The financial progression of any business entity has a direct relationship, among other factors, with their understanding of the principles of accounting theory. Irrespective of the size of the organisation, whether a large company, small or medium-sized, a comprehensive understanding of these accounting principles is crucial. This is because the benefits of such a vital knowledge range from knowing and keeping track of a company's assets to carrying out safe transactions. They also encompass issuing acceptable financial documents to anyone outside the confines of the organisation. Hence, in this article, we look at the basic principles that govern the reporting of the accounting activities of any organisation. Then, we also consider different accounting principles and concepts, among others.
Understanding and keeping track of the financial activities in any organisation is highly important. At least, it helps the organisation to know its financial capacity and how cash flows in and out at the same time. More so, with the right information on this financial activity, the management is able to make productive decisions that are healthy for the progress of the organisation. This is one reason why every organisation that wants to keep thriving must never take the issues of accounting with a levity hand.
Principles of accounting defined
In a simple term, the principles of accounting refer to those rudimentary principles that govern accounting operations in any given organisation. These principles are basic and are expected to be followed by any organisation in the preparation of their financial statements. By implication, an accountant is not considered to have done well if his report on the financial activities or operations of an organisation is not subject to these accepted principles. Even though whenever the report is submitted, it is expected to contain some financial information like the net earnings and the gross income of the organisation under consideration.
In the United States, for instance, the term that is being used to refer to these accounting principles is known as GAAP. GAAP is the acronym for generally accepted accounting principles. Interestingly, this accounting term has been adopted by all and as a result of this, it has become generally accepted and much pronounced when it comes to accounting principles.
Importance of principles of accounting
- It has been proven that any time these principles are put to work, among other benefits, they help an accountant to create financial statements with a high level of integrity. As a result of this, investors and other concerned bodies find it easy to compare the financial results of different related industries with an assurance of credibility.
- These principles are very important to any accountant because by working with them, it makes it easy for the financial analyst to come up with a detailed and transparent report. Based on this, investors, customers, and others are able to make an informed decision when they are appraising the effectiveness of an organisation, their productivity level and so on.
Basic accounting principles and concepts
Based on all that has been discussed so far on the principles of accounting theory, one may ask, what are the basic principles of accounting? This accounting principled has to do with the step-by-step guides that make the procedure of accounting effective. The essence of these principles is to show the steps that need to be followed whenever the demand for recording and reporting the transactions of any business entity comes up. As a result of their effectiveness, these principles have become the standard rules that govern anyone when making decisions on the development and operations of accounting techniques.
What are the five principles of accounting?
The following form the five basic principles that govern accounting operations; they are discussed below:
1. Revenue recognition principle
This principle has to do with the recognition of revenue in the income statement of an organisation. This means that the moment a product is sold or a service is rendered as the case may be, the revenues are recognised, not necessarily minding when the money is received. Therefore, it is possible for an organisation to record and report the earnings of GHC 20,000, for example, as their revenue when they have not received the actual cash.
It is worth noting that revenue is not and should not be seen as the same with a cash receipt. Revenue only talks about the inflow of cash, receivables and other considerations that may arise in the transaction process of an organisation. This may be realised from the sale of goods, rendering of services and the engagement of the resources of the organisation in a way that it yields interests or dividends.
2. Matching principle
The essence of this principle entails that the expenses of an organisation should be matched with revenues. In other words, whatever expenses that are incurred during an accounting period are expected to be matched with the revenues that are identified within that same period. To effectively use this principle, it is important for an organisation to use the accrual basis of accounting. The accrual basis of accounting is a type of accounting method in which the revenues of an organisation are recognised on the income statement when they are earned and not when the cash is received.
3. Full disclosure principle
What this principle entails is that the financial statements of an organisation should disclose a relevant and reliable information of everything they represent so that the users can find the information useful. Based on this, every information is expected to be explicitly spelled out with nothing being concealed.
4. Objectivity principle
According to this principle, every data that is contained in the accounting process should be definite and explanatory enough. More so, the data must be verifiable and then, it should not be influenced by the opinion of the accountant. It is expected that every transaction/event that is recorded in the books of accounts must have enough pieces of evidence that will support them. In other words, the data must not be vague but accurate and subject to verification.
5. Historical cost principle
The term "cost", to an accountant, has to do with the amount that an organisation spent at the time when they purchased an item originally. With this understanding gotten, historical cost principle explains that any asset that is acquired by an organisation is expected to be recorded in the accounting records. The record, however, should be based on the price paid for its acquisition irrespective of the period when it was acquired. This means that while recording the asset, it is not going to be based on the present market value i.e the amount of money that an organisation will realise in case they want to sell the asset today.
But then, if there was no amount paid or there was no cost implication at the time of acquiring an asset, it then means that such an item will not be recorded as an asset. Consequently, the information that is reflected in the financial statements of the organisation is what is known as the historical cost amounts.
3 basic principles of accounting
When creating entries in a journal, there are specific rules that must be followed. In accounting, these rules/principles are also referred to as the golden rules of accounting. There are three types of account where these rules are applied and they are Personal Account, Real Account and Nominal Account. Each of the golden rules is explained below in relation to these types of account:
1. Personal Account
The rule simply states that "debit the receiver, credit the giver".
Basically, this principle applies to the operation of a personal account. By personal account, this means the account that an individual uses for their personal needs. The account is different from those accounts that are used for business or corporate purposes. It is noteworthy that a person, in this context, can be a natural person and can also be a legal person.
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In applying this rule, it means that whenever a person receives something from an organisation, such becomes the receiver. With this, such a person's account will have to be debited in the organisation's books. On the other hand, if a person gives an organisation something, he becomes the giver. Therefore, such a person's account will have to be credited in the organisation's books.
2. Real Account
What this rule is all about is that you "debit what comes in and credit what goes out". The rule applies especially in the area of real accounts. A real account talks about things that have to do with a property like a machinery, building, and land, etc. It can also refer to the assets, liabilities, reserves and so on which appear on a balance sheet. By implication, it involves the basic things that may come in or go out from an organisation. In applying this rule, it means that for every property or goods that come into the organisation, the account of that property will have to be debited in the organisation's books. In effect, there will be an addition to the existing account balance.
On the other hand, any property or goods that move out of the organisation automatically means that the account of the property or goods has to be credited in the organisation's books. When this happens, the implication is that there will be a reduction in the account balance of such organisation.
3. Nominal Account
The rule here underscores the need to "debit all expenses and loss and credit all income and gains". A nominal account talks about an account that relates to the expenses and income, and losses and gains of an organisation. So, this rule posits that any time an organisation incurs expenses or losses in the management and/or the running of the business entity, it is essential for the account of such expense or loss to be debited in the organisation's books. Whenever this is done, it will amount to a decrease in the capital of the organisation.
However, whenever there is an earning in terms of income or profits after rendering a service, hiring any of the organisation's assets or whatever it is, the account of the income also needs to be credited in the organisation's books. The result of this action will always bring about an increase in the organisation's capital. Whenever this rule is followed, the good thing is that it helps the system to stay balanced.
Based on all that have been discussed on the principles of accounting theory so far, it is, without doubt, that every business entity needs this knowledge to keep their organisation thriving. When these principles are adequately carried out, it imparts positively on the growth of any business entity. However, if not properly executed, a business is likely to suffer. Interestingly, there are principles of accounting textbooks that can be accessed at libraries, local book stores and even on the internet to gain more understanding on the operations of these principles.