What are accounting Principles?
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Answer Posted / cool
1. Economic Entity Assumption :
The accountant keeps all of the business transactions
of a sole proprietorship separate from the business owner's
personal transactions. For legal purposes, a sole
proprietorship and its owner are considered to be one
entity, but for accounting purposes they are considered to
be two separate entities.
2. Monetary Unit Assumption :
Economic activity is measured in U.S. dollars, and
only transactions that can be expressed in U.S. dollars are
recorded.
Because of this basic accounting principle, it is assumed
that the dollar's purchasing power has not changed over
time. As a result accountants ignore the effect of
inflation on recorded amounts. For example, dollars from a
1960 transaction are combined (or shown with) dollars from
a 2010 transaction.
3. Time Period Assumption :
This accounting principle assumes that it is
possible to report the complex and ongoing activities of a
business in relatively short, distinct time intervals such
as the five months ended May 31, 2010, or the 5 weeks ended
May 1, 2010. The shorter the time interval, the more likely
the need for the accountant to estimate amounts relevant to
that period. For example, the property tax bill is received
on December 15 of each year. On the income statement for
the year ended December 31, 2010, the amount is known; but
for the income statement for the three months ended March
31, 2010, the amount was not known and an estimate had to
be used.
It is imperative that the time interval (or period
of time) be shown in the heading of each income statement,
statement of stockholders' equity, and statement of cash
flows. Labeling one of these financial statements
with "December 31" is not good enough—the reader needs to
know if the statement covers the one week ending December
31, 2010 the month ending December 31, 2010 the three
months ending December 31, 2010 or the year ended December
31, 2010.
4. 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.
Because of this accounting principle asset amounts
are not adjusted upward for inflation. In fact, as a
general rule, asset amounts are not adjusted to reflect any
type of increase in value. Hence, an asset amount does not
reflect the amount of money a company would receive if it
were to sell the asset at today's market value. (An
exception is certain investments in stocks and bonds that
are actively traded on a stock exchange.) If you want to
know the current value of a company's long-term assets, you
will not get this information from a company's financial
statements—you need to look elsewhere, perhaps to a third-
party appraiser.
5. 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.
6. Going Concern Principle :
This accounting principle assumes that a company
will continue to exist long enough to carry out its
objectives and commitments and will not liquidate in the
foreseeable future. If the company's financial situation is
such that the accountant believes the company will not be
able to continue on, the accountant is required to disclose
this assessment.
The going concern principle allows the company to
defer some of its prepaid expenses until future accounting
periods.
7. Matching Principle :
This accounting principle requires companies to use
the accrual basis of accounting. The matching principle
requires that expenses be matched with revenues. For
example, sales commissions expense should be reported in
the period when the sales were made (and not reported in
the period when the commissions were paid). Wages to
employees are reported as an expense in the week when the
employees worked and not in the week when the employees are
paid. If a company agrees to give its employees 1% of its
2010 revenues as a bonus on January 15, 2011, the company
should report the bonus as an expense in 2010 and the
amount unpaid at December 31, 2010 as a liability. (The
expense is occurring as the sales are occurring.)
Because we cannot measure the future economic
benefit of things such as advertisements (and thereby we
cannot match the ad expense with related future revenues),
the accountant charges the ad amount to expense in the
period that the ad is run.
8. Revenue Recognition Principle :
Under the accrual basis of accounting (as opposed to
the cash basis of accounting), revenues are recognized as
soon as a product has been sold or a service has been
performed, regardless of when the money is actually
received. Under this basic accounting principle, a company
could earn and report $20,000 of revenue in its first month
of operation but receive $0 in actual cash in that month.
For example, if ABC Consulting completes its
service at an agreed price of $1,000, ABC should recognize
$1,000 of revenue as soon as its work is done—it does not
matter whether the client pays the $1,000 immediately or in
30 days. Do not confuse revenue with a cash receipt.
9. Materiality :
Because of this basic accounting principle or
guideline, an accountant might be allowed to violate
another accounting principle if an amount is insignificant.
Professional judgement is needed to decide whether an
amount is insignificant or immaterial.
An example of an obviously immaterial item is
the purchase of a $150 printer by a highly profitable multi-
million dollar company. Because the printer will be used
for five years, the matching principle directs the
accountant to expense the cost over the five-year period.
The materiality guideline allows this company to violate
the matching principle and to expense the entire cost of
$150 in the year it is purchased. The justification is that
no one would consider it misleading if $150 is expensed in
the first year instead of $30 being expensed in each of the
five years that it is used.
Because of materiality, financial statements usually
show amounts rounded to the nearest dollar, to the nearest
thousand, or to the nearest million dollars depending on
the size of the company.
10. Conservatism :
If a situation arises where there are two
acceptable alternatives for reporting an item, conservatism
directs the accountant to choose the alternative that will
result in less net income and/or less asset amount.
Conservatism helps the accountant to "break a tie." It does
not direct accountants to be conservative. Accountants are
expected to be unbiased and objective.
The basic accounting principle of conservatism
leads accountants to anticipate or disclose losses, but it
does not allow a similar action for gains. For example,
potential losses from lawsuits will be reported on the
financial statements or in the notes, but potential gains
will not be reported. Also, an accountant may write
inventory down to an amount that is lower than the original
cost, but will not write inventory up to an amount higher
than the original cost.
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