Principles Of Accounting: Generally Accepted Fundamental Basics

Principles Of Accounting: Generally Accepted Fundamental Basics | Accounting Smarts
Charles Hall

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Charles Hall

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March 26, 2021

Learn the basic and fundamental accounting principles to improve the accuracy and completeness of your accounting records and financial statements.

Accounting is quite popular as the language of business. Note that through this language, you can easily analyze and assess the financial condition and financial performance of your small business. 

Accounting principles are the rules, concepts, and guidance that accountants use in order to prepare the financial statements of an entity. Standard-setting bodies also use these accounting principles to develop accounting frameworks and standards. All accountants have the responsibility to follow these accounting principles when performing their duties in order to maintain transparency and consistency. 

In this comprehensive guide, we will break down the fundamental principles of business accounting. Here is a quick look at the basic accounting principles. After reading this article, you will have comprehensive and detailed knowledge of accounting principles and fundamentals of accounting.

We have gathered this valuable information from some of the most trusted and reliable sources. The main goal is to provide you with authentic information so that you know and understand how to use accounting principles, such as materiality, for small business accounting.

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What are Accounting Principles?

You should know that accounting principles, such as the accrual principle, are the rules that all accountants have to follow when preparing financial statements, such as income statements, for a business organization. Through common usage, accountants have developed and modified these principles.  

Did you know that accounting principles, such as the consistency principle, are the building blocks for the Generally Accepted Accounting Principles (GAAP)? You can trace back all of the standards and concepts in GAAP to these underlying and fundamental accounting principles. It is worth noting that some accounting principles are derived from long-used accounting practices.

On the other hand, others come from various ruling-making bodies, such as the Financial Accounting Standards Board (FASB).

Note that the complete set of accounting standards rely on these accounting principles and basics. Keep in mind that these principles of accounting are used by accountants in every step of the accounting process to ensure the proper and accurate representation of the financial position of a business.

If your business organization is in a specific industry, you may have to follow additional accounting principles that apply to your business. These principles might not apply to other businesses.

Also, note that when working in a specific industry, such as manufacturing, accountants have to review the basic accounting principles and any industry-specific requirements and regulations in order to avoid errors and mistakes.

Important Accounting Principles and Basics

Accrual Principle

The accrual accounting principle requires you to recognize and record the revenues and expenses in your financial statements when you incur them instead of when you pay or receive cash. This principle is crucial as it helps the various users of financial statements, such as shareholders, to understand the financial information reflected in the current financial situation or economic status of an entity.

If your organization fails to follow the accrual principle, note that it may result in an artificial delay or acceleration of the financial transaction because of the associated cash flow, which can be problematic. For instance, an accountant may record a business expense at the time of payment, and this could result in a considerable delay based on the vendor’s payment terms and conditions.

Historical Cost Principle

According to this accounting principle, you should report all assets, such as plant and machinery, at the actual cost of acquisition rather than its existing market value. This means that you cannot depend on the current market value of the asset.

This is because it will change from time to time. So, it is essential to maintain an accurate and proper record using the amount that you paid for the asset.

However, it is worth noting that there’s an important exception to this accounting rule for highly marketable securities. You have to value them at their fair market value. 

Similarly, you have to present intangible assets, such as patents, with impairments in the financial statements at their suitable market values. This is how this accounting principle ensures a reasonable and accurate value/cost of the assets.

You should keep in mind that this principle might not be in effect for the long term. This is because more organizations are gradually moving towards fair value adjustments. By making fair value adjustments in your financial statements, you can create more consistent and accurate financial records.

Consistency Principle

The consistency principle is another important accounting principle. It requires your business to apply the same accounting policies, methods, and standards to report its financial statements. This means that if you are using a specific method, such as the straight line depreciation method, to maintain a record, you have to follow the same concept or method for future periods as well.

Note that this will guarantee that if you make any changes in the financial statements, it was because of the changes in the operation instead of changes in the accounting policies. As you can see, there are several benefits for the various stakeholders, such as investors, of financial statements when you correctly and strictly apply the consistency principle.

