Principles of Accounting- What & Why ???

Accounting is a consistent method of organizing information that makes it possible for you to compare results across periods and industries. If you think of money as the currency of business, then accounting is the language of business. It is this common language that allows you to have confidence in making decisions and forming relationships that are at the heart of every successful business. But what are the grammar of this language of business? The basic principles of accounting are essentially the general decision rules, which govern the development of accounting technique. On the basis of these assumptions of accounting, the following basic principles of accounting have been developed:

1.      Accounting Entity Principle:

 Accountants treat a business as distinct from the persons who own it. Then, it becomes possible to record the transactions of the business without the proprietor also. The concept of separate business entity is applicable for all types of organizations like sole proprietorship, partnership etc. where the business affairs are free from the private affairs of the proprietor or partner. 

2. Going Concern Principle:

It is assumed that the business will exist for a long time and transactions are recorded from this point of view. Based on this concept, the accountants, while valuing assets, will not consider the forced sale value of assets (market value), but the assets, normally, will be reflected at the cost of acquisition minus depreciation. Similarly, depreciation is provided based on the expected life of the assets. The concept, however, does not imply the permanent continuance of the business. The underlying presumption is that the business will continue in operations long enough to charge against income the cost of fixed assets over their economic lives and to pay the liabilities when they fall due. This concept is applicable to the business as a whole and not for a particular division or branch. Merely closing of a branch or division may not adversely affect the ability of the enterprise to continue other businesses normally. Once the business goes in to liquidation or becomes insolvent, this concept does not apply. In other words, the going concern status of the concern will stand terminated from the date of appointment of a receiver.

3. Accounting Period Principle:

According to this concept, the life of a business is divided into appropriate segments of time, say 12 months, for studying the results. While the life of a business is considered to be indefinite, according to the going concern concept, the measurement of income and studying the financial position of the business after a very long time would not be helpful in taking corrective steps at the appropriate time. Therefore, it is necessary that after each segment of time interval the management should review the performance. The segment of time interval is called accounting period, which is usually a year. At the end of each accounting period, an income statement and a balance sheet is prepared. The income statement discloses the profit or loss made by the business during an accounting period. The balance sheet discloses the state of affairs of the business as on the last date of the accounting period. The term “conventions” includes those customs or traditions, which guide the accountants while preparing the accounting statements.

4. Cost Principle:

Transactions are entered in the books of account at the amounts actually involved. An asset is ordinarily recorded at a price at which it has been acquired. For example, a plot of land purchased by a firm for Tk. 5,00,000 would be recorded at this value irrespective of its current market price. Cost concept has the advantage of bringing objectivity in the presentation of the financial statements. In the absence of this concept, the figures shown in the accounting records would have to depend on the subjective view of a person. 

5. Realization Principle:

Accounting is a historical record of transactions. It only records what has happened. It does not anticipate events, though anticipated adverse effects of events that have already occurred are usually recorded. For example, A places an order on B for supply of certain goods. Upon receipt of the order, B procures raw material, employs labor, and produces and delivers the goods to A. In this case, the sale transaction will be recorded in the books of B only when the goods are delivered and not upon the receipt of an enforceable purchase order from A.

There are certain exceptions to this concept, which are as follows:

                   

1. In the case of hire-purchase transaction, the ownership of the goods passes on to the buyer only when the last installment is paid, but sales presume to have been made to the extent of installments received and installments outstanding (installments due but not received).

2. In the case of contract accounts, though the contractor is liable to pay only when the whole of contract is completed as per terms of the contract, the profit at the end of accounting year is calculated on the basis of the work completed and certified by a competent authority.

6. Expenses Recognition Principle:

Cost is the total outlay or expenditure on acquiring resources required for the production of goods or rendering of services. Cost of resources utilized and lost during a particular period is termed as the expired cost or expense and is charged to the revenue of the period to obtain information about income. Costs of the resources remaining unutilized or un-expired at the end of the period are carried forward to the next accounting period and are termed as assets.

7. Dual Aspect Principle:

Each transaction has two aspects. With every increase in the money owned to others, there should be an increase in assets or loss. Thus, at any time the accounting equations is as follows:

Assets = Liabilities + Capital, or alternatively, Capital = Assets - Liabilities

For example, a proprietor brings in Tk. 1,00,000 in cash as capital to start a small business. Tk. 1,00,000 is the capital and corresponding amount of Tk. 1,00,000 will appear as cash in hand (assets). 

