Entity
Accounts are kept for entities and not the people who own or run the
company. Even in proprietorships and partnerships, the accounts for the
business must be kept separate from those of the owner(s).
Money-Measurement
For
an accounting record to be made it must be able to be expressed in monetary
terms. For this reason, financial statements show only a limited picture
of the business. Consider a situation where there is a labor strike
pending or the business owner’s health is failing; these situations have a huge
impact on the operations and financial security of the company but this
information is not reflected in the financial statements.
Going
Concern
Accounting assumes that an entity will continue to operate indefinitely.
This concept implies that financial statements do not represent a company’s
worth if its assets were to be liquidated, but rather that the assets will be
used in future operations. This concept also allows businesses to spread
(amortize) the cost of an asset over its expected useful life.
Cost
An asset (something that is owned by the company) is entered into the
accounting records at the price paid to acquire it. Because the “worth”
of an asset changes over time it would be impossible to accurately record the
market value for the assets of a company. The cost concept does recognize
that assets generally depreciate in value and so accounting practice removes
the depreciation amount from the original cost, shows the value as a net
amount, and records the difference as a cost of operations (depreciation
expense.) Look at the following example:
Truck
$10,000 purchase price of the truck
Less depreciation$ 1,000 amount deducted as a
depreciation expense
Net Truck: $
9,000 net book-value of the truck
The $9000
simply represents the book value of the truck after depreciation has been
accounted for. This figure says nothing about other aspects that affect
the value of an item and is not considered a market price.
Dual
Aspect
This concept is the basis of the fundamental accounting equation:
Assets = Liabilities + Equity
- Assets are what
the company owns.
- Liabilities are
what the company owes to creditors against those assets
- Equity is the
difference between the two and represents what the company owes to its
investors/owners.
All accounting
transactions must keep this equation balanced so when there is an increase on
one side there must be an equal increase on the other side or an equal decrease
on the same side.
Objectivity
The objectivity concept states that accounting will be recorded on the basis of
objective evidence (invoices, receipts, bank statement, etc…). This means that
accounting records will initiate from a source document and that the
information recorded is based on fact and not personal opinion.
Time Period
This concept
defines a specific interval of time for which an entity’s reports are
prepared. This can be a fiscal year (Mar 1 – Feb 28), natural year (Jan 1
– Dec 31), or any other meaningful period such as a quarter or a month.
Conservatism
This requires understating rather than overstating revenue (income) and expense
amounts that have a degree of uncertainty. The rule is to recognize
revenue when it is reasonably certain and recognize expenses as soon as they
are reasonably possible. The reasons for accounting in this manner are so
that financial statements do not overstate the company’s financial
position. Accounting chooses to err on the side of caution and protect
investors from inflated or overly positive results.
Realization
Revenues are recognized when they are earned or realized. Realization is
assumed to occur when the seller receives cash or a claim to cash (receivable)
in exchange for goods or services. This concept is related to
conservatism in that revenue (income) is only recorded when it actually occurs
and not at the point in time when a contract is awarded. For instance, if
a company is awarded a contract to build an office building the revenue from
that project would not be recorded in one lump sum but rather it would be
divided over time according to the work that is actually being done.
Matching
To avoid overstatement of income in any one period, the matching principle
requires that revenues and related expenses be recorded in
the same accounting period. If you bill $20,000 of services in a month,
in order to accurately represent the income for the month you must report the
expenses you incurred while generating that income in the same month.
Consistency
once an entity decides on one method of reporting (i.e. method of accounting
for inventory) it must use that same method for all subsequent events.
This ensures that differences in financial position between reporting periods
are a result of changed in the operations and not to changes in the way items
are accounted for.
Materiality
accounting practice only records events that are significant enough to justify
the usefulness of the information. Technically, each time a sheet of
paper is used, the asset “Office supplies” is decreased by an infinitesimal
amount but that transaction is not worth accounting for.
By understanding and applying these
principles you will be able to read, prepare, and compare financial statements
with clarity and accuracy. The bottom-line is that the ethical practice
of accounting mandates reporting income as accurately as possible and when there
is uncertainty, choosing to err on the side of caution.
Income is the payment you receive for your time, services you provide, or the use of your money.