For instance, if you use different accounting methods or policies in order to measure and then recognize revenues, there will likely be a considerably different amount of revenue in your income statement. On the other hand, this difference could be immaterial if you use the same accounting methods or policies.

You should, for example, apply the same depreciation rates and methods consistently from one accounting period to the next to the same fixed assets.

Monetary Unit Principle

You may have heard of the monetary unit assumption in accounting. It means that you can include only transactions in U.S. dollar amounts in your accounting records. The benefit of using this principle is that it ensures that all transactions are reported in the financial statements in a stable and dependable way. This is because the values of a currency or monetary unit are much easier to understand as well as quantify.

Did you know that using the monetary unit accounting principle prevents a business organization from excessively or aggressively estimating the values of its assets and liabilities? Also, it is vital to keep in mind that accountants ignore the impacts of inflation on the dollar amounts.

Objectivity Principle

According to the objectivity principle, accounting records, financial statements, and financial information of your entity as a whole must be independent as well as free from bias. In other words, this principle states that all the financial information in your books of accounts has to be reliable, objective, and accurate.

Also, it is worth noting that your accounting records should be free from the personal opinions and biases of the reporting individuals. More importantly, every transaction in the records should have adequate proof or evidence like receipts, vouchers, invoices, etc.

Keep in mind that the underlying idea behind this principle is that the financial statements, such as balance sheets, should convey the financial performance and position of a business instead of persuading end-users to take specific actions.

Full Disclosure Principle

This concept requires you to include either in or alongside your financial statements all the pertinent information that can impact a user's understanding of these financial statements. You should disclose all information that is related to your business organization and is essential to an investor or lender in the content of your financial statements.

You can also include it in the notes to your financial statements. And this is the main reason that various footnotes are often attached to financial statements.

Time Period Principle

According to this accounting concept, your business has to report the financial results of its operations, usually over a standard time period. Keep in mind that you can report your business activities in short, and distinct time intervals. These can be weeks, quarters, months, a calendar year, or a fiscal year.

You have to identify this time interval in the headings of your financial statements, such as the statement of cash flow, income statement, and stockholders’ equity statement.

You may realize that this may be the most glaringly obvious and evident of all accounting principles. This principle intends to create a standardized set of comparable accounting periods, which is valuable and useful for financial and trend analysis.

Going Concern Principle

According to the going concern principle, we have to assume that an entity will remain in business for the foreseeable period. In most cases, this period is normally 12 months from the operating date. This also means that you justifiably defer the recognition of certain expenses, like depreciation expense, until later periods.  If you did not follow this principle, you’d need to recognize all business expenses at once.

In other words, this principle assumes that your business doesn’t face going concern problem. As a result, the users of financial statements could rely on your financial information by considering that your business could survive for a period of 12 months.

This also means that users of the financial statements must assume the business will not be dissolved or declared bankrupt unless they have reliable evidence to the contrary. So, users have to assume that there’ll be another financial period in the future.

You should keep in mind that there are several factors that indicate that your business may face going concern problem in the future. For instance, the demand for your main services and products may decline in the market, and sales may dramatically drop as a result.

Revenue Recognition Principle

According to the accrual basis of accounting, you should report revenue in your income statement in the period in which you earn it. So, the revenue recognition principle states that you should only recognize revenue in your books when your business has largely completed the earning process.

We can define revenue as the gross or total inflow of cash, receivables, or any other consideration that arises in the course of ordinary business activities of your enterprise from the sale of products or goods, provision of services as well as use of various enterprise resources by other entities that yield interests, dividends, and royalties.  

This principle stresses that you have to recognize revenue as soon as the service has been performed or a product is sold. And this is regardless of the fact whether you have received money not. Perhaps, more importantly, the provision of services or the sale of goods should be complete. Also, payment must be due for it. And you should also book the associated costs during the same accounting period.

