Accounting refers to the systematic recording of business transactions and preparation of statements relating to assets, liabilities and functioning results of a business. Accounting has to follow certain fundamental rules that form the basic accounting concepts and principles.
The main purpose of financial accounting is to provide necessary economic information required for decision-making in a business. Financial accounting follows certain rules and guidelines to prepare reports on the financial standing of an entity. These rules and guidelines are usually referred to as Generally Accepted Accounting Principles (GAAP). GAAP sets its accounting standards and guidelines for preparing financial reports for public, private, non-profitable organizations, and government-owned companies.
Readers of a financial report should be intimated if the information provided in the financial statements follow the GAAP guidelines. The accountant or auditor is responsible for ensuring this procedure.
Fundamental Concepts of Accounting
This principle treats the company as a separate entity from its owners. Personal accounts of owners/partners should be kept separate from profits and expenses of the company. So, the accounting reports are prepared from the viewpoint of business purposes and not from the owner’s outlook.
This principle states that the company has to consider the original cost of fixed assets like building and machinery, rather than market value. But today, most of the companies report only the market value.
According to this principle, the auditors should prepare the financial reports in order to project the real financial position of the company rather than fabricating facts.
This principle assumes that transactions should be recorded in a single currency and exchange rate. This will help the company compare its accounts to the previous years, in spite of a change in the rate of inflation. This principle actually supports the preparation of business reports in a uniform manner.
According to this principle, the accountants should use the same methods and functions for different periods of time. For example, the same rate of percentage should be applied for all depreciation. This principle is also known as the principle of regularity.
The main objective of this principle is to show the real financial position of the company. The accountants should show the correct revenue accounts and provide a provision for expenses, which may occur in the future.
According to this principle, all the revenues and concerned expenses incurred should be shown in the same financial period. The main objective is to avoid any overstatements of income at any particular time.
This principle requires the company to record the revenue or income when it is actually earned.
Continuity or Going Concern
This principle presumes that the functioning of the company will be smooth and the business entity will continue to operate for a fairly long period. This principle mainly helps in preparing financial statements of the company as well as ensures that investors will get revenue on their investments.
This concept indicates the actual amount of revenue or cash inflows earned and realized from a business transaction. It means that realization occurs at the time of receiving the cash in the exchange of goods and services, and not at the time when the contract is granted.
This principle specifies a particular interval of time for which the financial reports are prepared. It can be either year, fiscal year or short period like a quarter or a month.
This principle states that the full disclosure of information and events should be ensured. The financial reports should not mislead the investors and should provide clear details of the financial position of the business.
According to this principle, all financial transitions have two effects. This concept, which is the cornerstone of accounting principles, assumes that making a record of transactions in the books of accounts has a dual outcome. For instance, getting goods for some amount of money has two effects: (1) paying cash and (2) receiving goods. A record of both should be made into the books of accounts. The dual aspect concept is expressed by the following equation:
Assets = Liabilities + Equity
Assets are owned by a business, and liabilities are the debts of a business, that the company owes to its creditors. Equity is what the company owes to its owners. So all transactions must comply to the above equation.
Due to these guidelines of GAAP, consistency in the methods of preparations of financial accounts of the companies has been maintained. These principles are directly proportional to the complexity of the accounts of a business and may hence, seem complex. The continuing complexity of business transactions has made it necessary for the accounts sector to have some standardization. GAAPs have not only set the benchmark for standardization, but have also ensured that the general public has a clearer view of the financial stability of a company.