Basic “Principles” of Accounting

Accounting Principles, Part I

For starters...

 

Monetary Unit Principle. Requires that only those business activities that can be expressed in terms of a unit of currency are included in the accounting records. Having talented employees or providing excellent customer service are of value to the company; however, this “value” is not included in the Financial Statements. Helps limit a company’s arbitrary estimates of assets and liabilities.

 

Cost Principle. Requires companies to account and report assets based on acquisition costs rather than fair market value. This principle provides information that is more reliable or supportable (removing opportunity to provide subjective and potentially biased market values), but not very relevant (i.e., does not consider/factor that value of things can change or appreciate with time …land and other assets). However, there is no subjectivity when you use acquisition cost, right… the cost is what it is.

 

Full Disclosure Principle. Requires that companies disclose all circumstances and events that would make a difference to financial statement users…usually included in the notes to Financial Statements. For example, terms of loans to company officials or lawsuits (likelihood of a liability).

 

* Matching Principle (expense recognition). This and the following principle on revenue are critical to understanding accounting basics. The matching principle requires expenses to be matched with revenues. Specifically, expenses must be recorded in the period in which they are incurred to generate revenue (not necessarily, when cash is paid for them). Or, expenses should be recognized/reported in the same period in which revenue is recognized. This principle allows greater evaluation of actual profitability and performance (shows how much was spent to earn revenue). Depreciation and Cost of Goods Sold expenses are good examples of application of this principle. This method of accounting is part of accrual basis accounting (i.e., expenses are accrued (recorded) when incurred, even if cash was not paid). Also see below discussion on adjusting entries.

 

* Revenue Recognition Principle. Revenue principle requires companies to recognize revenue in the accounting period in which it is realized and earned, not necessarily when cash is received. This method of accounting is also part of accrual basis accounting (i.e., revenue is accrued (recorded) when earned, even if cash was not received).

 

* Must knows!...for analyzing and successfully answering many accounting principles questions.