Accounting Principles and Rules

Accounting Rules

• Accounting uses standard rules, followed by everyone, to ensure consistent and understandable financial information.
• Without these rules, comparing the financial health of different businesses would be difficult.
• This chapter covers key accounting principles, outlining how businesses record capital and revenue expenditure and receipts, as well as valuing inventory consistently.

Accounting Principles

• Accounting principles, also called concepts and conventions, are rules directing how businesses record financial activities.
• A 'concept' is a basic rule, while a 'convention' is the accepted way to apply that rule in specific situations.
• These principles ensure consistency and accuracy in financial records.

Business Entity Principle

• The business entity principle treats a business separately from its owner.
• This means the owner's personal assets and transactions are not recorded in the business's accounts.
• Transactions involving both business and owner are recorded in the business's accounts.
• e.g., owner investment is credited to the capital account; owner withdrawals are debited to the drawings account.

Consistency Principle

• In accounting, multiple methods (e.g., depreciation calculation) may be applicable.
• The chosen method should provide realistic results.
• Consistency, using the same method consistently, is crucial for comparing financial results over multiple years.
• Changes in methods, when justified, must be explained in financial statements.

Duality Principle

• The duality principle states that every financial transaction has two sides: one giving something and one receiving something.
• This is recorded in two places in accounting records, called double-entry accounting.

Going Concern Principle

• This principle assumes a business will operate indefinitely.
• Non-current assets are recorded at their book value (original cost minus depreciation), and inventory at the lower of cost or expected selling price.
• If business closure is imminent, asset values are adjusted to reflect potential sale values.

Historic Cost Principle

• Assets and expenses are initially recorded at their actual purchase cost.
• This principle relates to the verifiable nature of costs.
• While helpful, this principle can sometimes make it difficult to compare transactions over time due to inflation.
• Depreciation is often employed to more accurately reflect the value of non-current assets over time.

Matching Principle

• This principle, also known as the accruals principle, ensures revenue and expenses are recognised in the same accounting period.
• This occurs regardless of when cash transactions happen.
• This extends the realization principle by including all income and expenses for the accounting period.
• This alignment helps in meaningful comparisons of profits, sales, and expenses across different years.

Materiality Concept

• Businesses can ignore insignificant transactions.
• The effort and cost of tracking such items exceed the benefits, so recording them is unnecessary.
• Small, insignificant items are not tracked separately; rather, they could be lumped into a single expense category.

Money Measurement Principle

• Only measurable financial data in monetary terms is included in accounting records.
• This avoids subjective opinions, making it easily observable and objective.
• Non-monetary factors like employee morale, managerial effectiveness, etc., are not usually recorded.

Prudence Principle

• Also known as the conservatism principle, ensuring financial records are realistic and trustworthy.
• It discourages overstating profits and understating losses.
• Profits should only be recognised when certainty exists; possible losses should be anticipated. This principle helps prevent overoptimistic accounting practices, which aren't useful for informed decision making.
• Instances where another rule conflicts with prudence necessitate adhering to prudence.

Realization Principle

• A profit is recognised when the transaction is complete.
• Earnings are recognized when ownership of goods or services is transferred from seller to buyer.
• Creating a legal obligation for the buyer to pay is also necessary.
• A profit isn't recorded until goods or services are transferred.

International Accounting Standards

• These standards establish rules for consistent financial statement preparation worldwide.
• Their goals include protecting users of financial statements and preventing misinformation.
• Effectiveness depends on the quality of financial information, measured by four key aspects: comparability, relevance, reliability, and understandability.

Compatibility

• Financial statements are most useful for comparing over time, or with similar businesses.
• Knowing if accounting methods or policies have changed is vital for comparison.
• This understanding lets users better appreciate business performance and position.

Relevance

• Financial statements need to be timely to be considered helpful.
• Relevant information helps check past expectations and predict the future.
• Knowing the present state helps people understand and forecast business health better.

Reliability

• Reliable financial statements meet specific criteria to be considered trustworthy.
• Characteristics of reliable statements include accuracy, verifiability, unbiassed and error-free representation of transactions.
• An essential part of reliable statements is that judgments and estimates are considered carefully.

Understandability

• Financial statements should be easy to interpret by users.
• Clarity depends on the information itself and the user's competence.
• This includes a basic grasp of business, economics, and accounting principles.
• Important information should not be ignored, even if complex for particular users.

Capital and Revenue Expenditure/Receipts:

• Capital expenditure: Money spent on buying/improving non-current assets (e.g., machinery, buildings). Such costs are recorded as non-current assets, as they generate benefits over several years and are therefore not treated as immediate expenses.
• Revenue expenditure: Money spent on the daily operations of the business. This includes day-to-day expenses for running the business (e.g., administrative expenses, selling expenses, etc.). Revenue expenditure is matched against the revenue earned in the same period.
• Capital receipts: Money received from sources other than trading activities(e.g., owner contributions, loans, selling non-current assets). These receipts don't part of revenue of the business
• Revenue receipts: Money received through ordinary business operations (e.g., sales, fees, rent). These are recorded in the income statement.

Inventory Valuation

• Inventory should be valued at the lower of cost or net realizable value.
• Cost of inventory includes purchase price and additional costs (shipping).
• Net realizable value is the estimated selling price minus any costs to finish or sell goods.
• If the cost of inventory is higher than the net realizable value, inventory should be valued at the net realizable value to prevent overvaluation.

Explore the fundamental rules and principles of accounting in this quiz. Learn about the importance of consistent financial reporting and how different accounting concepts guide the recording of business transactions. This includes the business entity principle and valuation methods for inventory.