Major Accounting Principles/Concepts

Accounting principles are essential rules and concepts that govern the field of
accounting, and guides the accounting process should record, analyze, verify and
report the financial position of the business.
These principles are used in every step of the accounting process for the proper
representation of the financial position of the business. These are explained below:

1. Revenue Recognition/Realization Principle

Revenue Recognition Principle is mainly concerned with the revenue being

recognized in the income statement of an enterprise. Revenue is the gross inflow of
cash arising in the course of ordinary activities of an enterprise from the sale of
goods, rendering of services and use of enterprise resources by others yielding
interests, royalties, and dividends. It excludes the amount collected on behalf of
third parties such as certain taxes.

Example: A product is sold on March 5. The customer receives the product on

March 5 but will pay for it on April 5. The business recognizes the revenue from the
sale on March 5 when the sale occurred even though the cash is not received until a
later date.

When should Revenue be recognized? In most cases, the Realization Principle

indicates that Revenue should be recognized at the Time Goods are Sold or Services
are Rendered. At this point, the Business has essentially completed the Earnings
Process, and the Sales Value of the Goods or Services can be measured objectively.
After the Sale, the only step that remains is to collect from the customer, usually a
relatively certain event.

Further to illustrate, assume that on July 25 a Radio Station contracts with a Car
Dealership to air a series of one-minute advertisements during August. If all of the
agreed-upon ads are aired in August, but payment for the ads is not received until
September, in which month should the station recognize the advertising revenue?
The answer is August, the month in which it rendered the services that earned the
advertising revenue

In other words, Revenue is recognized when it is earned, without regard to when a

contract is signed or when cash payment for providing goods or services is received.
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2. Matching Principle:

According to Matching Principle, the expenses incurred in an accounting period

should be matched with the revenues recognized in that period, e.g., if revenue is

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recognized on all goods sold during a period, the cost of those goods sold should also
be charged to that period. It is wrong to recognize revenue on all sales, but charge
expenses only on such sales as are collected in cash till that period. This concept is
basically an accrual concept since it disregards the timing and the amount of actual
cash inflow or cash outflow and concentrates on the occurrence (i.e. accrual) of
revenue and expenses. This concept calls for an adjustment to be made in respect of
prepaid expenses, outstanding expenses, accrued revenue, and unearned revenues.
Matching does not mean that expenses must be identifiable with revenues. Expenses
charged to a period may or may not be related to the revenue recognized in that
period, e.g. cost of goods sold and commission to salesmen are directly related to
sales whereas rent, interest, depreciation accruing with the passage of time and
stock lost by fire are not directly related to sales revenue yet, they are charged to the
accounting period to which they relate.

A Significant Relationship exists between Revenue and Expenses. Expenses are

incurred for the Purpose of Generating Revenue. In the measurement of Net Income
for a period, Revenue should be offset by all the Expenses incurred in earning that
Revenue. This concept of offsetting Expenses against Revenue on a basis of Cause
and Effect is called the Matching Principle. Timing is an important factor in
Matching (Offsetting) Revenue with the Related Expenses.

For example, in the preparation of Monthly Income Statements, it is important to

offset This Month’s Expenses against This Month’s revenue. We should not Offset
this Month’s Expenses against Last Month’s Revenue because There is No Cause
and Effect Relationship between the Two.

Assume that the Salaries earned by A Company’s Marketing Team for serving
customers in July are not paid until early August. In which month should these
Salaries be regarded as Expenses—July or August? The Answer is July, because
July is the Month in which the Marketing Team’s Services helped to generate
Revenue. Just as Revenue and Cash Receipts are not one & the same, Expenses &
Cash Payments are not identical.

In fact, the Cash Payment of an Expense may occur before, after, or in the same
period that Revenue is earned. In deciding when to report an Expense in the Income
Statement, the Critical Question is, “In what period does the expense help to
produce revenue?”— Not, “When does the payment of cash occur?

3. Historical Cost Principle:

According to Historical Cost principle, an asset is ordinarily recorded in the

accounting records at the price paid to acquire it at the time of its acquisition and
the cost becomes the basis for the accounts during the period of acquisition and

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subsequent accounting periods. Accordingly, if nothing is paid to acquire an asset;
the same will not be usually recorded as an asset, e.g. a favorable location, and
increasing reputation of the concern will remain unrecorded though these are
valuable assets.

Example: A business purchased a piece of land for $70,000 ten years ago. Even
though the land can be now sold for more than this, it is not revalued in the financial
statements. It remains recorded at $70,000.
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4. Business Entity Principle/Concept:

The business entity concept states that the transactions associated with

a business must be separately recorded from those of its owners or other businesses.
Doing so requires the use of separate accounting records for the organization that
completely exclude the assets and liabilities of any other entity or the owner.
For example, there is a business organization operating as a travel agency. Its
owners may have personal bank accounts, homes, cars, and even other businesses.
These items are not involved in the operation of the travel agency and do not appear
in financial statements of the business.

If the owners were to commingle their personal activities with the transactions of
the business, the resulting financial statements would fail to describe clearly the
financial activities of the business organization. Distinguishing business from
personal activities of the owners may require judgment by the accountant
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