Accounting Principles

There are general rules, guidelines and concepts in every field of study, accounting is no different. Accounting principles are accounting standards or rules that have been generally accepted. Based on these rules, accounting takes place and financial statements are made. If a company reports its financial statements to the public, it is expected to follow GAAP (Generally Accepted Accounting Principles) while preparing its financial statements.

Without the GAAP, companies would be free to decide for themselves what and how to report their financial information, making things quite difficult for investors and creditors who have invested in that company. GAAP makes a company’s financials comparable and understandable for investors, creditors and others to make intelligent decisions.

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Principle of Income Recognition

It is also called the Revenue recognition concept. According to this concept, the income is considered to be earned on the date it is realized. In layman terms, income is considered as earned on the date when goods or services are transferred to a customer for cash or for a promise (credit). The terms of a contract between the buyer and the seller determines a point of sale. Generally, a sale is said to have been completed & ownership is considered to be transferred when goods are delivered to the buyer by the seller.

Key Highlights

  • It doesn’t matter when the cash is received for a particular transaction, the income will be recorded at the time of point of sale (POS).
  • Only revenue, which is realized, should be taken to the Income statement.

 

Example: Let us assume that a company Unreal Corporation sells goods worth 20,000 to one of its buyers in January, 2014, but gets paid for them in March, 2014. The income from this sale should be recorded in the month of January, when the goods were sold, and not in March. This is because a legal obligation was made in January.

A different example is when Unreal Corporation has received an advance for 20,000 in the month of January, 2014 from one of its buyers for sales to be made in July, 2014. Now, in this case, the income would only be recognized in the month of July and not in January as the legal obligation is made in July.


 

Dual Aspect Principle

Also known as the Duality Principle, it is the most basic feature of an accounting transaction and is embodied in the double entry system itself. This is linked to the business separate entity concept as business is a separate, independent entity, it receives benefits from some and gives benefits to some others. Benefits received and benefits provided should always match and balance out. Every transaction will have two aspects, a debit and a credit, of equal amounts.

 

Example: Let’s assume that Mr Unreal starts business with 10,00,000 and buys a vehicle for 2,00,000 for official purpose. The current financial position of the business would be as follows:

 

Balance Sheet
 Liabilities  Assets
 Capital 10,00,000 Vehicle  2,00,000
 Cash  8,00,000
 10,00,000  10,00,000

 

The total liabilities are equal to the total assets. This is the dual aspect principle of accounting.

There were 2 aspects of each transaction mentioned in the example:

1. On one hand, the business gets an asset for 10,00,000 and on the other hand, has a liability of 10,00,000 towards Mr Unreal (Capital).

2. The second transaction, where Mr Unreal buys a vehicle for business priced 2,00,000, also has two effects: on one hand, it brings in an asset for 2,00,000 and on the other hand, it also reduces cash by 2,00,000 as a payment towards it.


 

Principle of Expenses

Expenses are not payments, a payment only becomes an expense when it is revenue in nature. It means that for a payment to be qualified as an expense, it has to be for consideration. All revenue expenses are transferred to the profit and loss account to ascertain profit or loss of the business undertaking. So, there are three different forms: revenue, expenses and capital payments. Revenue expenditure is charged against profits and is shown in the profit and loss account. However, capital payments are shown in the balance sheet as assets.

 

Example Wages Paid is an example of an expense, where vehicle purchased for official purpose is an example of a capital payment.


 

Modifying Principle

According to this principle, the cost of implementing a principle should not be more than the benefit derived from it. A cost and benefits analysis is necessary before applying the principle. If the cost is more than the benefit derived, then the principle should be modified. There should be flexibility in adopting a principle and the advantage out of the principle should over weigh the cost of implementing the principle.

 

One of the areas which governs the selection and application of an accounting policy is

  • Substance over form: Transactions and events should be accounted for and presented in accordance with their substance and financial reality and not merely with their legal form. In accounting, substance should normally take priority over form in deciding how a particular transaction should be recorded.

 

      Example: Hire-purchase transactions are based on the substance over form principle, it looks at the substance of the transaction and not its legal form. The purchaser can record the asset at its cash down price, while the payment for it can still happen as installments over a pre decided period of time.


 

Principle of Matching Cost and Revenue (Accruals)

The accrual or matching concept is an outcome of the periodicity concept. According to this principle, the expenses for an accounting period are matched against related incomes, instead of comparing the cash received and the cash paid. The revenue earned during a period is compared with the expenditure incurred to earn that income, whether the expenditure is paid in that period or not. This is called Accrual or the Matching Cost and Revenue Principle.

The principle is used to find exact profit earned for that period. It is also important to give a true and fair view of the profitability and the financial position of business.

