What is accounting? The official definition in the book provided by the American Accounting Association said, the process of identifying, measuring, and communicating economic information to permit informed judgments and decisions by users of the information.
The main elements and activities of accounting means -
- any process of data which identifies, classifies, and summarizes the financial events that occur within any organization.
- a reporting system which transmits applicable financial data for concerned people that allow them to evaluate performance, make essential decisions and check the economic resources in the organization.
Keeping this definition in mind, let's move on to the accounting principles and concepts which make up for the whole structure of accounting.
The Basic Principles
The 4 basic principles mentioned further make up the GAAP in the United States. Almost all businesses record and report their financial earnings, and/or losses for the accounting period under the accounting rules. Issued by the Financial Accounting Standards Board, these rules usually are in alignment with other government entities.
Although, accountants are not asked to follow these rules specifically, these rules have to be followed closely. They help businesses set criteria which need to be met to assure correct accounting activity, comprehensibility, and equivalence of the data. We will break the basic accounting concepts and principles in order to understand them properly.
The Cost Principle
Businesses need to register and report all their assets depending on the actual cost received to the businesses, while gaining those assets rather than the free-market rate of the assets themselves.
Cost principle is a reliable method to record and report data. Also, it decreases the chance for elements like predetermined market values to step in with the accounting. Although cost principle is looked as irrelevant, since it refers to the actual value of assets.
The Accrual Principle
Businesses need to register and report revenue when it's earned or made, realized or recognized, and definitely not once the cash for the revenue is received. The accrual principle basically shows the work finished by the company/business, and not the work that needs to be done for the future.
The Matching Principle
Businesses get to analyze current expenses and revenues. The matching principle shows the market, how well companies/businesses are doing financially and effective they really are. Similar to accrual principle, the expenses in matching principle can only get recorded and reported when revenue is actually earned.
The Disclosure Principle
Businesses have to disclose their records, so that judgment over their financial status can be made accordingly. But revealing the accounting and financial data of the companies/businesses should not make them decrease unjustified expenses or make incorrect notions.
The Basic Concepts
No matter which spectrum of the market you are, understanding the fundamental concepts of financial accounting is essential.
Basically, what these concepts do is become a means of communicating the financial data of businesses easily. Also, these concepts form the basis for the Generally Accepted Accounting Principles (GAAP). Just so that readers of financial statements and accounting data are not mistaken, these principles become the foundation.
The financial accounts are recorded for business entities, and not for people who run or own that particular business. The owners' accounts are kept separate from the entities.
The assumption here is made that a business will keep on trading/operating for a very long time. Going concern concept indicates that the financial statements don't necessarily represent that business's worth, if the assets were liquidated (any given point in time). However, those assets can be used for any future financial operations.
For all businesses, the principles used should be same for each and every set of accounts which are prepared. This means, if a depreciation is recorded, it should always be set at the same percentage every time.
Businesses should try to make mistakes on the side of caution, while making estimates and valuations. If revenue was to be over-estimated, the dividends would appear due to its shareholders, when basically those dividends are not really earned yet.
When we talk about fixed assets, like machinery, the original cost of that item needs to be recorded. The actual cost could differ because of rise in property prices, however in order to calculate, that value would make the accounts immanent.
Any transactions occurring over a certain time frame should always reflect single currency and exchange rate. This way, a year's accounts can be compared with another, despite the rate of inflation.
Every transaction has 2 effects. Let's say the business purchases a new asset, printing machine. This will show an increase in fixed assets, and also an increase in liabilities or cash.