This article has been written by Jay Chandrashekhar Bhatt pursuing a Executive Certificate Course in US Accounting and Bookkeeping from Skill Arbitrage.

This article has been edited and published by Shashwat Kaushik.

Introduction

Accounting, explained in layman’s language, is to keep a record of the course of events that are majorly financial but can also be non-financial and occur during the conduct of day-to-day business activities. Accounting can also be termed somewhat similar to what we call “Book-keeping”. However, accounting is an advanced version covering a wider scope than the term book-keeping.

Accounting can also be referred to as classifying the events occurring during the course of your business into four major groups: income, expenses, assets, and liabilities.

Definition of book-keeping and accounting

According to J. R. Batliboi, bookkeeping can be defined as “the science as well as the art of recording the business transactions in appropriate accounts.” 

The term Accounting can be defined as the systematic process of identifying, classifying, summarising, interpreting, and communicating information about financial transactions to the user of the financial statements, such as owners, governments, investors, creditors, etc.

Scope

The scope of accounting is much wider than it is understood in general terms of business. Accounting not only includes recording the business transactions but also grouping them appropriately, classifying the transactions, keeping records of the transactions for understanding the trends in the financial market, and presenting the transactions in a manner that does not depict window dressing and shows a true and correct view of the financial position of the business as of the date. Making decisions regarding when an accounting policy adopted by the organisation needs to be changed or amended from time to time, whether the accounting policy adopted is in accordance with the generally accepted accounting principles or not, shall also fall under the scope of the term “accounting.”.

Why should one understand the principles of accounting

Maintaining the books of accounts and doing the accounting task without understanding the principles of accounting is just like knowing how to ride a vehicle but not knowing what is to be done when the vehicle faces a technical glitch during the ride. So understanding the principles of accounting is crucial for completing and finalising the financial statements, presenting the same in a manner so that all the users of financial statements are able to read, understand, make decisions, and act accordingly on their own without requiring them to explain the concepts and figures.

Principles of accounting can be referred to as tools with the help of which you can measure your income and expenses and account for them accordingly. It also helps you classify your liabilities and assets, measure them, and present them in the financial statements. Principles of accounting are also required to be understood for measuring the future probable losses and/or events that can hamper the financial position of the organisation, classifying them, recording them at the present value of future outcomes, and helping you to be financially sound today.
Principles of Accounting can also help you compare your financial positions with those of your competitors. It also assists in budgeting the finances, and preparing the cash in and out-flows from the business. Hence, knowing the principles of accounting is a crucial part of the process of preparing the financial statements.

Principles of accounting

Principles of accounting can be lined up as follows:

• Accrual Concept
• The Conservatism Principles
• The Cost Concept
• Revenue Recognition Principle
• Consistency Principle
• Objectivity Principle
• Growing Concern concept
• Economic entity concept

These are the major principles of accounting that play a crucial role in the preparation of the financial statements of an entity. Each and every business organisation, be it a sole proprietorship, an LLP or major enterprises like big MNCs, is required to follow the principles of accounting. Let us understand each one of them briefly.

Accrual concept

This concept is mainly for the income and expenditure portion of the financial statement. It says that one should recognise an income and an expense when it is initiated. An accountant following this concept need not wait for an expenditure to be completed in terms of payment (actual deduction of the amount from the bank or in cash). Once it is judged or identified that an organisation has to incur the expense, or, in simpler terms, there is going to be an out-flow of finances, accountants need to book the expenditure into their financial statements. The same lies with the incomes, which are definitely going to be earned in the near future or the probability of the same is much higher. However, a doubt generated here can be about the valuation of such income and expenses, which is altogether a different point to be discussed. The concept of accrual helps an organisation to depict or report its financial position, and performance appropriately during a given time frame, thereby giving a true and correct picture.

The conservatism principle

This concept requires an accountant to record potential revenues to be generated by an organisation in a cautious manner, meaning that revenues should be recognised only when they are realised in terms of cash-inflows or when it is highly probable that they will be realised, the evidence of which is obligatory.

It also requires an accountant to be very vigilant in recognising the potential losses an organisation may incur, which can be dependent on the occurring or non-occurring of certain events. Accountants should recognise an expense/loss as soon as it is suspected that there will be probable outcomes that are non-favoring for the organisation.

The cost concept

This concept explains to an accountant how an asset is to be valued. By speaking, the term “valued” means what figures are recorded in the financial statements. An asset has always to be recorded at cost, meaning the cost incurred by an organisation, including its purchase value up to bringing it into the premises and making it ready to use. All costs and expenses incurred for the above shall be recognised as the cost of the asset and the same shall be recorded in the financial statement. The core of the concept is to provide an actual figure at which an asset is acquired and to prioritise the actual transaction value.

Revenue recognition principle

This principle explains that revenue is to be recognised only when it is probable that it will be earned by the organisation. Again, the word probable is in itself a debatable term; however, it solely depends on case to case and entity to entity whether a particular revenue is recognised or not. This principle is also required to be adopted in order to ensure that revenues are not recorded prematurely. For example, for an entity that is in the personal finance business (lending of loans, O/D’s), interest income on the loan given is subject to the realisation of EMIs, which are to be received gradually and over a period of time that can be highly uncertain. However, an organisation that is not into such business can recognise the interest income on the basis of interest certificates obtained from banks where they might have kept their deposits.

