Understanding Accounting Principles

Introduction

Accounting is the process of summarizing, analyzing and reporting financial transactions related to a business. Accounting principles provide the general rules, guidelines, conventions and procedures that must be followed while preparing financial statements. The purpose of accounting is to accurately record and report financial activities in order to determine the financial position of an entity and to provide useful financial information to decision makers.

Definition of Accounting

• Accounting is the process of summarizing, analyzing, and reporting financial transactions related to a business.

Purpose of Accounting

• To accurately record and report financial activities
• To determine the financial position of an entity
• To provide useful financial information to decision makers

The Four Accounting Basic Principles

Accounting principles are the standards that govern financial accounting processes, dictating how transactions are addressed, recorded and presented. Understanding these principles is essential for anyone wanting to understand financial statements. The four basic accounting principles are the revenue principle, the accrual principle, the materiality principle, and the match principle.

The Accrual Principle

The accrual principle is one of the most important fundamental accounting concepts. It states that revenue and expenses should be recognized in the period in which they occur, regardless of when the cash is received or payment is sent.

The Revenue Principle

The revenue principle is a fundamental accounting concept. It states that revenue should be recognized and recorded when it is earned, not when cash is received. Revenue is recognized when a business provides services or sells goods to a customer, rather than when the customer pays the company.

The Match Principle

The match principle states that expenses should be recognized in the same period as the related revenue. Accordingly, all costs related to generating revenue should be recognized and recorded in the same period as the associated revenue.

The Materiality Principle

The materiality principle states that the amounts of transactions must be large enough to affect the decision-making process of a financial statement user. That is, an accounting item is considered material if its omission or misstatement would influence the economic decisions of users taken on the basis of the financial statements.

The Accounting Equation

The accounting equation is the foundation of Double-Entry Accounting System and is used to balance all accounting transactions. It states that the value of the assets of a business is equal to the sum of liabilities and owners’ equity.

What is the Accounting Equation?

The Accounting equation, also known as the balance sheet equation, is fundamental to the Double-Entry Accounting System and is expressed as follows:
Assets = Liabilities + Equity

The accounting equation states that, the value of the assets of a business is always equal to the sum of its liabilities and owners’ equity. This is a fundamental principle and all the transactions of a business must adhere to this equation.

How is it Used?

Every transaction made in accounting affects the accounting equation. When a business incurs liabilities or acquires assets, a journal entry is made to record the transactions that affect the equation. The changes in each side are recorded as either increases or decreases. For every increase in one side, there must be a corresponding decrease in the other side. This ensures that the equation remains in balance.

The accounting equation is used to gain insight into the financial position of the business. By looking at the equation, you can get a sense of the company’s financial health. Moreover, it helps in the preparation of the financial statements, including the balance sheet and the income statement, which together show the financial performance of the organization.

The Accounting Cycle

The accounting cycle is a series of steps that involve the analysis, recording, and summarizing of financial transactions. It provides an overview of the key financial statements, such as the income statement, balance sheet, and statement of cash flows. It also helps to ensure transparency and accuracy in bookkeeping and record-keeping.

Step-by-Step Overview

The accounting cycle is composed of nine major steps. These steps are:

• Identify and Analyze Transactions
• Journalize Transactions
• Post to Ledger Accounts
• Adjusting Entries
• Prepare an Unadjusted Trial Balance
• Prepare Adjusting Entries
• Prepare an Adjusted Trial Balance
• Prepare Financial Statements
• Close the Accounts

Different Theories

There are a few different theories on the accounting cycle. The most commonly referenced theories are the revenue recognition principle, the cost principle, and the matching principle.

• The revenue recognition principle states that revenue should be recorded when it is earned, even if the payment has not been collected.
• The cost principle states that assets should be recorded at their cost at the time of purchase.
• The matching principle states that expenses should be recorded in the same period as the revenue they help to generate.

Records Used in Accounting

Accounting is a branch of business that involves measuring, classifying, analyzing, summarizing, and communicating financial information. To take part in effective accounting, it is important to understand the records that play an important role in it. The most common records used in accounting involve ledgers, journals, and bank statements.

Ledgers

Ledger is the summarized book of all types of accounts of an organization. It records all financial transactions related to the assets, liabilities, equity, income and expenses. The debit and credit balances are available in the ledger. From the ledger, balance sheet and income statement are prepared.

Journals

Journal is the book of original entry. It records the financial transactions in chronological order. It includes the actual records of the transactions with particular details such as date, description, cash amount or credit amount, etc. with the specific ledger account. After recording in the journal, transactions are completely transferred to the ledger.

Bank Statements

Bank statements play an important role in accounting. Bank statements provide detail of all the transactions such as withdrawal, payment, deposit etc. on our bank accounts. The financial statement generated by the bank is used to verify the cash transactions of the business. It helps in formulating a balance sheet and income statement.

Types of Accounting

Accounting is a complex field and understanding the basics can be quite a challenge. There are a variety of different accounting approaches, depending on the nature of an organization and the decisions it must make. It is important to understand the differences between the various types of accounting and when each is applicable.

Financial Accounting

Financial accounting focuses primarily on the generation of financial reports for external use. Organizations use financial accounting to create financial statements and other reports for both internal and external stakeholders such as shareholders, creditors, and customers. Financial accounting is the most common type of accounting and it helps organizations to make important business decisions.

Management Accounting

Management accounting is focused more on providing useful internal information for organizational decision-making. It includes activities such as budgeting, cost accounting, analytics, and performance evaluation. This type of accounting helps organizations to understand their businesses and make strategies to achieve their goals.

Tax Accounting

Tax accounting is primarily focused on preparing and filing tax returns. It involves activities such as calculating taxes and preparing tax returns to be submitted to the government. Tax accounting is a specialized field that requires knowledge of tax laws and regulations, as well as understanding of the organization's financial situation and the implications of any tax treatment that is applied.

Conclusion

Accounting principles are the set of rules and regulations that govern the accounting field. Understanding accounting principles is essential for anyone who is entering the accounting field, and it is a wise decision to learn this early on in your professional development. Accounting principles provide the fundamental guidelines by which financial statements and records are prepared, and through understanding, you are armed with a greater ability to make informed decisions and an understanding of the full implications of your business transactions.

How Understanding Accounting Principles Helps

Accounting principles provide the best framework for decisions to be made in the most accurate and responsible way. They allow for full transparency and accurate process documentation, helping businesses to avoid any potential accounting pitfalls. Having a good sense of understanding of the various accounting principles helps businesses create accurate financial statements and records, which allows for more informed business decisions.

Summary of Principles

The fundamental principles of accounting are objectivity, consistency, going concern and matching principle. Other important principles are cost principle, which defines that business transactions should be recorded at the historical cost; full disclosure principle, which requires that all relevant facts and circumstances should be transparently disclosed in the financial statements; and revenue recognition principle, which states that all revenues should be recorded at the time the goods are delivered or services are rendered.

Ultimately, understanding the fundamentals of accounting principles is key for individuals to make informed decisions, regardless of their position in an organization. By gaining an understanding of these principles, businesses can create more accurate financial statements and records, as well as be more aware of the full implications of accounting processes.