A Guide To Basic Accounting Principles

A Guide To Basic Accounting Principles

May 29, 2020 Bookkeeping 101 by ann

basic accounting principles

Basic accounting principles underly generally accepted accounting standards (GAAP), which are “principles-based”. The Financial Accounting Standards Board (FASB) codified “authoritative” Accounting Principles in ASC 105. GAAP is often used in financial reporting to present company financial statements to management, banks, and investors. Some small privately-held companies prepare their financial statements on a non-GAAP cash basis, primarily for tax reasons. Generally Accepted Accounting Principles (GAAP) are the guidelines adopted for recording and reporting of business transactions.

Accounting Principles (Explanation)

For example, if you ignored the accrual principle, you would record an expense only when you paid for it, which might incorporate a lengthy delay caused by the payment terms for the associated supplier invoice. Matching Principle is the accounting principle that uses to records and recognizes expenses and revenues in the financial statements.

The board wanted to create a standardized set of accounting practices in order for more transparency of financial records between publicly traded companies. Accounting principles are generally accepted only when enforced by law and the Securities and Exchange Commission (SEC) who regulates public companies, requires public companies to use GAAP. Private companies have also, for the most part, adopted these rules, largely due to pressure from lenders and investors so they have access to the information they need to make sound decisions.

Based on Joe’s business plan, Marilyn sees that there will likely be thousands of transactions each year. She states that accounting software will allow for the electronic recording, storing, and retrieval of those many transactions. Accounting software will permit Joe to generate the financial statements and other reports that he will need for running his business. Some of the basic accounting terms that you will learn include revenues, expenses, assets, liabilities, income statement, balance sheet, and statement of cash flows. You will become familiar with accounting debits and credits as we show you how to record transactions.

These rules bring uniformity in the preparation and the presentation of financial statements. Depending on the characteristics of a company or entity, the company law and other regulations determine which accounting principles they are required to apply. The standard accounting principles are collectively known as Generally Accepted Accounting Principles (GAAP). GAAP provides the framework foundation of accounting standards, concepts, objectives and conventions for companies, serving as a guide of how to prepare and present financial statements. At his first meeting with Marilyn, Joe asks her for an overview of accounting, financial statements, and the need for accounting software.

This introduces a conservative slant to the financial statements that may yield lower reported profits, since revenue and asset recognition may be delayed for some time. Conversely, this principle tends to encourage the recordation of losses earlier, rather than later. This concept can be taken too far, where a business persistently misstates its results to be worse than is realistically the case. This is the concept that accounting transactions should be recorded in the accounting periods when they actually occur, rather than in the periods when there are cash flows associated with them. It is important for the construction of financial statements that show what actually happened in an accounting period, rather than being artificially delayed or accelerated by the associated cash flows.

Monetary Unit Assumption is the accounting principle that concern about the valuation of transactions and event that entity records in its financial statements. In monetary unit assumption, transactions or even could records in the Financial Statements only if they could measure in the monetary. Materiality Principle or materiality concept is the accounting principle that concern about the relevance of information, and the size and nature of transactions that report in the financial statements.

You will also see why two basic accounting principles, the revenue recognition principle and the matching principle, assure that a company’s income statement reports a company’s profitability. This is the concept that you should record expenses and liabilities as soon as possible, but to record revenues and assets only when you are sure that they will occur.

Conservatism has long been a principle of accounting for recording transactions relating to estimates and uncertain future events. Conservatism results in recording unpredictable expenses and liabilities earlier than uncertain revenue and assets. An example transaction would relate to the future outcome of an existing lawsuit or threat of a lawsuit. When establishing financial accounting standards, the FASB may use neutrality (unbiased) rather than conservatism as a decision basis.

What are the 5 basic principles of accounting?

Revenue Recognition and the Matching Principle are reflected in the income statement, as revenues and costs or expenses are recorded. Conservatism is reflected when recording accruals relating to the impact of possible future events like expected or unresolved litigation. It is useful to discuss with the company’s auditors what constitutes a material item, so that there will be no issues with these items when the financial statements are audited.

Reporting the entire expense during the year of purchase might make the company seem unprofitable that year and unreasonably profitable in subsequent years. Once the time period has been established, accountants use GAAP to record and report that accounting period’s transactions.

