Basic accounting principles


Basic accounting principles

Since there are many users of accounting information and their interests are not exactly similar, it is important that information they are provided with is uniform and contains figures all can generally agree on. Furthermore, as these users look at information from different businesses and over different periods of time, they need some assurance that information provided is, within reason, accurate and comparable. This can be achieved only if financial statements are prepared using similar approaches across businesses and over time.

For this purpose, some basic ground rules, more commonly known as accounting principles, have been developed. Financial statements are prepared on the assumption that these rules have been complied with.

The important basic accounting principles are as follows:

Business entity

This concept states that the business exists separately and distinct from its owners.  Its books of accounts and records should reflect only those transactions which pertain to the firm and should not include personal transactions and activities of the owner. If the owner buys a new pair of dress shoes it is incorrect to record this in a firm's books of account as a business expense.

Going concern

The business is assumed to continue in its operations indefinitely unless there is evidence which indicates otherwise.  In this context, the business should continue to value all its fixed assets at original cost as it is not foreseen that they will be sold.

Accrual

Revenue should be recognized when earned rather than when cash is collected, and expenses should be recognized when goods and services are consumed regardless of when they are paid for.

Matching Concept

In determining profit or loss at all times, revenues should be matched against expenses incurred in the process of generating that revenue in the same period. It is necessary to recognize all the revenue/income earned during a period regardless of when money is received.  In the same way, all expenses incurred by the business should be included regardless of when money is paid for them. It is evident that the accrual and matching principles are closely connected.

Prudence

The business is encouraged to take a conservative approach in reporting its affairs. If the accountant is faced with a choice of approaches and estimates which are all acceptable to use in the financial statements he should take a pessimistic rather than an optimistic approach. This is also known as the conservatism principle. A conservative view tends to underestimate rather than overestimate assets, revenues and profits; while it overestimates rather than underestimates liabilities, expenses and losses.

Cost

Assets of a business must be recorded at their original cost.  Cost is determined through an arms-length transaction with an independent supplier and in most cases this is the most objective figure to use as long as the going concern assumption holds.

Unit of measure

Also known as the money measurement concept and states a position that accounting is more concerned with activities capable of being measured in monetary terms. Therefore, money is used as a unit of measure in recording and reporting all transactions of the business. Events and attributes that cannot be reliably measured in monetary terms are therefore, not a major concern of accounting. An example of such an attribute being motivation and commitment of employees. Also inherent in this concept is the assumption that currency will remain stable in value.

Accounting Period

Although a business is assumed to continue to exist indefinitely, its life can be broken into periods of time, usually twelve months, during which results can be measured.  The significance of this concept is that users do not have to wait until cessation of business to determine profit or loss.

Consistency

When there are alternative accounting methods or policies which a business may use, it is important that whichever method or policy is adopted it is used consistently from one accounting period to another, as well as within one accounting period.  If for some good reason the method has to be changed, this should be clearly stated so that users are aware of the reason and impact of the change.

Materiality

Only significant items should be considered when preparing financial statements.  These are items whose omission or non-disclosure will result in a distorted view of the financial statements and will mislead the users of these financial statements.  Items may be considered significant in amount or importance depending on the nature and size of the firm.  For example, a miscellaneous expense of shs. 100,000/= may be insignificant for a large insurance company but significant to a sole trader.

Qualitative attributes of accounting information

In addition to complying with the basic accounting principles, accounting information must have certain qualities for its users to attain maximum benefit from it. These qualities are Timeliness, Relevance, Quantifiability, Verifiability/Objectivity and Understandability.

Timeliness

To have the intended benefits, accounting information should be available to the user at the appropriate desired time so that it is incorporated in decision-making processes.

Relevance

Since the volume of accounting data which can be generated is infinite, it is important that the provider of accounting information selects from all data available only those which are most likely to meet needs of users of accounting information.  Inclusion of irrelevant data results in wastage of resources.

Quantifiability

Accounting information should be able to be quantified.  Quantification is usually in monetary terms although quantities other than currency are employed by accountants. This however, does not mean exclusion of non-quantifiable qualitative factors in management decision making.

Verifiability/Objectivity

Accounting information should be measured in such a manner that two or more professional accountants of equal competence should be able to measure the same data and arrive at approximately similar results. Verifiable, objective information is also reliable.

Understandability

Accounting information to be useful must be understood by the different users.  It has to be presented concisely and with clarity.

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