Let’s take a look at very basic foundations of the accounting practice. It is important for accountants all over the world to follow the same accounting principles. In other words, Final Accounts ought to be based on the same basic concepts.
Otherwise, it would be impossible to make comparisons between Final Accounts from different firms based in different countries. It would also cause huge problems for multinational companies which operate in many countries around the world, if basic accounting principles in the home country are different from those in each foreign country.
The following brief explanation of these seven basic accounting concepts will help to make key accounting principles clearer.
1. Time period. This basic concept says that a business should report in Final Accounts all its financial activities and transactions over a standard period of time – usually monthly, quarterly and annually.
Profit and Loss Account (P&L Account) specific accounting principles
2. Matching. Matching says that Sales Revenue should be recorded during the period when it is earned regardless of when the business received Cash for that particular sale. And, Expenses should be reported in the same period in which the corresponding Sales Revenue was earned. Otherwise, there will be a mismatch and the users of the accounts cannot see how much it costed to generate certain Sales Revenue.
3. Revenue Recognition. Or, the realization concept. It says that all revenues and profits should be recorded in Final Accounts when the legal title to the product is transferred from the seller to the buyer. Meaning, that when the good or service have been provided to the customer. Not when the order was taken or when the cash was paid.
4. Conservatism. Accountants must be realistic about all the values used in Final Accounts. Profit should only be recorded when it is realized (when products have been sold already at a profit) to protect users of financial information from inflated Sales Revenue. Losses should be recorded as soon as they are anticipated to make sure that all potential liabilities are recorded as soon as possible.
5. Accruals. Accruals happen when the business received something, but has not yet paid for it. For example, raw materials had been supplied to the business, used to make products and the business already sold the products made from those supplied raw materials. If no adjustment was made on the Profit and Loss Account (P&L Account) for this accrued expense, then the Profit will be falsely exaggerated. Therefore, accruals add all of those unpaid Direct Costs and Indirect Costs (Overheads) to the Profit and Loss Account (P&L Account) of the current year to make the numbers more accurate.
Balance Sheet specific accounting principles
6. Double-entry. Double-entry means that every time a business engages in a business transaction, there are always two sides of this transaction – Debit and Credit. These two sides must be properly recorded and balanced to maintain correct information. For example, when a business sells ready products to customers for Cash, Inventory decreases and Cash increases on the Balance Sheet.
Cash-Flow Statement specific accounting principles
7. Money measurement. Money is a common form of storing wealth and measuring performance of businesses. And money is generally expressed as Cash. Simply, money is Cash – cash from regular business operations, cash from investing and cash from financing. All business transactions are converted into accounting data expressed in monetary terms and recorded in a business’s account books. If something cannot be measured using money, or Cash, it will simply not be recorded in Final Accounts.
Are there common accounting standards?
Simply, there are two main systems that set accounting standards and accounting principles. They are IFRS (International Financial Reporting Standards) and GAAP (Generally Accepted Accounting Principles). GAAP is present in the US while IFRS dominates in Europe and elsewhere.
Both GAAP and IFRS are the ground rules for financial reporting. They both provide a general framework for what financial information is included in Final Accounts and how it is presented. When in doubt, follow them. However, remember that new principles emerge continuously as accounting adapts to new business activities.
These standards aim to ensure that accounts produced by companies all over the world conform to similar terminology and layout. This helps to avoid confusion when analyzing accounts from companies based in different countries.
