What are basic accounting principles and assumptions?

1. Reasons principles and assumptions are important

Accounting principles and assumptions are the essential guidelines under which businesses prepare their financial statements. These principles guide the methods and decisions for a business over a short and long term. For both internal and external reporting purposes, it is important to understand the concepts presented below because they serve as a guideline to the analysis of financial reporting issues.

2. Principles of accounting

Revenue Recognition Principle – Under this principle revenue is to be recorded when it is realized (or realizable), and when it is earned and not when it is received. Revenue is realized when goods or services are exchanged, is realizable when assets received can be converted to cash, and is earned when all necessary requirements are met entitling the company to the benefits represented by the revenue (e.g. services performed).

For example, suppose a neighborhood coffee house orders 100 coffee mugs from a coffee wholesaler in June. The coffee house takes delivery of the new mugs in July and pays for the order in August. The wholesaler does not recognize the revenue from this sale in June, when the order was placed, or in August, when the cash was received.  For recording purposes, the revenue is recognized by the wholesaler in July, when the coffee mugs were delivered to the coffeehouse.

This principle is used for the recognition of revenue for both goods and services. For example, if an attorney is hired with an agreed upon retainer fee of $2,500 in May, and the services are not performed until July, the attorney does not recognize the revenue until July.  The attorney must earn the income before it can be recorded as such, even though he/she received cash for the service at an earlier date.

Historical Cost Principle – The historical cost principle deals with the valuation of both assets and liabilities.  The value at the time of acquisition is used to value most assets and liabilities.  For example, say the coffee wholesaler purchased an office building in 1990 for $1.2 million.  Over time this asset has most likely appreciated in value.  However, in accordance with the cost principle, the original (historical) price of the building is what is recorded as the cost of the building in the books of the business.

Note that another basis for valuing elements of financial statements is coming into play.  The new basis is fair value.  With the convergence of global standards, fair value is used more in the United States to value elements of financial statements.

Matching Principle – This principle mandates that the expenses of a business need to line up with its revenue.  The expense or cost of doing business is recorded in the same period as the revenue that has been generated as the result of incurring that cost.  In the case of the coffee wholesaler, when the 100 coffee mugs were delivered in July they changed from being a part of inventory (asset) to a cost of goods sold entry (expense) in the month that the revenue from the sale was recognized.  At this point, the difference between the revenue and expense is determined as the gross profit from the sale. 

Full Disclosure Principle – This principle states that all past, present and future information that may have had an impact on the financial performance of the company needs to be fully disclosed.  The historical performance of a company is readily available, but examining the numbers does not always provide the entire financial picture of a company. Sometimes there are alternative situations that need to be reported. Pending or current lawsuits are one example of a transaction that could severely impact a company’s bottom line.  In addition, incomplete financial transactions or any other conditions that could impact the company’s performance must also be disclosed. Most of these transactions are disclosed in the footnotes to the financial statements.

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