Financial accounting principles are the guidelines that accountants follow when recording and reporting financial information. They are designed to ensure that financial statements are accurate, reliable, and comparable.
There are seven basic financial accounting principles:
- Historical cost principle: This principle states that assets should be recorded at their acquisition cost. This cost includes the purchase price, plus any costs incurred to get the asset ready for use.
- Matching principle: This principle states that expenses should be matched with the revenues they generate. This means that expenses should be recorded in the same period as the revenues they help to generate.
- Revenue recognition principle: This principle states that revenue should be recognized when it is earned, not when it is received. This means that revenue should be recorded when the customer has a legal obligation to pay for the goods or services provided.
- Going concern principle: This principle states that the entity will continue to operate for the foreseeable future. This principle is important because it affects how assets and liabilities are valued.
- Full disclosure principle: This principle states that all relevant information should be disclosed in the financial statements. This information includes both positive and negative information, as well as information that is not required by law.
- Consistency principle: This principle states that accounting methods should be used consistently from period to period. This principle helps to ensure that financial statements are comparable over time.
These principles are important because they help to ensure that financial statements are accurate and reliable. They also help to make financial statements comparable, which is important for investors and other users of financial information.
Examples of how financial accounting principles are applied
Here are some examples of how financial accounting principles are applied:
- Historical cost principle: A company purchases a new piece of equipment for $10,000. The company would record the equipment at $10,000, even if the market value of the equipment is higher.
- Matching principle: A company sells goods for $100,000. The cost of goods sold for those goods is $50,000. The company would record $50,000 of expense in the same period as the $100,000 of revenue.
- Revenue recognition principle: A company provides services to a customer for $10,000. The customer has a legal obligation to pay for the services within 30 days. The company would record $10,000 of revenue in the period in which the services were provided.
- Going concern principle: A company is facing financial difficulties. The company’s management believes that the company will be able to continue to operate for the foreseeable future. The company would continue to use the going concern principle in its financial reporting.
- Full disclosure principle: A company is involved in a lawsuit that could result in a significant loss. The company would disclose the lawsuit in its financial statements, even though the outcome of the lawsuit is uncertain.
- Consistency principle: A company has always used the accrual method of accounting. The company decides to change to the cash basis of accounting. The company would have to disclose the change in its financial statements.
Financial accounting principles are essential for the preparation of accurate and reliable financial statements. By understanding these principles, you can better understand the information contained in financial statements.