Accounting is a critical pillar of every business, big or small, whichever industry it belongs to. It supports businesses in a methodical recording, analysis, and reporting of financial transactions in a way that makes sense. Through accounting, companies gain insight into their financial status, evaluate their performance, and disclose financial information with transparency. In this article, we cover what is accounting along with its basic accounting principles, importance, limitations and typical mistakes that real businesses should steer away from if they want to have correct and dependable financial records.
What is Accounting?
Accounting is highly essential in business since it keeps track of, generates, checks, and conveys the records of all the financial dealings. Besides, accounting is referred to as the backbone of the business; this is because financial statements are accurate and transparent through this process. Business of any size need accounting.
Furthermore, through accounting businesses get to know their financial health and growth. Besides, accounting assist companies in planning, controlling their spending which on one hand helps in getting the cash flow for the necessary maintenance. In fact, accounting is the best tool to give you the real view of your business’s financial situation and also to guide you on whether your business is being successful or not.
What are the Accounting Principles?
Accounting principles refer to the standard sets of rules that explain how to properly record and report financial data. These principles comprise consistency, accrual, matching, revenue recognition, prudence, materiality, and going concern among others. Their main goal is to make sure that the financial statements are trustworthy, can be compared and are clear. Hence, by adhering to these principles, companies reveal an accurate and genuine picture of their financial situation, their performance, and the changes in their cash flows that thus allow investors, managers, and regulators to have the necessary information for making economic decisions both in business and public sector settings at a global level.
Importance of Accounting Principles
Here we have discussed some of the importance of accounting principles that help to enhance our business and the process of financial statements.
- Ensures Uniformity: Accounting principles lay down a standard approach to recording transactions which result in uniform financial records across different businesses.
- Improves Accuracy: They assist in minimizing errors and ensuring that the financial information is correctly and systematically recorded.
- Builds Reliability and Trust: Financial statements that comply with the standards of generally accepted accounting principles (GAAP) are a reliable means of disclosure to investors, creditors, and other stakeholders.
- Helps in Decision Making: The availability of accurate and consistent financial records facilitates the making of sound business and financial decisions.
- Prevents Fraud and Manipulation: Principles of accounting such as objectivity and prudence are essentially aimed at decreasing the chances of manipulation and fraudulent reporting.
- Supports Legal and Regulatory Compliance: Accounting principles serve as guidelines when performing work to be in compliance with laws, regulations, and audit requirements.
- Assists in Financial Planning and Control: They enable management to use cost, profit and financial position data for planning and controlling activities effectively.
List of the 10 Basic Accounting Principles
There are some basic accounting principles that help businesses to enhance their business. Cover the 10 basic accounting principles with examples listed below.
Economic Entity Principle
According to this principle, a business should be recognised as an entity different from the owner or any other business struggle. The financial records should only show the business transactions without any personal expenditure of the owner.
For instance, if the owner uses business cash to pay for personal rent, it should be recorded as owner’s drawing rather than business expense.
Monetary Unit Principle
This principle emphasizes that only those activities which can be quantitatively measured and be expressed in terms of money can be recorded in the accounting books. Non-financial aspects like employee morale, customer satisfaction, or brand reputation, which cannot be quantified, are therefore, excluded.
For Example: The purchase of a machine for $50,000 will be recorded while having competent employees will not be capitalized in dollar terms.
Time Period Principle
The principle identifying the company’s life cycle is the time period principle. It also specifies the different accounting periods that a business chooses to divide its life into, be it monthly, quarterly or annually. It facilitates the production of financial statements.
Example: Even if the business continues, a company may still be preparing income statements on a yearly basis to determine the profit for that year.
Cost Principle
The acquisition cost is the basis for recording assets not the value at which they can be sold.
Example: Assume that a piece of land was purchased for $100,000 and after some time its value rose to $200,000. Despite that the records would still show the purchase price of $100,000.
Full Disclosure Principle
Besides including notes, the financial statements must contain all the significant and relevant information that is necessary to users for making their decisions.
For instance, even if the lawsuit is still pending, a company should disclose such information if it is of major significance to potential losses/gains.
Going Concern Principle
The main idea behind this principle is that a business is going to be operating for a while, so it is not being closed or liquidated.
Example: A business’s assets are spread over several years because the company is expected to stay in operation and therefore use those assets.
Matching Principle
Expenses are to be reported in the same accounting period as the revenues to which they relate.
Example: If the sales revenue is recorded in March, the advertising and production cost related to that sale should also be recorded in March.
Revenue Recognition Principle
Revenue is recorded when it is earned, injection of cash is not a condition.
Example: If in December the company makes the service and in January receives the payment, then December is the period of recording total revenue.
Consistency Principle
After deciding on an accounting method, it should be applied from period to period to obtain comparable results.
Example: This year the company uses straight-line depreciation in accounting, so the next years it should still use the same method unless it has a good reason to change.
Conservatism Principle
Accountants should opt for the solution that least overstates income or assets when the facts are not entirely clear.
Example: Expected losses are recognized as soon as they are forecasted, whereas gains are recognized only when they are realized.
Advantages of Following Basic Accounting Principles
The principle-based approach will empower a business to a new vision. These principles help accountants to provide proper financial reports and improve the efficiency of the financial processes. Some of the basic advantages are mentioned below.
- These accounting principles will enhance compatibility so that investors can compare different periods and make better decisions.
- Accounting principles provide accuracy and help in tracking business performance.
- By following these principles, accountants provide transparent financials that build trust among the investors.
- Businesses that follow these principles improve their business growth and efficiency.
Limitations of Accounting Principles
Accounting Principles have serious limitations because it total depend on current market value not historical cost. Discuss some basic accounting principles limitations that help in the process of financial reports and statements.
- Historical Cost Basis: Many time, assets are set at their original purchase price instead of their current market value, which may lead to a misrepresentation of the actual financial position.
- Monetary Measurement Only: The records only show financial transactions, leaving out important non-financial, qualitative aspects like management quality, staff morale, or a company’s reputation.
- Subjectivity and Estimates: The principles call for the use of personal judgment in areas such as the choice of depreciation method or the estimation of bad debts, therefore lessening the degree of objectivity.
- Ignoring Inflation: Generally, financial statements are not re-stated to reflect changes in the value of money, so it is difficult to compare them over different time periods.
- Manipulability (Secret Reserves): Accounting principles can be twisted, either purposely or unknowingly, to cover up the true financial condition of the company through practices like “window dressing” or profit manipulation.
- Time Period Principle Limits: The division of a company’s existence into arbitrary time periods can cause inaccuracies in reporting, as many transactions extend over more than one period.
- Conservatism Bias: The prudence principle (conservatism) tends to result in the undervaluation of assets and income, hence, a distorted, excessively cautious figure is presented.
Common Accounting Mistakes You Should Avoid
Here are some common mistakes you need to avoid which are mentioned below.
- Mixing Personal and Business Finances.
- Ignoring Small Transactions.
- Failing to Reconcile Bank Statements.
- Incorrectly Categorizing Expenses.
- Not Backing Up Financial Data.
- Ignoring Accounts payable and Accounts receivable.
- Forgetting to Review Financial Reports.
Conclusion
Accounting plays a crucial role in managing and assessing a business’s financial condition. Accounting always adhering their principles that help improve its business and make the process for creating the financial reports. Despite the fact that accounting principles are limited in some respects, they serve as a legitimate basis for decision-making, adherence, and financial planning. Accurate accounting can guide the company away from errors and fraud, and hence, it becomes a pillar of business success and financial soundness.