8. The Matching Principle:

In determining the net income, it is necessary to match related costs and expenses to revenue for the reporting period. The cost of a product sold and all expenses incurred in generating the sale should be matched against the respective revenue.

This concept is basically an accrual concept since it disregards the timings and the amount of actual cash inflow or cash outflow and concentrates on the occurrence of revenue and expenses.

This concept calls for adjustments to be made in respect of prepaid expenses, outstanding expenses, accrued revenue and un-accrued revenue. Thus, appropriate costs have to be matched against the appropriate revenue for the accounting period.

9. Objectivity Principle:

According to this principle, the accounting data should be definite, verifiable and free from personal bias of an accountant. In other words, this principle requires that each recorded transaction/events in the books of accounts should have an adequate evidence to support it.

In historical cost accounting, the accounting data are verifiable since the transactions are recorded on the basis of source documents such as vouchers, receipts, cash memos, invoices and the like. The supporting documents form the basis of their verification by auditors afterwards.

For items like depreciation and the provisions for doubtful debts where no documentary evidence is available, the policy statement made by the management is treated as the necessary evidence.

10. Materiality Principle:

According to this convention, the accountant should attach importance to material details and ignore insignificant details. This is because otherwise accounting will be unnecessarily overburdened with minute details. The question “what constitutes material details” is left to the discretion of the accountant. Moreover, an item may be material for one purpose while immaterial for another. The term materiality is a subjective term. The accountant should regard an item as material if there is a reason to believe that knowledge of it would influence decision of the informed investor. According to Kohler, “Materiality means characteristic attaching to a statement, fact or item whereby its disclosure or method of giving it expression would be likely to influence the judgment of a reasonable person”.

11. Full Disclosure Principle:

According to this principle, the financial statements should act as a means of conveying and not concealing. It means that the financial statements should disclose all the relevant and reliable information, which they purport to represent, so that the information may be useful for the users.

The practice of appending notes to the financial statements has developed as a result of the principle of full disclosure. The disclosure should be full, fair and adequate so that the users of the financial statements can make correct assessments about the financial performance and position of the enterprise.

The changes, which have a significant impact on the accounts, should be disclosed. For accurate interpretation, the accounting reports should include financial statements and accompanying notes. Accompanying notes should be included to call attention toward events and circumstances that may have significant effect on potential future earnings and/or a company’s position, e.g., future take over or merger taking place.

12. Consistency Principle:

The accounting practices should remain the same from one year to another. For example, consistency in valuation of stock, in trade or in method of charging depreciation. If the stock has been valued by adopting the principle of cost or market value, whichever is less, the same principle has to be consistently followed year after year. Similarly, the method of charging depreciation, either straight line or written down value method, has to be consistently followed. This is necessary for the comparison of results. However, consistency does not mean inflexibility. In the case of change in law or from the point of view of improved reporting, this convention is broken and then adequate disclosure, as to the impact on the profit due to such change, has to be mentioned in the notes appended to the accounts.

13. Conservatism Principle:

Financial statements are usually drawn up on a conservative basis, especially in the initial stages when the anticipated profits, which were accounted, did not materialize. This results in less acceptability of accounting figures by the end-users. Therefore, accountants follow the rule “anticipate no profits but provide for all possible losses.” Similarly, based on this convention, the inventory is valued at cost or market price whichever is less. Necessary provision for bad and doubtful debts is made in the books of account. Window-dressing, i.e. showing a position better than what it is, is not permitted. It is also not proper to show a position substantially worse than what it is. In other words, secret reserves are not permitted. Therefore, this convention has to be applied with reasonable caution and care.

14. Stable Money Measurement Principle:

Accounting records normally those transactions, which are being expressed in monetary terms. Measurement of business events in monetary terms helps in understanding the state of affairs of the business in a much better way. For example, if a business owns two factory buildings, five lathe machines and Tk. 1,00,000 as cash at bank, we cannot add these numbers so as to produce a meaningful result. However, if we say the value of two factory buildings is Tk. 10,00,000, the value of five lathe machines is Tk. 5,00,000 and cash of Tk. 1,00,000, we can add these values and say that the value of assets owned by the business is Tk. 16,00,000. This is definitely informative and useful. 

You can rely on the principles of accounting to help eliminate the guesswork from almost every important business decision that you make.

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