Financial accounting is no easy subject to unpack.
It includes moving parts and variables in the accounting cycle that can depend on the size of a company, the type of business it does, the period of time over which information is reported, and many other aspects of business operations.
To grasp the fundamentals of such a complex field, we compiled this list of 13 essential accounting principles. These principles break down the general rules of accounting into individual parts that demonstrate the fundamentals on which the financial accounting world is based.
These 13 principles form the backbone of financial accounting. Let’s dive in to take a look at what these principles are and how they affect the work of accountants:
The foundation for accrual basis accounting, the accrual principle states that transactions should be recorded in the period in which they occur. This principle is in contrast to the idea that transactions should be recorded in the period in which cash flows as a result of the transaction’s occurrence. A demonstration of the accrual principle would be recording revenue when a customer is invoiced instead of when the customer pays.
The conservatism principle of accounting helps accountants decide between two seemingly equally acceptable options when reporting an item. In practice, the conservatism principle implies that an accountant should recognize the transaction resulting in the lowest amount of net profit when given a choice of transactions with equally likely outcomes. At the center of the conservatism principle is the fundamental that revenue and assets should be recognized only when they are sure of being received
The consistency principle outlines that accountants should maintain the same accounting method across transactions and over a long period of time. If a business uses different accounting methods and practices, it can skew the reporting so that long-term results are difficult to interpret.
The cost principle asserts that a business should record its assets, liabilities, and equity investments at their original purchase costs rather than what they’re currently valued at. However, this principle is not widely used. Recent trends in accounting have popularized the practice of recording these items at their fair values instead of their original purchase prices.
The economic entity principle states that a business’s transactions should be kept separate from those of the owner, partners, and shareholders of the company. All transactions under this principle must be assigned to a specific entity of the business, and cannot be mixed with other entities.
The full disclosure principle demands that businesses report all necessary information about their financials to all parties that are inclined to read this information. This principle ensures that all viewers of a company’s financial information are not misled or left out of having access to important information.
The going concern principle is the assumption that an entity will remain in business for the long-term future. While seemingly intuitive, this principle assures readers of financial information that a company will not be folding operations or liquidating its assets in the short term. Therefore, an accountant can be justified in holding off on recognizing certain expenses until a later period, when the company will still be in business.
The matching principle mandates that a business should report an expense on its income statement in the same period in which the revenue is earned. If this expense is not directly tied to revenues, then it should be reported on the income statement in the period in which it expires.
The materiality principle guides accountants to ignore the accounting standard if the net impact of ignoring this standard is so small that it does not mislead readers regarding any financial information. There are no set guidelines for what constitutes a small net impact, as even if a minor item constitutes 1% of total assets, it still has the potential ability to change a net profit to a net loss. In using the materiality principle, it’s best to exercise personal judgment on a case-by-case basis to determine when its use is appropriate.
The monetary unit principle states that businesses should only record transactions that can be presented in terms of a unit of currency. An asset that is purchased for a specific price falls under this category. This principle guides a business to avoid estimating its value of assets and liabilities.
The reliability principle is the base assumption for all financial statements that all financial information presented is the most accurate and relevant information available. In order for financial information to be of use to accountants and shareholders alike, it needs to be useful or important for decision-making regarding a company’s financial health.
The revenue recognition principle states that revenue should only be recorded when it is earned, not when cash is collected. For example, if a furniture business agrees to sell a table to a customer and provides the customer with the table, it can recognize the revenue can be recorded right then even if the customer does not pay for the table until a week later.
The time period principle outlines that a business should report all of its financial results from its activities over a standard time period. A standard time period is typically monthly. quarterly, or annually. Any financial statement includes in its header the time period covered by the statement to note that this principle is acknowledged.
These accounting principles are essential to an understanding of the field of financial accounting. And if you are just starting out and trying to get the hang of keeping track of your company’s financial information, G2’s guide to the best accounting software can be of major help to your business.
Interested in learning more about accounting theory? Check out our guide on calculating variance now!
Rob is a Content Writer at BKA Content, and a former Content Marketing Specialist at G2. Originally from New Jersey, he previously worked at an NYC-based business travel startup. (he/him/his)
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