Financial Accounting

What are fundamental accounting principles?

Accounting is a necessary component of any organisation, regardless of its size. Corporate and accounting are inextricably linked in today’s business requirements.

Accounting assists in determining the financial success of an organisation by creating financial statements. These financial statements are used by internal as well as external stakeholders such as investors, tax authorities, regulators, and banks.

Assume that if each organisation generates financial statements in their own unique manner, we will all end up with hundreds of thousands of different financial statement forms all attempting to express the same information. This makes it very impossible for a corporation to compare and interpret the financial statements of other companies.

As a result, financial data is rendered useless. This is why accounting principles contribute to bridging the divide and attempting to achieve some sort of consistency in financial reporting.

fundamental accounting principles

Accounting Principles

The term “accounting principle” refers to generally accepted accounting principles or procedures for recording financial transactions and generating financial statements. Accounting principles serve as the bedrock upon which financial statements are recorded and prepared. Accounting principles are frequently abbreviated as ‘Generally Accepted Accounting Principles (GAAP)’.

Accounting principles contribute to the standardisation of accounting and financial statement preparation and are widely followed worldwide. While each country’s regulators and authorities may have their own accounting principles, such as UK GAAP, US GAAP, or IFRS, the fundamentals and objectives of accounting principles remain the same.

The accounting policies a firm follows rest on certain fundamental principles. They are:

The Going Concern Assumption

The assumption underlying the going concern concept is that a company will continue to function indefinitely. Assets acquired for long-term use should be reported at their historical cost, regardless of whether the current market value exceeds or falls below the original cost.

When expenses are paid in advance, they should be recorded as an asset. In the case that a company is nearing its demise, this information should be mentioned in its financial accounts. Accounting procedures should be modified to meet a company’s unique requirements in liquidation.

Under the going concern assumption, a common time frame might be twelve months. However, one should presume the business is doing well enough to continue operations unless there is evidence to the contrary. For example, a business might have certain expenses that are paid off (or reduced) over several periods. If the business stays operational in the foreseeable future, the company can continue to recognize these long-term expenses over several periods. Some red flags that a business may no longer be a going concern are defaults on loans or a sequence of losses.

Consistency

The company applies the accounting policies it has adopted consistently. Like transactions and events are accounted for in the same way from one period to the next. This increases users’ confidence in a firm’s accounts and allows them to make inter-period comparisons.

Prudence

The financial statements are prepared on a prudent basis. More specifically, profits are only recognised in the income statement when they are ‘realised’ or ‘realisable’, that is, when cash or claims to cash are received. In addition, prudence requires liabilities and potential losses to be provided for as soon as they arise.

The Accruals Concept

A company recognises revenues and expenses in the period they occur. This may not coincide with the date of cash receipt or payment. The ‘matching principle’ illustrates the accruals concept at work: the expense of a sale (cost of goods sold) is recognised in the same period as the revenue from it. Note that if prudence and the accruals
concept conflict, prudence usually takes precedence.

How did these principles arise? Although they are set down in commercial and tax codes in many countries, their origins are found in long-accepted business practices. Consider the timing of revenue recognition under accrual accounting. The practice of recognising revenue at the time of delivery – the dominant practice in the case of goods – took hold for legal and practical reasons.

Legal title is usually transferred when the buyer receives the goods. In addition, shipment prompts changes to the seller’s books: a shipping note and invoice are issued, and the inventory records are adjusted, too. Recognising sales revenue minimises the number of entries the seller must make to its records.

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