 

Example

 Sales Revenue in 2013  10,00,000
 Expenses incurred in 2013  7,50,000
 Out of the above, expenses to be paid in  2014 are  1,50,000
   
 Net profit as per matching principle  10,00,000 – 7,50,000 =  2,50,000

 *Even if 1,50,000 is due in 2014, it will  still be considered as an expense for the year 2013.

 

Accruals are adjusted while preparing financial statements such as outstanding expenses, prepaid expenses, an accrued income, an income received in advance.


 

Materiality Principle

The concept of materiality is the basis for recognizing a transaction in the entire process of accounting. Important details of the financial status must be provided to all relevant parties, insignificant facts which don’t influence any decisions of the investors or any interested party need not be communicated. According to American Accounting Association, “an item should be regarded as material if there is a reason to believe that knowledge of the item would influence the decision of an informed investor“.

What is material or not depends on the nature and/or amount of item. For example, to make the accounting calculations manageable, amounts are rounded off to the nearest currency denomination. It all depends on judgement, there can’t be any hard and fast rule to determine if something is material or not. It also depends on the size of a business and this is usually measured in terms of a turnover rather than profit. Once a thumb rule has been established, it is important that it is maintained uniformly from period to period.

 

Example  1000 spent in an office on stationery may be material for a business with a turnover of 1,50,000 a year. However, the same amount may not be material for another business making 1,50,000,000 as an annual turnover.


 

Historical Cost Principle

Also known as Cost Principle. According to this principle, an asset is recorded in books of accounts at the price paid to acquire it. The cost thus recorded is the basis on which asset is later accounted. An asset is recorded at the cost price during the time of purchase, but is consistently reduced in value by charging depreciation. In layman terms, an asset is recorded at its cost and this cost becomes the basis for all further accounting related to that asset.

This principle helps in achieving uniform accounting records under the condition of stable price. However, under the condition of inflation, this cost concept doesn’t provide a true picture of a business. This led to the rise of the Inflation accounting.

 

Example  In case there is a piece of land that was bought for 10,00,000, it will continue to be shown at the same price in financial statements regardless of current or the future market value. It could be a case that the value of land is now appreciated to 10,50,000, however, it will still be shown at 10,00,000 only.


 

Full Disclosure Principle

Full disclosure means the act of fully making something evident. According to this principle, a business enterprise should disclose all the relevant information to all the relevant parties concerned with the business. Any significant matter affecting the financial statement should be disclosed. This principle defines that there should be understandable and complete reporting. The information of substance or of interest to an average investor will have to be disclosed in the financial statements.

Full disclosure is needed in cases where alternative options are available. For example, methods of depreciation such as straight line or diminishing value method, another example is LIFO/FIFO, etc. This principle helps in maintaining the relevance and reliability of financial statements. Even the company’s act 1956 requires that the income statement and the balance sheet of a company must give a fair and honest view of the state of affairs of the company.

 

Example

  1. Providing appending note to the financial statements is governed by this principle.
  2. Similarly, in case of low turnover, the reasons should be clearly disclosed.

In the both of the above examples, if the company fails to follow the standard guidelines, it would be considered as the concealment of material information and a violation of the full disclosure principle.


 

Principle Of Consistency

Consistency is one of the most sought for quality when it comes to performance. The same applies to a company’s operations. According to this principle, accounting practices once adopted should remain consistent, they are expected not to be changed. It is possible to adopt a variety of principles and procedures for business transactions. There are several areas in accounting where alternatives are present, for example straight line vs written down value methods of depreciation, valuation of closing stock, etc.

So, no matter which accounting approach a business follows, it should be kept consistent so that financial statements are comparable between different accounting periods. It should not be confused as a permanent or “Whatever-happens-it-can-not-change” type of principle. The accounting practices may be changed if the law demands, according to the accounting standard or in case it helps in a much better and meaningful demonstration of facts. In case a change occurs, it should be clearly mentioned and justified to the concerned authorities.

 

Example If a company applies the straight line method of depreciation to its fixed assets, it should be consistent in all the accounting periods and should not change to diminishing value or another depreciation method.


 

Principle of Conservatism or Prudence

According to the principle of conservatism, accountants follow the rule “anticipate no profits, but provide for all possible losses”. Whenever a risk is anticipated, a sufficient amount should be kept aside to create a provision. This principle also requires that assets and profits should not be overstated. The value of investments for that matter are taken at cost, even if the market value is higher.

This principle helps to demonstrate the true picture of a business and ensure that a business is not window-dressed to deceive investors and other accounting information users.

 

Example In case of evaluation of closing stock, it is valued at cost value or net realizable value whichever is less. This is to ensure that prudence and no profits are anticipated until a sufficient evidence of the realization of profits is available.