Expense Principle

It is worth noting that the expense principle in accounting is basically the opposite of the revenue recognition principle. This means that when your business organization receives goods or has services offered to it, you have incurred an expense, and now you owe money for those services or goods.

Conservatism Principle

Note that the accounting principle of conservatism stresses that you should record all expenses and liabilities as soon as possible. On the other hand, revenues and assets should only be recorded in the books when an accountant is sure they will occur.

This principle is important and prevents accountants from underestimating future expenses and overestimating future revenues that could mislead the users of financial statements. However, note that some accountants take this concept too far. As a result, a business persistently misstates its financial results, such as assets, to be worse than is actually the case.

As you can see, the application of this principle can slant the financial statements in a conservative way, showing considerably lower reported profits because of the delays in revenue and asset recognition.

Materiality Principle

The materiality principle, also called the materiality concept, is a crucial accounting principle that is concerned with the relevance of financial information, as well as the nature and size of transactions that you report in your financial statements.

Keep in mind that due to the materiality principle, accounting records and financial statements typically show amounts that are rounded to the nearest dollar. It also means that if a business event or transaction occurred, that’s so insignificant that a creditor or an investor would not care about it, the event does not have to be recorded.

For example, tracking pieces of paper or individual paper clips is immaterial and quite burdensome, and time-consuming for any company's accounting department. 

It is worth noting that based on this accounting concept, financial information is only material if its addition and omission could mislead the users’ decision. Also, keep in mind that the same nature and size of financial information may be material to one company’s financial statements mightn’t be material to another.

For example, several thousand dollars might not be material to a huge entity like General Motors or IBM, but the same figure will likely be quite material to a small or family‐owned business.

You should know that accountants are not the only professionals who use this principle to prepare financial statements. Did you know that auditors also use this principle in order to calculate things like tolerable error, planning materiality, and performance materiality?

Assumptions Underlying Fundamental Accounting Principles

You may know that several additional concepts, also known as assumptions, underlie these accounting principles. Keep in mind that these assumptions ensure that everybody using accounting information can depend on standardized financial reporting. This is important as it allows for a better understanding of what is present in financial records.

Continuity Assumption

This is an important concept and states that a business entity is expected to continue unless stated to the contrary. Note that when a business closes, the values of various assets, such as inventory, are usually more difficult to calculate.

Separate Entity Assumption

According to this assumption, a business has a separate economic status from its stockholders or owners. This is why only the financial information of the business is shown in its financial statements. And business records should never include the personal assets and liabilities of its owners.

As a result, for example, a restaurant owner's personal car or other vehicles, in his or her name, wouldn’t be an asset on that restaurant's balance sheet.

Unit-of-Measure Assumption

This assumption states that the most suitable unit of measure for your business's accounting or financial records is the currency of your home country. In simple words, this assumption means that a US-based business would maintain its accounting records and data in U.S dollars. On the other hand, a Japanese business would keep its financials in the Japanese Yen.

Importance of Accounting Principles

There is no doubt that accounting principles, such as revenue recognition, are vital as they set the rules for financial reporting and bookkeeping. It is worth noting that these rules and principles maintain consistency and reliability in financial reporting from one company to another across all industries.

In the absence of these principles and basic concepts, businesses wouldn't be held to a consistent and strict set of standards. This means they would have much more leeway when it comes to deciding what information they decide to share or keep hidden. Therefore, these principles serve the crucial function by making sure that organizations cannot "cheat" on their financial reporting.

Accounting principles are also important for potential investors. These investors would like to direct funds to a specific kind of industry, such as pharmaceuticals, without a specific company in mind and will find these principles an essential tool while reviewing individual businesses.

Principles of accounting are crucial as they promote consistency in financial reporting, allowing investors to easily compare and contrast several companies across one industry or several industries through income statements, balance sheets, and annual report reviews.

They don’t need lessons in each company's accounting and reporting practices when every business uses the same principles.

Keep in mind that the whole point of financial accounting and reporting is to provide pertinent and useful information to the users of financial statements. It is evident that if every business reported its financial information differently, then it would be challenging and difficult to compare multiple companies.