Consistency principle

Consistency simply means to strictly follow the adopted accounting principles and methods from one financial period to the next and to not change them unless and until it is required statutorily to do so or it is addressed that changing the methods will depict a more correct view of the financials for the organisation. Here are some key aspects of consistency in accounting:

• Continuous application: Adhering to the same accounting policies, rules, and procedures consistently across all accounting periods allows for reliable and comparable financial reporting.
• Disclosure of changes: If any changes are made to the accounting principles, methods, or estimates used, they should be disclosed in the financial statements along with a clear explanation of the reasons behind the change.
• Statutory requirements: Changes enforced by statutory requirements, such as a change in tax laws or the adoption of new accounting standards, must be implemented.
• Presentation of financial statements: Consistency is also crucial in the presentation of financial statements. Similar formats, classifications, and terminology should be used from period to period to ensure comparability.
• Impact on comparability: Consistency enhances the comparability of financial statements, allowing users to assess the organisation’s financial performance and position over time and make informed decisions.
• Reliability and credibility: Consistent accounting practices contribute to the reliability and credibility of financial statements. Users can have confidence that the information presented is accurate and consistent, facilitating meaningful analysis and decision-making.
• Regulatory compliance: Consistency in accounting practices aligns with regulatory requirements and standards, ensuring compliance with applicable laws and regulations.
• Internal control and audit: Consistent accounting policies facilitate effective internal control systems and audits, streamlining processes and enhancing the accuracy and transparency of financial reporting.

Objectivity principle

By the term “objectivity,” we mean to say that the financial statements prepared must not be prejudicial or based on some human judgements without any evidence to prove them. The figures in the financial statements should have objective evidence rather than mere facts, on which reliability cannot be established. Here are some key aspects of objectivity in financial reporting:

1. Independence: Auditors and other professionals involved in the financial reporting process must be independent of the entity being reported on. This means that they should have no financial or personal interests that could impair their ability to provide an objective opinion on the financial statements.
2. Evidence: The information presented in the financial statements should be supported by objective evidence. This evidence can include source documents, such as invoices, receipts, and contracts, as well as independent verification, such as audits and reviews.
3. Transparency: Financial statements should be prepared in a transparent manner, with all relevant information being disclosed. This includes both positive and negative information, as well as any uncertainties or risks that may affect the entity’s financial position.
4. Consistency: Financial statements should be prepared consistently from period to period, using the same accounting principles and methods. This allows users to compare the entity’s financial performance over time and make informed decisions.

Growing concern concept

The term growing concern means to visualise that the organisation is going to be operational to its fullest strength and grow infinitely. Accountants are required to prepare their books of accounts, taking into consideration that the business is never going to be halted unless there is substantial evidence that might question the principle of growing concern for an organisation. There are several factors that accountants consider when assessing the going concern assumption, including the entity’s financial condition, its industry outlook, and its management’s plans for the future. If there are any material uncertainties about the entity’s ability to continue operating, the accountant must disclose this in the financial statements.

The going concern assumption is important for several reasons. First, it allows accountants to prepare financial statements that are more useful to users. Second, it helps to ensure that businesses are not forced to liquidate or curtail their operations prematurely. Third, it promotes stability in the financial markets.

Here are some examples of events or circumstances that might indicate that the going concern assumption is no longer appropriate:

• The entity has suffered significant financial losses.
• The entity’s industry is in decline.
• The entity is facing a significant lawsuit.
• The entity’s management has announced plans to liquidate or curtail its operations.

Economic entity

This term tries to explain that the business is an economic entity; it is neither related to someone personally nor has to be treated accordingly. This states that a business is a separate, identifiable and distinguished personality. (An exception to this concept can be a Sole Proprietorship business.) Here are some examples of how the concept of business entity separation works:

• If a customer sues a business for damages, the customer can only sue the business, not the owners of the business.
• If a business owes money to a creditor, the creditor can only collect the debt from the assets of the business, not from the personal assets of the owners.
• If a business goes bankrupt, the owners of the business are not personally liable for its debts.

Limitations to the principles of accounting

1. Principles of accounting will undoubtedly provide us with a path to measure financial transactions; however, these do not take into consideration events that are non-financial in nature, like political events, changes in the laws by the government, environmental changes, or natural events, which might have a major impact on the principles that are followed.
2. Accounting principles majorly focus on the time value of money and do not focus on the changes in events that affect the value of money from time to time, especially the present value of the future estimated cost.
3. Another limitation can be substance over form; importance is not given to the substance of the information available; only the form of the information is highlighted and accounting is to be done accordingly.

Adverse effects if accounting principles are misunderstood

Accounting principles, when misunderstood, can have adverse effects, like the non-recognition of  future losses that the organisation is not ready to face, which can bring serious financial crunch and thereby lead to inviting the winding up procedures.
Misunderstanding of accounting principles might occur when there is no objectivity to the principles adopted and there is just a cause to safeguard the personal interests of a few.

Conclusion

Understanding the accounting principles before getting into the actual accounting process is very crucial for an accountant. This can help him/her to keep a track record of the transactions, ensure a smooth process, and provide transparency to the figures in the financial statements. In summary, a firm grasp of accounting principles is vital for accountants to perform their duties effectively and ethically. It facilitates accurate record-keeping, enhances efficiency, promotes transparency, ensures compliance, and contributes to their professional growth.

References

• https://www.shiksha.com/online-courses/articles/understanding-the-principles-of-accounting/
• https://cleartax.in/s/accounting-principles
• https://www.nerdwallet.com/article/small-business/basic-accounting-concepts
• https://online.champlain.edu/blog/basic-accounting-principles
• https://www.wallstreetmojo.com/accounting-principles/ 
• https://www.investopedia.com/terms/a/accounting-principles.asp