Whether you intend to do your bookkeeping or plan to pay someone else to do it for you, gaining an understanding of the basic accounting principles will help you to understand your bookkeeping reports.
Why are basic accounting principles important?
One of the purposes of accounting information is to enable us to compare and contrast the performance of a business with others in the same or similar industries. The generally accepted accounting principles mean accounting information is created using the same basic assumptions.
Where there is any deviation from these principles, the organisation/business is required to disclose that fact in the statements.
The Accounting Entity Assumption
A bookkeeper is required to record, classify and summarize the transactions of a business in the financial statements. To do so, he or she must be able to identify the boundaries between the business and the business owner.
Under the accounting entity assumption, the business is considered to be a separate entity from its owner. (Even for sole trader businesses).
It is assumed that each entity owns its assets and incurs its liabilities. The assets, liabilities, and business activities are kept entirely separate from those of the owner.
This assumption is particularly important for small business owners. There is often a tendency to blur the lines between the business and themselves. This can be to their detriment financially. If your accountant or bookkeeper has to spend time sorting through your business and personal records it will cost you!
The Cost Principle
The resources of a business are initially recorded at their cost under the cost principle. Cost is calculated as the price paid plus any other expenses incurred for the delivery or set-up of the resource.
In reading a balance it pays to remember this principle. The dollar values reported in the balance sheet are the original cost. And not an indication of the current market value.
The Going Concern Assumption
Financial Statements are prepared on the assumption that the business will continue to operate in the future.
The Period Assumption
The financial performance of a business is measured in terms of the net profit. Net profit is calculated over a fixed period. This principle divides the life of the business into equal intervals of time. The statutory requirements specify that the reporting period is twelve months (i.e. a financial year).
The Objectivity Assumption
Accounting data is to be reported on an objective or factual basis. This also explains the cost principle. Recording assets at cost allows a certain degree of stability or certainty about the data. Current market values are based on estimates, appraisals or opinions, whereas the original cost is factual data.
