasible in accounting. The materiality principle means that events or information should be included if they have the potential to “make a difference” to the users of financial statements. An item is deemed material if its inclusion or omission would alter or influence the judgment of a reasonable person.
Conservatism
This principle emphasizes prudence in recording transactions and assigning values. Historically, accountants have adhered to a conservative approach, preferring methods or procedures that result in lower net income or asset values. (Egan, 2012; Payne-Palacio, 2015)