Accounting principles are essential as they set the rules and conventions for reporting financial information. This ensures that you can compare all companies or businesses uniformly.

Why Use Accounting Principles

As you can see, the use of accounting principles, such as the historical cost principle, leads to transactions that reveal the true financial substance of your business.

Reduces Frauds and Risks

It is no secret that accounting principles help businesses reduce the risk of business frauds and data misrepresentation. In most cases, guidelines and rules derived from these principles are what your stakeholders and investors follow to hold you accountable for reporting business finances efficiently and effectively.

Did you know that the process may also push you to consider and answer other important questions? For example, why your business isn’t reaching the expected sales rate can be one of these questions. GAAP and accounting principles provide you with the valuable details and insights you need to diagnose any gaps in collection issues or earning capabilities. And that is not all; they also identify mistakes that you have to rectify to operate your business efficiently.

More Control

You may know that the accounting and financial reporting boards that prepare these accounting principles, like the Financial Accounting Standards Board (FASB), can control the preparation of financial statements. It is worth noting that control is crucial because it keeps unethical accountants and other professionals from preparing financial statements that don’t reflect a true and fair view of a business’s financial performance.

Always remember that incorrect or misleading statements can lead the business into financial distress or bankruptcy.

Provides Detailed and Reliable Information on Business Spending

As a business owner, you may think that you have an optimized track of all the spending related to your business and employees. However, note that there are usually so many other things that tend to go beyond your line of sight, causing you to lose track of the money.  

This is where accounting principles offer you an in-depth view of the costs that you’ve incurred and the way your investors, creditors, and other people see them.

Accounting principles help you analyze how you spend your funds, whether you are making wise decisions, and if there is any scope for improvement.

Flexibility

You can use accounting principles in a variety of situations. The matching principle, for example, states that you should match revenues and costs in the accounting period in which they occur, whether or not cash is received.

You will be glad to know that this principle can be easily used in any kind of business organization, whether it is health care, leasing, or banking. This is because all businesses incur expenditure and earn revenues. You can also use accounting principles and standards for unexpected transactions.

Boost Stakeholder's Confidence and Trust

Keep in mind that presenting your financial information using accounting principles also helps instill trust and confidence in people and entities with an interest in your business. You may know that there are several possible ways to manipulate or misstate the financial information of your business. Also, many times, just a simple change in the way you present things can change the face of your financial statements.

Remember that these changes and modifications can cause the readers to interpret the financial statements differently than if these modifications and changes were not made.

One of the best things about complying with accounting principles is that it gives assurance to anybody interested in your business that your financial statements, such as the balance sheet, were prepared using standard rules and guidelines.

Comparisons

Businesses that use accounting concepts and principles can easily and quickly compare their financial statements with other companies in the industry that are using the same set of principles. Note that this is simply because these businesses have and follow a common guideline for preparing financial statements.

It is worth noting that comparisons, financial and operational, are essential. This is because they help your business gauge its financial performance with other businesses in the industry and rectify where you are going wrong. Also, inter-period comparisons show performance trends from one period to the other.

Final Thoughts

The field of financial accounting is complex and vast. However, by understanding and appreciating these basic accounting principles and rules, you will get better insights into your business’s financial processes.

Also, by learning and understanding these accounting principles as well as adhering to them, you will be in a position to communicate more effectively and efficiently with your accountant or bookkeeper.

Note that the current set of principles, such as the accrual principle, which accountants use usually rests on some underlying assumptions, such as the separate entity assumption. And the basic principles and assumptions presented above apply to most financial statements.  

However, you should know that not every business organization is mandated by law to comply with accounting principles and GAAP.  Most accountants will, however, insist on following these accounting principles in order to ensure that there is never any question or doubt about the integrity and reliability of your financial statements.

Charles Hall

Charles Hall

Charles has spent 25 plus years in the world of accounting and business. His experience includes working as a CPA/Auditor international accounting firms. He has worked as a controller and as a COO for small to medium sized companies.

Learn more about Charles Hall