This principle wants to make sure that the incomes and expenses in the income statement really reflected in the period that they actually incurred. And the expenses are recordings and recognized in the financial statements when the cash is an outflow from the entity. Accrual accounting concept has required the revenues and expenses to be recorded and recognized in the entity’s financial statements when they are incurred rather than when cash is paid or received. Accounting Principles are the principle, concept, basic, guidance, as well as the rule that use by the accountant to prepare the financial statements of an entity.

  • Conservatism has long been a principle of accounting for recording transactions relating to estimates and uncertain future events.
  • Conservatism results in recording unpredictable expenses and liabilities earlier than uncertain revenue and assets.

These rules are accounting standards and guidelines to help us make our financial statements (income statement, cash flow statement, balance sheet) more consistent, comparable, meaningful, and informative. Not every U.S based company is required to comply with GAAP, with the exception of publicly traded companies (or those that plan to someday).

Accounting Principles Outline

Completeness is ensured by the materiality principle, as all material transactions should be accounted for in the financial statements. When accounting principles allow choice between multiple methods, a company should apply the same accounting method over time or disclose its change in accounting method in the footnotes to the financial statements. This is the concept that the transactions of a business should be kept separate from those of its owners and other businesses. This prevents intermingling of assets and liabilities among multiple entities, which can cause considerable difficulties when the financial statements of a fledgling business are first audited.

Double-entry accounting is one of the most fundamental accounting principles around—all financial statements are based on it. It means that each recorded transaction (recording a sale, paying a bill, collecting payments) has equal yet opposite effects in at least two different accounts. GAAP is exceedingly useful because it attempts to standardize and regulate accounting definitions, assumptions, and methods. Because of generally accepted accounting principles we are able to assume that there is consistency from year to year in the methods used to prepare a company’s financial statements.

It is essential for the preparation of financial statements which show what really happened within an accounting period. Most businesses exist for long periods of time, so artificial time periods must be used to report the results of business activity. Depending on the type of report, the time period may be a day, a month, a year, or another arbitrary period. Using artificial time periods leads to questions about when certain transactions should be recorded. For example, how should an accountant report the cost of equipment expected to last five years?

This is because such information can be compared over a period of time while making decisions. Hence, a business needs to preparefinancial statementsthat are consistent and follow basic accounting principles. The basic accounting principles are typically referred to as Generally Accepted Accounting Principles (GAAP). These principles are developed to bring uniformity in the financial statements. This concept advocates that accounting transactions get recorded for the accounting time period when they actually happened.

Transactions are generally recorded on a going concern basis that assumes the business will continue operating. Unless otherwise indicated and disclosed, the assumption is that a company has the resources required to stay in business for the foreseeable future. The adequacy of cash flows, liquidity position, and ability to obtain additional financing impact the going concern status of a business enterprise. Management must also disclose going concern issues in the Notes to Financial Statements.

The materiality principle states that an accounting standard can be ignored if the net impact of doing so has such a small impact on the financial statements that a reader of the financial statements would not be misled. Under generally accepted accounting principles (GAAP), you do not have to implement the provisions of an accounting standard if an item is immaterial. This definition does not provide definitive guidance in distinguishing material information from immaterial information, so it is necessary to exercise judgment in deciding if a transaction is material.

Accounting principles ensure that companies follow certain standards of recording how economic events should be recognised, recorded, and presented. External stakeholders (for example investors, banks, agencies etc.) rely on these principles to trust that a company is providing accurate and relevant information in their financial statements. GAAP standards are issued by the FASB (Financial Accounting Standards Board) in response to the 1929 stock market crash. After that time, the FASB eventually came to be and in 1973, these new standards were adopted.

Accounting Basics Outline

They are also used by the standard-setting body to develop accounting standards and frameworks. The accounting principles of Going Concern and Period of Time apply to the recording of assets and liabilities on the balance sheet. Prepaid assets like insurance are spread over the time period (monthly) to which they apply if paid in advance for a year. Expenses are accrued as liabilities to apply to specific Periods of Time to which they relate. Historical cost is generally used to record assets unless the FASB financial accounting codification or industry accounting practice provides specific guidance that is different.

basic accounting principles

byann