Principle’ is an overused term in accounting. It can refer to a norm or assumption that underlies the accrual basis of accounting. It’s also found in the phrase ‘generally accepted accounting ‘principles’ or GAAP. This is a US term. It refers to the set of accounting methods in general use in that country, including the accounting rules laid down by the US standard-setting body, the FASB.
The accounting policies a firm follows rest on certain fundamental principles. They are:
The going concern assumption
The financial statements are prepared – and assets and liabilities are valued – on the assumption that the company is able to continue trading for the foreseeable future. This means that it is expected to recover its investment in fixed assets through normal operations and sell its inventory in the same way.
The company applies the accounting policies it has adopted on a consistent basis. Like transactions and events are accounted for in the same way from one period to the next. This increases users’ confidence in a firm’s accounts and allows them to make inter period comparisons.
The financial statements are prepared on a prudent basis. More specifically, profits are only recognised in the income statement when they are ‘realised’ or ‘realisable’, that is when cash or claims to cash are received. In addition, prudence requires liabilities and potential losses to be provided for as soon as they arise.
The accruals concept
A company recognises revenues and expenses in the period they occur. This may not coincide with the date of cash receipt or payment. The ‘matching principle’ is an illustration of the accruals concept at work: the expense of a sale (cost of goods sold) is recognised in the same period as the revenue from it. Note that if prudence and the accruals
concept conflict, prudence usually takes precedence.
How did these principles arise? Although they are set down in commercial and tax codes in many countries, their origins are found in long-accepted business practice. Consider the timing of revenue recognition under accrual accounting. The practice of recognising revenue at the time of delivery – the dominant practice in the case of goods – took hold for legal and practical reasons. Legal title is usually transferred when the buyer receives the goods. In addition, shipment prompts changes to the seller’s books: a shipping note and invoice are issued and the inventory records are adjusted, too. To recognise sales revenue at that time minimises the number of entries the seller must make to its records.