Accounting is one of the significant parts of a business around which all financial decisions depend. Recording and accounting financial transactions to not only keep track of the company's revenues and expenses but also understand the overall financial health and performance.
However, if you do not have a clear knowledge of accounting principles, it may be difficult for you to record transactions and analyse the financials effectively. In this article, we will give you comprehensive detail on accounting principles and their importance for financial analysis.
What Are Accounting Principles?
Accounting principles are thecommon guidelines and rules relatedtoaccounting transactionsthat are followedto prepare financial statementssuccessfully. These principles are thefounding guidelinesfor preparing and recording financials for proper analysis. These accounting principles arealso known as Generally Accepted Accounting Principles or GAAP.
These principles guide accountants in financial analysis and ensure that the quality of financial information a company has is improved as efficiently as possible. Moreover, the rules prepare an accountant to develop error-free and consistent accounting data. It also helps organisational stakeholders to compare the financial data of different companies over the years.
Purpose of Accounting Principles
The main purpose of accounting principles is to guarantee that abusiness's financial recordings and statements are consistentand to the point. Accurate knowledge of accounting principles makes it easy for investors to extract and analyse necessary information from financial statements.
Furthermore, these rules helpmitigate any fraudarising in the accounting process, thus making business finances transparent. Any red flags in the company's finances get identified, making it easy to compare the details over a specific period.
Importance of Accounting Principle
There are a few reasons why accounting principles are considered important for a business. They are discussed as follows -
- The principles are important to prepare financial statements that are complete, consistent and fruitful.
- This concept determines the expenses, income, liabilities, profit, assets and losses for financial reporting.
- Accounting rules help to compare financial information and statements easily.
- Transparency in the financial system is maintained, and efficient detection of financial fraud is possible.
- The accounting principles allow investors to analyse and tally significant information to make financial decisions.
Types of Accounting Principles
There are a number of accounting principles that accountants and investors follow to implement appropriate financial processes and make informed decisions. The list is given below.
- Accrual Principle
Accounting'saccrual principlerecognisesincome and costswhen they are generated or spent, regardless of when cash is exchanged. It guarantees that a company's financial situation and performance are appropriately reflected in its financial statements at any given moment.
- Conservatism Principle
Theconservatism principledirects accountants to be cautious in recognisingpotential gains, only recognising themwhen realisedwhile recognisingpotential losses as soon as they are probable. This principle safeguards against over-optimistic reporting, promoting prudence in financial statements.
- Cost Principle
Assets are first documentedat their historical cost under thecost principle, assuring financial reporting dependability and impartiality. Adjustments for depreciation or impairment may occur in the future, but the concept prioritises actual transaction values.
- Revenue Recognition Principle
This principle dictates thatrevenue should be recognisedwhen it is bothearned and realisable. It ensures that revenue is not prematurely recognised and reflects the actual value a company has generated.
- Economic Entity Principle
Theeconomic entity principledistinguishesbetweenpersonal and business finances. It treats the firm as a separate accounting entity, limiting the mixing of personal and corporate assets and liabilities and improving financial transparency.
- Consistency Principle
Theconsistency principleencourages uniformity in accounting methods from one period to the next. Itpromotes comparability of financial statementsover time, allowing stakeholders to analyse trends and make informed decisions.
- Objectivity Principle
According to theobjectivity principle, financial information must be reliable and free of prejudice. It emphasises the need torely on objective evidence rather than human judgementsto ensure the trustworthiness of financial data.
- Going Concern Principle
Thegoing concern principleassumes that acompany will continue to operate indefinitelyunless there is substantial evidence to the contrary. It allows for the valuation of assets and liabilities as if the business will continue to operate, fostering realistic financial reporting.
Characteristics of Accounting Principles
Before implementing the different types of accounting principles in your accounting processes, it is important to know the characteristics of such principles. They are as follows.
- The set of rules focuses on bringing uniformity and easy understanding of different accounting information.
- The principles are not static in nature. It could change over time as per changes in government legislations, business practices and demands of accounting users.
- Accounting principles are generated as per reasons and experiences. They can vary in different business scenarios and are not applicable universally.
Features of Accounting Principles
There arethree main features of accounting principles. It is discussed below.
1. Usefulness
A Generally Accepted Accounting Principle (GAAP) will only be useful or relevant if it satisfies the requirements of its users. These principles provide necessary and required information to accountants or stakeholders.
2. Feasibility
The principles of accounting are applicable as required. If any cost continuously changes, suppose due to a change in market prices, it will be difficult for the bookkeeper to show them in the books. Hence, the rules of accounting are quite flexible in this regard.
3. Objectivity
Any rule can be justified objectively if it is based on accurate figures and facts. There are not any personal biases or external influences when it comes to incorporating accounting figures in the books; if there are, the usefulness of such values will become limited and may not be as per business requirements.
Limitations of Accounting Principles
Even though accounting principles are important during the bookkeeping process, there are certain limitations of the rules which can affect the company's financial recordings. Some major limitations of accounting principles are:
- The recordings are only measured in monetary value. Some events can affect a business's finances, but if it is not in terms of money, they are not accounted for.
- Accounting principles are treated as per 'time value of money' and maintained as per historical cost. The rule ignores current changes in values, which can fail to exhibit the proper financial position.
- Only past records can be accounted for. GAAP does not provide any scope of accounting or recording any future events that can affect business finances in some cases.
- A key limitation of the accounting principle is its importance of form over substance. This suggests that while preparing the accounts, importance is given to tables or forms and not to explanations of substantial information.
Conclusion
Overall, understanding accounting principles before implementing accounting processes in a business is important. It will help keep a smooth track of the finances and maintain transparency of financial events. Even if you are a novice accountant, make sure to have clear ideas of the types and characteristics of accounting principles to avoid errors in financial recordings and produce accurate results.
Frequently Asked Questions
What are accounting concepts and principles?
Accounting concepts and principles are a set of rules and assumptions that are necessary to set a standard while recording financial transactions as well as maintaining books of accounts in the business.
What are the 5 basic accounting principles?
The five basic accounting principles are as follows -
- Accrual principle
- Historic cost principle
- Matching principle
- Conservatism principle
- Going concern principle
