The principles and rules for accounting require that a company’s financial statements accurately represent its current and historical financial situation. The principles emphasize the value of the accountant’s judgment in determining what amounts are material and immaterial to the business. For example, the principle of matching states that revenues must equal expenses. The cost principle states that historical cost should be used. The objectivity principle requires that the accountant only use data that is verifiable. The conservatism principle requires that the accountant round the financial statement to the nearest dollar.
The conservatism principle requires that the amount reported in the financial statements be the lesser of the actual costs or cash equivalents of the items. In an example, suppose a company A reported a loss of $50,000 on machinery it had purchased for $60,000 but sold for only $50k. The accountant must decide whether to report the loss in the current period or wait until the machinery is sold to account for it. If the loss in the machinery is significant, the accountant will report it as a current expense.
The principle of conservatism requires the accountant to use their best judgment when making the financial statements. Debiting expenses and credits reduce the account balance. In contrast, the giver must be credited in the books. If the giver gives money to an organization, the giver must be credited. This process occurs whenever a business receives money from the public. The principles of conservatism require an accountant to record every expense and revenue when it is realized. If the accountant fails to use their best judgment, they may be unable to forecast the future results of the business and will be overly conservative in their assessments of the business’s financial health.
The principles and rules of accounting set guidelines to ensure that the company’s financial statements are accurate and comparable. The purpose of using consistent accounting principles is to reduce the risk of fraudulent accounting. It also helps companies improve their transparency and reduce the risk of accounting fraud. When a company follows the principles, the financial statements are easy to understand and use. So, a knowledgeable individual should be able to review financial statements with ease. They should also be able to identify any red flags within the financial statements.
The principles and rules of accounting apply to businesses regardless of their industry or size. Revenues are accounted for in the same way as expenses. Sales commissions, for example, should be matched with expenses during the same period. Wages paid to employees should be reported as expenses when they occur and be recorded in the same period. Additionally, companies should report bonuses as an expense in the year in which they were given. However, the bonus should be reported as a liability if it was unpaid at the end of December 2018.
The monetary unit principle is another fundamental rule of accounting. This rule requires businesses to record all transactions in terms of currency units. Thus, a single transaction involving one currency is easier to record than a hundred in another. Additionally, this principle is a significant factor for businesses because it prevents overestimating the value of assets and liabilities. By using the monetary unit principle, businesses can ensure that they always show the correct values of all their financial transactions.