Basic Accounting Principles

Written by joseph nicholson
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So much depends on the reliable accounting of large, publicly traded businesses. A set of basic accounting principles exists to establish some transparency. These principles and the other standards incorporated into GAAP provide general uniformity in accounting. These produce figures used by investors and analysts to calculate financial ratios and evaluate a company. Even compliant balance sheets can be challenging to decipher, but without a system defining each category of entry, corporate financial statements would be virtually opaque and worthless.

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The first principle of accounting from which all the other basic principles flow is the economic entity assumption. This defines the entity being accounted, often a corporation, as a distinct organisation. By keeping its financial transactions separate from those of its owners, employees or affiliated groups, this principal is the root of corporate identity and the starting point of accounting.


After identifying the entity itself, there are several accounting principles that generally orient the accountant to the purpose and nature of their work. The principles regularity, consistency, permanence and sincerity, go towards the encouraging companies to use the same accounting practices quarter after quarter in a good faith effort to show the true financial condition of the company. Accounting is not known for excitement--good accounting is predictable, repetitive, honest and consistent. Accounting innovations are actually a red flag for many investors because they almost inevitably resolve in scandal.


Some of the basic accounting principles address very functional matters. A key example would be the issue of when revenue should be recorded. The revenue recognition principle makes it clear earnings should be reported when they are earned. This opens the door to the concept of accounts receivable, money earned by not yet collected, and helps provide insight into a company's financial situation. An even more important concept is the matching principle, which states that expenditures should be matched to the same time period as the revenue they generate. In other words, businesses should be able to show quarter to quarter and year to year how the money they invest in their operations generates new money, an important understanding for potential investors.


The matching principle goes hand-in-hand with the idea of periodicity, a principle that allows accounting to be broken down into artificial time periods. Business isn't usually stopped and started at each new calendar year or quarter, but accounting can create a snapshot at those periods by presenting the balance sheet as if it did. At the same time, companies must adhere to the cost principle, which smooths out fluctuations in the value of assets over time. According to the cost principle, an asset is only worth what a company paid for it unless it has been resold at a different price. Until then, any estimations of the changing value remain speculative, and therefore do not make for sound accounting.


The remaining core principles of accounting, non-compensation, prudence and continuity establish guidelines for how to prepare a balance sheet to report the financial status of the company as it truly is, and without treating assets in unorthodox ways to misrepresent the operations of the company or simply to offset other entries. Most of the white collar scandals of the late 90s and early 21st century were accounting scandals. Enron and Worldcom involved the use of offshore entities to evade taxes and embezzle billions of dollars away from the company, leaving shareholders and pensioners with nothing. Even the subprime mortgage collapse that led to the credit crisis and bailout of several large Wall Street firms was rooted in the practice of holding risky mortgage-backed securities as off-balance sheet assets. The earlier scandals led to the bankruptcy of accounting firm Arthur Anderson and to accounting reform in the Sarbanes-Oxley act.

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