5 Basic Principles of Accounting

Understanding the 5 Basic Principles of Accounting

Posted: January 11, 2023 | Updated: January 11, 2023

When starting your own business, there are many departments that you need to prioritize in the beginning. One such department is the accounting department, which manages your finances through the use of accounting principles.

There are many reasons why setting up an accounting department is important for your company, but the main reason is that it can keep your financial records in an organized fashion. Furthermore, by using various accounting principles, it can make sure that all of the financial records are accurate and updated, ensuring financial safety and efficiency.

Let us discuss this in a bit more detail, taking a look at the importance of accounting, and exploring the five accounting general principles as well.

Basic Accounting: Why Is It Important?

Before understanding the five important principles of accounting, lets first take a look at accounting and why it is an important part of any company. By definition, accounting is a term that is used to explain the process which involves strengthening the financial position of the company, and also ensuring financial transparency and responsibility.

The main purpose of an accounting department is to keep a record of any transactions that they make, the cash flow, and generate profit and loss reports based on the financial information.

In addition to solidifying the finances of a company, the account is also important due to other benefits that it brings to the table:

·       Records All Business Transactions

One of the most important reasons why accounting is essential for every company is because it is through these processes that the company is capable of keeping a systematic record of the company’s finances.

Having access to updated financial records at all times can help companies when comparing their current situation with that of the previous years, allowing them to evaluate their financial position.

·       Helps in Decision Making for the Management

One of the greatest benefits of having a capable accounting department is that the accumulated financial information greatly helps in the decision-making process.

The management team needs accounting in order to make any important decision, mainly due to the fact that accurate financial information can help them evaluate their position when it comes to capital, allowing them to make a well-informed decision.

·       They Meet Legal Requirements

Tax authorities such as the Internal Revenue Service, also known as the IRS, require accurate financial statements in order to properly evaluate the net income and total revenue of the company.

This is done to ensure the legality of the inflow and outflow of capital that is involved with the organization, and this is where accounting comes in.

It is the job of the accounting department to ensure that all of the financial documents are constantly updated and reach the IRS in order to ensure the legality of all the transactions that have occurred within the company.

Basics of Accounting Principles and the Five Types

merchant account vs payment gateway

Information is key in building a trusting relationship with both your clients and your stakeholders as well.

The best way to do that is to keep a record of all of the financial exchanges that have taken place within the company, and the best way to do that is to adopt the basic principles of accounting.

Although there are many regulations and different requirements when it comes to the preparation and organization of the financial statements that are comprised of all the transactions that have taken place in a company, they follow the same accounting principles.

Let us take a look into these five cornerstones of financial development and accounting and understand them in a bit more detail.

The Accrual Principle

When shipping goods to a customer, an exception that may arise may be that the product may be sent in one accounting period, but the customer might have sent you the payment in the next accounting period.

The Accrual accounting principle takes a look at this situation and helps understand when a sale in this particular situation should be recorded in the books.

According to this principle, it is advisable to you recognize the income at the time it is earned regardless of the time you receive it, after which you should recognize the expenses at the time you incur them.

When doing so, the time duration does not hold any importance, and you can recognize the incurring expense at any point in time.

When dealing with financial statements in accordance with the Accrual principle, transaction recognition is closely related to when the business activities take place and not the time at which the money is exchanged.

The Matching Principle

Another key principle that is part of basic accounting is the matching principle, and it normally explores the situation involving the time when a company buys a piece of equipment in one quarter and then uses it for the upcoming quarters.

When facing such a situation, this principle looks at the expenditure that takes place and the time that it should take place.

The main function of the matching principle is to make sure that the company revenue is aligned with the expenses that have taken place.

This means that the company should be able to recognize the expenses around the same time as when they are earning the revenues for them and vice versa.

This is done primarily because recognizing the expenses at the same time can help the organization evenly divide the cost of the equipment over the span of the increasing number of quarters they have used it for.

The Historic Cost Principle

Most of the functionality that is concerned with accounting ties closely to past events. This is partly why comparison and consistency are such important aspects, and in order to ensure that the financial records remain consistent, this principle is taken into account.

Before understanding the historic cost principle, let us first understand what the term “historic cost” exactly means, as it is important to ascertain the purpose behind this key principle.

By definition, the historic cost of a transaction means the real value of the involved resource, such as any cash or liability that is related to the exchange.

The main requirement for a company to implement this principle into its accounting regulation is to record any transaction that takes place at its historic cost.

How it works is that if the resource involved in the exchange goes through an increase in value due to some internal or external factors, it does not affect its value in the official financial records unless allowed by the accounting standards.

This principle and the overall concept behind historic cost are essential, mainly in the case of property.

This is because the real estate market is a volatile one, and if organizations did not follow the concept of historic costs when recording the value of their assets, it could greatly impair future comparisons to evaluate the overall financial situation.

Conservatism Principle

There are times when a company is already aware that an event is about to occur that will incur massive costs for the company. The principle deals with this manner of potential expenditure, and whether it will be recognized in the records.

There are a number of different ways to record such transactions, meaning that there is a possibility that different accountants make a decision that is distinct from each other, and this is where the conservatism principle comes in.

In accordance with this accounting principle, accountants are required to adopt an approach that results in the lowest possible net income, or the utilization of the lowest net assets, when engaging with any merchant services.

Furthermore, accountants should also keep all anticipated costs into account and recognize only the gains that are projected to occur and when they occur.

Principle of Substance Over Form

What makes this different from the other accounting principles is that it requires your company to record the economic value of the transaction and the events as well, rather than just their legal form.

There may be a possibility that the lease can be very brief, lasting for only a few months. In this case, the statement should show the entirety of the expenses paid by the company without having the need to list any asset.

However, if the piece of equipment has been leased for a considerable amount of time, the resulting exchange is similar to a sale and loan in terms of economic value because of the fact that the lease covers the majority of the life of the asset.

When dealing with such a situation, the regulations and laws in accounting dictate that the lease should be treated as a purchase that is done by your company and viewed as a debt that is owed to the individual who has leased the equipment.

Conclusion

The main reason why many accountants and teams integrate the use of proper principles is due to the fact that they offer staff members and management a very easy-to-follow and streamlined path that is tailor-made for different situations. Having strong accounting principles in place in your organization can help you maintain a clean understanding of what your current financial situation is, and help you make accurate decisions based on where you need to go.

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