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Accounting Principles

Accounting principles and guidelines form the basic framework upon which more detailed standards and
rules are developed.
We've talked about generally accounting principles (GAAP) and International Financial Accounting
Standards (IFRS) in the previous lesson.
Those standards are actually fruits of these fundamental accounting principles:

1. Accrual Concept
The concept of accrual states that income should be recognized when earned regardless of when
collected; and expenses should be recognized when incurred regardless of when paid. It means that the
recognition of income does not depend upon cash collection or payment, but upon occurrence.
For example, if we made a sale to a customer on credit on May 20 of the current year, it is proper to
recognize the income on that day regardless of when the customer pays for it. Remember, from the time
the sale was made, we already earned the income, even if it is still to be collected.
Another example: unpaid rent. Should it be expensed even if not yet paid? Based on the accrual
concept, yes. Company XYZ has 3 months of unpaid rent from January to March. The rent should be
recognized as expense for those months even of it was paid, let's say, on April. Why? Because the
company incurred such rental expense in those months.
Other alternatives to the accrual basis accounting, such as cash basis and percentage-of-completion
method, are allowed in certain cases.

2. Going Concern
Going concern means that a business will continue to exist in the future. The financial statements are
prepared and analyzed with the assumption that the company will still be there in the next years.
This is the main reason assets are generally carried at cost rather that fair value Also, fixed assets are
depreciated with the assumption that they will be used for a long period of time. The going concern
primarily affects the balance sheet.
If a company will not be able to continue as a going concern, it is required that the matter be disclosed in
the notes to financial statements.

3. Periodicity or Time Period


The assumed unlimited life of a business is divided into several accounting periods. In these periods,
financial statements are prepared to be used by interested users. Financial statements are generally
prepared monthly, quarterly, and annually.

4. Accounting / Economic / Separate Entity Concept


The transactions of a business should be kept separate from the transactions of the owner/s, and vice
versa. For example, Mr. C purchased a personal house. That transaction should not be recorded as a
transaction of his mini-mart. In the same case, the rent of the mini-mart space should not be treated as an
expense of Mr. C but should be recorded separately as expense of the mini-mart.
What if the space is used both by the owner for personal use and by the business? Then the rent should
be split according to a rational basis such as floor area occupied or some other logical ratio.

5. Monetary unit
Business transactions are recorded in terms of money, in U.S. Dollar, Euro, Peso, whatever would be
most relevant as the case maybe. It also states that the purchasing power of the currency is stable.
Hence, the effect of inflation is ignored in the financial statements.

6. Full Disclosure
All important information should be disclosed. This does not mean that allinformation must be included in
the financial statements. We're talking about important or material information, those that could influence
the decision of the users. This is why the notes to financial statements exist. The notes to financial
statements contain other information (mostly qualitative) not seen and cannot be placed in the face of the
financial statements.
For example: the continuity of a business. As stated earlier, if the company is believed not to exist in the
near future, the users should know about it. It should be disclosed in the notes to financial statements.

7. Historical Cost
The amounts shown in the financial statements are measured at cost. Historical costrefers to the amount
incurred to acquire the item. Any appreciation or increase in the value of that item is ignored.
For example, Company XYZ acquired 100 bags of cement. The purchase price at that time was $10 per
bag. Now, it has gone up to $12. The cements should stay at $10 per bag, the historical price.
Fixed assets are carried at carrying value, i.e. historical cost minus accumulated depreciation. There are,
however, exceptions where items are measured at bases other than historical cost. Nonetheless, the
general measurement base used is historical cost.

8. Revenue Recognition Principle


Generally, revenue (or income) is recognized when earned regardless of when received. This is in
accordance with the accrual concept discussed above. Income is considered earned when the sale is
made or the service is performed.

9. Materiality
Materiality is relative. It depends upon the natured and size of the item. $10,000 may be immaterial
(insignificant) to one company but may be material to another. Materiality allows accountants to ignore
items that are useless or immaterial to users. At times, this allows violation of some accounting standards.
But in any case, accountants should apply due care and professional judgment in deciding over cases
involving materiality.

10. Prudence or conservatism


In cases when there are two or more acceptable accounting standards, the principle of conservatism
directs accountants to choose the one that will result in lower net income or lower net assets. This
principle is the basis for standards on recognition of probable gains and losses, lower of cost or net
realizable value, and other similar standards.

11. Matching principle


The matching principle aims to align revenues and expenses. Expenses should be recognized in the
period the revenues from them were earned. In the same way, revenues should be recorded in the period
the expenses incurred to earn them were recognized. The matching principle is actually a result of the
application of the accrual concept.

12. Consistency
Accounting methods and procedures adopted by a company should be applied consistently in future
periods, unless there is a reasonable ground to shift to other methods. For example, ABC Company uses
the straight-line method in depreciating its delivery equipment. This method should be maintained in the
next years, unless there is reasonable explanation to change to let's say, declining balance method.
The above principles are the building blocks upon which detailed accounting rules and standards such as
GAAP and IFRS are based. It will be much easier to comprehend and apply accounting standards no
matter how complex they are if the above principles are understood.