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Accounting is the process of measuring, recording, classifying, summarizing, interpretation of numerical data and communicating the findings of operational result to the concerned parties. The person in charge of accounting is known as accountant. Accounting allows the company to analyze the financial performance of the business, and look at statistics such as net profit.
Accounting has to follow certain principles and concept for recording financial transaction. Without accounting principles we cannot keep systematic and proper accounting.
Following are the basic principles of accounting:
It is the concept which is used while preparing profit and loss statement. It was created and was introduced in accounting as a principle of Companies Act in 1985. This concept determines that the revenues and expenses are recognized when they are earned or incurred by the company.
Concert tickets are sold days before the actual show, the payment received is not considered as revenue because the event is yet to occur.
An accounting firm obtained its office on rent and paid $180000 on January 1. It does not record the payment as an expense because the building is not yet used. While preparing the quarterly repot on March 31, the firm expensed out three months' rent i.e. $45,000 [$180000/12*3] because 3 months equivalent of time has expired.
Business transactions are recorded when they occur and not when the related payment are received or made. It is fundamental to the usefulness of financial accounting information.
Going Concern Concept:
This concept states that the business is established to continue its transaction for a long period of time. It means business will continue to operate for a long period of time. So, various balances of assets and liabilities are carried forward to the next year.
An oil and gas firm operating in Arab is stopped by a Arabian court from carrying out operations in Arab. The firm is not a going concern in Arab, because it has to shut down.
A nationalized refinery is in cash flows problems but the government of the country provided a guarantee to the refinery t help it out with all payments, the refinery is a going concern despite poor financial position.
The auditors of the company determine whether the company is a going concern or not at the date of the financial statement.
Business Entity Concept:
According to this concept the business organization and business owner are two different entities. By this concept a business has nothing to do with personal transaction of its owner
A business owner received $1000 bill for utilities. He paid the whole amount using his business account $700 is to be considered a withdrawal because only $300 (1/3rd) is related to business and the other $700 was for domestic purpose.
Assuming each public accounting business is required to pay $200 to a local association of CPAs each month. If the CPA pays that amount from a personal bank account the amount shall be considered additional capital.
Businesses are organized either as a proprietorship, a partnership or a company. They differ in level of control of the business, but in all forms the personal transactions of the owner are not mixed up with the transactions and accounts of the business.
Monetary Unit Assumption:
According to this concept, accounting records only those activities which can be expressed or measured in monetary terms. Events or transaction which cannot be expressed in terms of money are not recorded in the book of accounts.
The company's property, plant and equipment on 2010 balance sheet amounted to $3 billion. During 2011 inflation was 10%. The monetary unit and stable dollar assumption prohibits any adjustment to current or prior period figures to account for the inflation.
Oil spill in Nigeria was a natural disaster but accounting only reports the financial impact in the form of claim paid, damages paid, cleanup costs, etc. This is due to the limitation imposed by the monetary unit assumption.
One aspect of the monetary unit assumption is that currencies lose their purchasing power over time due to inflation, but in accounting we assume that the currency units are stable in value. This is alternatively called stable dollar assumption.
Time Period Concept:
The time period concept implies that for the purpose of reporting financial information, the whole life of business is separated into imaginary time intervals. Each time period is called an accounting period. At the end of each accounting year, financial statements are drawn to ascertain the profit or loss and the financial position of the business, and are reported to their users such as owners, managers and creditors.
One presumption of the time period concept is that we have to make estimates at the end of the time period to correctly to decide which events need to be reported in the current time period and which ones in the next.
Revenue recognition and matching principles are harmonious to time period assumption. Revenue recognition principle provides guidance on when to record revenue while matching concept tells us how to reach an accurate net income figure by creating 1-1 correspondence between revenues and expenses.
Full Disclosure Principle:
Full disclosure principle is harmonious to materiality concept. It requires that all material information has to be disclosed in the financial statements or in the notes to financial statement.
Accounting policies has to be disclosed because they help to understand the basis of accounting.
Compelling events occurring after the date of the financial statements but before the issue of financial statement need to be disclosed.
Tax rate is expected to change in near future. This information needs to be disclosed.
The company sold one of its subsidiaries to the spouse of its directors. This information is material and need to be disclosed.
Details of unexpected liabilities, contingent assets, legal proceedings, etc. are also germane to the decision making of users and hence need to be disclosed.
Historical Cost Concept:
Accounting is concerned with the prior events and it requires flexibility and comparability that is why it requires the accounting transactions to be recorded at their historical costs. This is called historical cost concept.
200 units of an item were purchased one month back for $20 per unit. The price today is $25 per unit. The inventory shall appear on balance sheet at $4,000 and not at $5,000.
The company built its ERB in 2006 at a cost of $50 million. In 2010 it is estimated that the present value of the future benefits attributable to the ERB is $1 billion. The ERB shall stand on balance sheet at its historical costs less accumulated depreciation.
The principle that requires a company to match expenses with related expenses with related revenues in order to report a company's profitability during a specified time interval. Ideally, the matching is based on a cause and effect relationship. If a cost cannot be linked to revenues or to an accounting period, the expense will be recorded immediately.
$3,000,000 worth of sales is made in 2011. Total purchases of inventory were $2,000,000 of which $100,000 remained on hand at the end of 2011. The cost of earnings is $3,000,000 revenue is $1,800,000 [$2,000,000 minus $200,000] and this should be recognized in 2011 thereby yielding a gross profit of $2,200,000.
An office pays $20,000 per month to 5 of its employees. Monthly sales are $500,000. $100,000 worth of monthly salaries should be matched with $500,000 of revenue generated.
Relevance and Reliability:
In relevance information should be relevant to the decision making needs of the user.
In reliability information is reliable if a user can depend upon it to be actually accurate and if it is faithfully represents the information that it aims to present.
Before the date of issue of balance sheet a company wants to deal with its subsidiaries and is in final stages of reaching a deal but the outcome is still uncertain. If the company waits they are expected to find more reliable information but it would cost them relevance. The information would be outdated and no longer very relevant.
After the balance sheet date during the time when audit is carried out, it becomes clear which debts were realized and where were not hence it improves the reliability of allowance for bad debts estimate but the information loses its relevance due to too much time being taken. Timeliness is key to relevance.
Revenue Recognition Principle:
According to this principle, revenues are recognized when they are realized or realizable, and earned, no matter when cash is received. Cash can be received in an earlier or later period than obligations are met and related revenues are recognized that results in the following two types of accounts:
A monthly magazine receives 2,000 subscriptions of $240 to be paid at the beginning of the year. Each month it recognizes revenue worth $20,000 [($240/12)*2,000].
A media company recognizes revenue when the ads are aired even before the payment has been made.