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Principles of Accounting
I would like to share with you the five basic principles of accounting, followed by an example each. I hope this answer enhance your basic accounting knowledge.
This principle states that the organization has a separate entity apart from its owner. Every accountant should consider business as distinct from its owner. This means business transactions must be recorded in business books of accounts and the owner’s transactions in his books of accounts.
For Example- Company A started a watch business by investing 1,00,000 with which he purchased raw materials for 40,000 and maintained balance in hand. He further withdrew in 8,000 for his personal use from the business.
As per the business entity principle, his capital invested will get reduced by 8,000 and these expenses should not be treated as business expenses. Now the business owes 92,000 to the owner.
The accrual principle states that the effects of transactions and events are identified at the time when they occur (say mercantile basis) and not on cash or cash equivalent either received or paid. The accrual principle records total revenue generated. Revenue includes gross inflow of cash, receivables and other consideration arising out of business activities.
For Example- Mr Alex started a Jute business. He invested 10,00,000, bought raw materials for the manufacturing of Jute bags for 6,00,000. He manufactured 50,000 Jute bags and sold the same for 8,00,000 to ABC Ltd. ABC Ltd. paid in 5,00,000 in cash and assured him to pay the rest of the amount in future.
As per the accrual principle, the total revenue of Alex is 8,00,000 (say 5,00,000 from cash and 3,00,000 by way of receivables).
Going Concern Principle
Going concern principle states that the business has a long fair life and it continues its operations until it is legally wound up in the foreseeable future. Hence it is presumed at the organization has neither the intention to shut nor the need to liquidate.
For Example- Standard Chartered Bank will close one of its bank branches in the middle east for the sake of improving its profitability and performance.
As per the going concern principle, Standard Chartered Bank will keep continuing its operations because closing down of a small portion of the business doesn’t affect the capability of the bank.
The cost principle states that assets must be valued at historical cost (say the acquisition cost). If the machinery is acquired by paying 1,00,000 then the acquisition cost of the machinery is 1,00,000. It is highly objective and free from all biases.
For Example- Company B purchases a motor van for 3,00,000. The market value of the motor van is 2,50,000. At the time of preparation of the balance sheet, the motor-van must be valued at 3,00,000.
As per the cost principle, it is clear that motor van must be valued at cost and not at market value.
Conservatism principle states that never anticipate future income and should account for all the possible losses. When there are various alternatives available for the valuation of the closing stock then the accountant should opt for that method that provides lesser value.
For Example- At the time of preparation of final accounts, the value of closing inventory shown in the books is 5,00,000. Net realisable value is 2,50,000.
As per the conservatism principle, closing inventory must be valued at cost price or net realisable value whichever is lower. Therefore, Closing stock must be shown at 2,50,000 in the books of accounts.