Principles for Preparing Financial Statements

The accountant keeps all the owner’s personal transactions different from the transactions of hisA businessA of sole proprietorship. ForA legalA purposes, a sole proprietorship and its owner are considered to be one entity, but in accounting they are two separate entities. Monetary Unit Assumption: Any Economic activity taking place is measured in U.S. dollars, and the ones which can be expressed in U.S. dollars are recorded. Because of this principle, an assumption is made that the purchasing power of the dollar has not changed over time. Hence, accountants do not take into account the effect of inflation on recorded amounts. For example, dollars from a 1952 transaction are shown with dollars from a 2008 transaction. Time Period Assumption: According to this principle it is possible to report the ongoing activities of a business in relatively short, distinct time intervals such as the five months ended June 31, 2009, or the 5 weeks ended June 1, 2009. The bigger the time interval, the less likely is the need for the accountant to estimate amounts relevant to that period. For example, the property tax bill is received on December 15 of each year. On the income statement for the year ended December 31, 2008, the amount is known; but for the income statement for the three months ended March 31, 2008, the amount was not known and an estimate had to be used. It isA imperativeA that the time interval be shown in the heading of each income statement, statement of stockholders’ equity, and statement of cash flows. Labeling one of theseA financial statementsA with “December 31” is not good enough-the reader needs to know if the statement covers theA one weekA ending December 31, 2008 theA monthA ending December 31, 2008 the three monthsA ending December 31, 2008 or theA year endedA December 31, 2008. Cost Principle: From an accountant’s view point, the term “cost” refers to the money spent (cash equivalent or cash) when an item wasA originallyA obtained, whether that purchase happened 2 years ago or fifty years ago. So, the amounts shown on the financial statements are referred asA historicalA cost amounts. In view of this principle, assets are not adjusted in accordance with the inflation factor. An increase in value cannot be reflected by making changes to the assets. Thus, if an asset were to be sold at their present prices it would not tell how much amount of money a company would finally recieve. However, an exception to the above are the investments made in the stock exchange in the trading of bonds and stocks. To get the value of a company’s long term assets one needs to look for a third party because it is not reflected in the financial statements of the company. Full Disclosure Principle: If some important information of an investor or lender is there using the financial statements, that information has to be disclosed in the statement or in the notes of the statement. It is due to this accounting principle that many “footnotes” have to be attached to the financial statements. As an example, let’s say a company X is named in a lawsuit that demands a lot of money. When the financial statements are prepared it is not clear if the company X would win or lose the lawsuit. Because of this principle the lawsuit will be described in the notes to the financial statements. A company generally lists its significant accounting policies as the first note to its financial statements. Going Concern Principle: The basic assumption made by the accounting principle is that a company will fulfill all its functions, objectives and at the same time will not liquidate in the following course of time. However, if the accountant believes that the company is in a financial crunch and will not be able to carry its work forward, he is required to make this assessment public. In such a situation the going concern principle allows the company to postpone part of its prepaid expenses to another time or till one of the future accounting periods Matching Principle: This above stated principle uses accrual basis of accounting i.e. the expenses must be synchronized with the revenues. For example, sales commission’s expense should be recorded in the time period when the actual sales were carried out and not in the time period of payment of commissions. Similarly, wages are calculated as expense in the period when the employees actually worked excluding the period when the wages were dispersed. If a company decides on a bonus of 3% of its 2008 revenues on January 25, 2010, the bonus would be included in its expenses of 2008 and the amount unpaid at December 31, 2008 is considered as a liability. Since there are no means to measure the future economic profit of things like advertisements the accountant makes sure that the ad amount to expense is charged only in the period when the ad is shown. Revenue Recognition Principle: Under the accrual basis of accounting (as opposed to theA cash basis of accounting),A revenuesA are recognized as soon as a product is sold, and not when the money was received. Under this basic principle, a company could earn and report $40,000 of revenue in the first month of operation but receive $0 in actual cash in that month. For example, if ABC Consulting completes its service at an agreed price of $1,000, ABC should recognize $1,000 of revenue as soon as its work is done-it does not matter whether the client pays the $1,000 immediately or in a month. Do not confuseA revenueA with aA cash receipt. Materiality: Because of this principle or guideline, an accountant might be allowed to violate another accounting principle if an amount is insignificant. An example of an obviously immaterial item is the purchase of a $165 scanner by a multi-million dollar company. Since the scanner will be used for four years, theA matchingA principle directs the accountant to expense the cost over the four-year period. TheA materialityA guideline allows this company to violate the matching principle and to expense the entire cost of $165 in the year it was purchased. The justification is that no one would consider it misleading even if $165 is expensed in the first year instead of $40 being expensed in each of the four years that it is used. Because of this principle, financial statements usually show amounts rounded off. Conservatism: If there is a situation which has two alternatives, then according to this principle the accountant can choose the alternative which will result in less asset amount and/or less net income. Accountants should not be biased. The basic accounting principle of conservatism leads accountants to show losses, but it does not allow them to show gains. For example,A losses from lawsuits will be shown in the financial statements or in the notes, butA potentialA gains won’t be shown. Also, an accountant may give the amount of inventory less than the actual cost, but not vice versa.

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REFRENCES

https://www.accountingcoach.com/online-accounting-course/09Xpg01.html

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