Accounting Principles

Accounting is the language of business and finance. The modern field of accounting was established by the Italian mathematician Luca Pacioli in 1494 when he became the first to publish a description of a method of double-entry bookkeeping being used in parts of Italy. Double entry bookkeeping had an enormous impact on how business operations could be overseen and administered. The essentials of double-entry accounting have for the most part remained unchanged for over 500 years.

Accounting or accountancy is the measurement, processing, and communication of financial information about economic entities such as businesses and corporations. It involves the systematic and comprehensive recording of financial transactions as well as the process of summarizing, analyzing and reporting these transactions to oversight agencies, regulators and tax collection entities.

Basic accounting terms include revenues, expenses, assets, liabilities, income statement, balance sheet, and statement of cash flows.

5 Principles of Accounting

There are 5 key principles of accounting. These principles dictate how revenues and costs should be recorded to accurately reflect the real profitability of operations.

1. Revenue Recognition

The revenue recognition principle states that revenue for the business is earned and recorded at the point of sale. This means that revenue occurs at the time at which the buyer takes legal possession of the item sold or the service is performed, as opposed to the moment at which cash for the transaction is accepted by the seller.

2. Expense Recognition

The expense recognition principle, states that an expense occurs at the time at which the business accepts goods or services from another entity. Essentially, it means that expenses occur when the goods are received or the service is performed, regardless of when the business is billed or pays for the transaction.

3. Accrual Accounting

The matching principle states that you should match each item of revenue with an item of expense. In other words, you match the expense of the input with the revenue earned from the sale of the output. When a business applies the revenue, expense, and matching principles in practice, they are operating under the accrual accounting method.

4. Historical Costs

The cost principle states that you should use the historical cost of an item in the books, not the resell cost. For example, if a business owns a property, that property should be listed at the purchase value less depreciation of the property, not the current fair market value of the property.

5. Objectivity Data

The objectivity principle states that you should use only factual, verifiable data in the books, never a subjective measurement of values. Even if the subjective data seems better than the verifiable data, the verifiable data should always be used.

Financial Statements

The three basifinancial statements are:

  1. The Balance Sheet, which shows a firm’s assets, liabilities, and net worth on a stated date;
  2. The Income Statement, which shows how the net income of the firm is arrived at over a stated period through, and
  3. The cash flow statement, which shows the changes in changes in cash during the period.

Public companies are required to file quarterly financial statements, in addition, to the Annual Report.

Balance Sheet

a statement of the assets, liabilities, and capital of a business or other organization at a particular point in time, detailing the balance of income and expenditure over the preceding period.

Income Statement

An income statement or profit and loss account is one of the financial statements of a company and shows the company’s revenues and expenses during a particular period. It indicates how the revenues are transformed into the net income.

Cash Flow Statement

a cash flow statement, also known as the statement of cash flows, is a financial statement that shows how changes in balance sheet accounts and income affect cash and cash equivalents, and breaks the analysis down to operating, investing and financing activities.

GAAP vs IFRS

A major difference between GAAP and IFRS is that GAAP is rule-based, whereas IFRS is principle-based. With a principle-based framework, there is the potential for different interpretations of similar transactions, which could lead to extensive disclosures in the financial statements.