FUNDAMENTAL PRINCIPLES OF ACCOUNTING
Following are the basic
fundamental principles of accounting:
1. MONETARY UNIT
Accounting needs all values to be
recorded in terms of a single monetary unit. It cannot account for goods like
the barter system. Assigning values to goods and items therefore becomes a
problem since it is subjective. However, accounting has prescribed rules to
deal with the same.
2. GOING CONCERN
A company is said to have an
eternal existence. Once it is formed, the only way to end it is by dissolution.
It does not die a natural death like humans do. Hence, accountants assume the
going concern principle. This principle implies that the firm will continue to
do its business as usual till the end of the next accounting period and that
there is no information to the contrary. Because of the going concern
principle, organizations can function on credit, account for accounts
receivables and payables which intend to receive or pay in the future and
charge depreciation assuming that the machine will be used for many years.
In case, the management has information that the operations will be suspended in the near future, normal accounting ceases. A special type of accounting meant for dissolution purpose is used.
3. PRINCIPLE OF CONSERVATISM
Accountants are said to be very
conservative by nature. They want to hope for the best and be prepared for the
worst. This is displayed in the rules that they have created for their
profession. One of the central tenets of accounting is the principle of
conservatism. According to this principle, when there is doubt about the number
of expected inflows and outflows, the organization must state the lowest
possible revenue and the highest possible costs.
This can be seen in the fact that
accountants value inventory at lower of cost or market price. However, such
conservatism helps the company be prepared for any forthcoming financial
crises.
4. COST PRINCIPLE
Closely related to the principle
of conservatism is the cost principle. The cost principle advocates that
companies should list everything on the financial statements at the cost price.
Usually assets like land and building, gold, etc appreciate. However, the
accountants will not allow this appreciation to be reflected on the financial
statements of the company till it is realized.
Accountants believe that the
market value of anything is just an opinion. Accountants cannot account on the
basis of opinions because there are many of them. The selling price of
something is a fact since someone has paid for it and the same can be verified.
Hence accounting works on cost principle and therefore on facts.
CASH VS. ACCRUAL BASIS OF ACCOUNTING
CASH BASIS OF ACCOUNTING
Cash Basis of Accounting uses
receipts and payments of cash to record incomes and expenses. Therefore,
under the cash basis of accounting, if a corporation makes salary payments of
January, 3 months later in April, it will be considered as expenses in the
month of April, since that is when the cash was paid. Also, if the same company
pays advance salary for the month of May in April, then it will be considered
as an expense for April.
Similarly, the time companies
spend doing value addition to their products, shows up in the books as
expenses. Only when sale is closed and cash comes in the door, is income
recognized. Cash basis of accounting considers advance payments as income since
the cash has been received.
There are obvious problems with
cash basis of accounting. They are as follows:
- Expenses Tend to be Cluttered:
It is not uncommon for firms to
negotiate trade credit for themselves. Under the terms of trade credit, firms
use raw materials over a period of time and then make one lump sum payment for
the use. Under the cash basis of accounting, all expenses appear on the financial
statements at one go when the payment is made. This clutters expenses on the
financial statements.
- Income Tends to be Cluttered:
Just like we use credit from our
suppliers, the firms that deal with us also tend to use our credit. They also
make our payments in one lump sum. Therefore, just like the expenses, the
income also tends to be cluttered.
- Financials Become Unpredictable:
Under the cash basis of
accounting, there will be no or very little income and expenses in some months
and very large income and expenses in some others. This will be because of the
cluttering effect. As a result, the financials become unpredictable.
ACCRUAL BASIS OF ACCOUNTING
On the other hand, accrual
basis of accounting, recognized income when it is earned and recognizes
expenses when they are incurred:
- The firm will expense raw materials consistently as they are used and not in one single charge when they are paid for.
- The firm will record income when all responsibilities pertaining to the sale have been fulfilled and the firm has a right to claim money from the customers.
- Advance cash received will be treated as a liability. The firm will either have to return the cash back or provide services in lieu of the same.
We use a combination of cash and
accrual basis of accounting. The profit and loss account and balance sheet are
prepared as per accrual basis while the cash flow statement talks about the
cash situation of the firm.
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