Accounting principles

An accounting principle is a belief that certain doctrines are desirable and should be followed by members of the accounting profession. In contrast to a convention, which is an accepted practice or procedure, a principle requires accountants to exercise professional judgement in applying specific principles.

  • Cost principle
    • From an accountant’s point of view, the term “cost” refers to the amount spent (cash or the cash equivalent) when an item was originally obtained, whether that purchase happened last year or thirty years ago. For this reason, the amounts shown on financial statements are referred to as historical cost amounts. The cost principle requires that all transactions of a business entity are recorded and shown in financial reports at the original cost to the enterprise.
  • Realization principle
  • With this principle, accounts recognize transactions (and any profits arising from them) at the point of sale or transfer of legal ownership – rather than just when cash actually changes hands. For example, a company that makes a sale to a customer can recognize that sale when the transaction is legal – at the point of contract. The actual payment due from the customer may not arise until several weeks (or months) later – if the customer has been granted some credit terms.
  • Matching Principle
  • The matching principle defines when an expense should be recognized. It requires that in any period when revenue is recognized, the expense incurred in generating that revenue should be recognized. In other words, the expenses should be matched to and charged against the revenues in the same accounting period as the revenues are recognized. Some expenses reflect a direct cause-and-effect relationship where revenue and expense occur simultaneously. These expenses are usually called direct expenses which can be related directly and specifically to a particular revenue. Examples are cost of goods sold, sales commission expense, and delivery expense, etc., but, in practice, quite a lot of expenses cannot be matched to particular revenue in that direct way. Examples are depreciation, shop rent, etc., which is usually referred to as indirect expenses. In such case, the matching is done on a time basis. That is to say that the expenses for the period are related to the period rather than to specific revenues.
  • Full disclosure Principle
  • If certain information is important to an investor or lender using the financial statements, that information should be disclosed within the statement or in the notes to the statement. It is because of this basic accounting principle that numerous pages of “footnotes” are often attached to financial statements.
  • As an example, let’s say a company is named in a lawsuit that demands a significant amount of money. When the financial statements are prepared it is not clear whether the company will be able to defend itself or whether it might lose the lawsuit. As a result of these conditions and because of the full disclosure principle the lawsuit will be described in the notes to the financial statements.
  • A company usually lists its significant accounting policies as the first note to its financial statements.
  • The full disclosure principle requires the disclosure in the financial reports of a business of all important information that may influence the decisions of users of these reports. For example, a change in the method of valuing assets would be of vital concern to parties providing finance to or investing in the business.
  • Conservatism Principle (Prudence Principle)
  • According to the conservatism principle, the accountant will take risk into consideration by recognizing both expenses and liabilities when there is some reasonable probability of some adverse event occurring.
  • On the other hand, the accountant will recognize revenues and assets only when there is virtual certainty of an advantageous event occurring. More specifically it means that suspected but uncertain losses should be anticipated.
  • This principle is a prudent reaction to uncertainty and is adopted in order to ensure that adequate consideration is given to all inherent business risks.
  • Consistency Principle
  • Transactions and valuation methods are treated the same way from year to year, or period to period. Users of accounts can, therefore, make more meaningful comparisons of financial performance from year to year. Where accounting policies are changed, companies are required to disclose this fact and explain the impact of any change.
  • Understandability Principle
  • This implies the expression, with clarity, of accounting information in such a way that it will be understandable to users – who are generally assumed to have a reasonable knowledge of business and economic activities
  • Relevance Principle
  • This implies that, to be useful, accounting information must assist a user to form, confirm or maybe revise a view – usually in the context of making a decision (e.g. should I invest, should I lend money to this business? Should I work for this business?)
  • Comparability Principle
  • This implies the ability for users to be able to compare similar companies in the same industry group and to make comparisons of performance over time. Much of the work that goes into setting accounting standards is based around the need for comparability.
  • Reliability Principle
    • This implies that the accounting information that is presented is truthful, accurate, complete (nothing significant missed out) and capable of being verified (e.g. by a potential investor).
  • Objectivity Principle
    • This implies that accounting information is prepared and reported in a “neutral” way. In other words, it is not biased towards a particular user group or vested interest