There are two principles that govern financial reporting: conservatism and explanatory consistency. Conservatism requires that an accountant report a significant amount of a loss but also reports a smaller amount of a gain. The conservatism principle is a good one, as it guards against overestimating future gains while minimizing unnecessary expenses. This principle may be taken too far, however. Here are a couple of examples. Listed below are some examples of the conservatism principle at work in practice.
The first principle relates to monetary units. The US dollar is generally considered the functional currency of a business. In addition, the value of the dollar is not indexed to the historical cost of the assets. This principle is also known as a “monetary unit assumption principle” because it implies that the monetary unit should remain stable over time. However, this principle is not universal. Therefore, it is important to have a clear understanding of these principles to ensure proper accounting.
The second principle relates to the accrual principle. It says that accounting transactions should be recorded when they occur, rather than when the accounting period ends. In other words, the accrual principle protects against artificially delayed financial statements. Consequently, it also helps to avoid misleading practices. For example, a company that ignores this principle may report its income in a year but not in the next year. While this might be the case, it is best to follow the accrual principle if you are preparing financial statements that will be used for tax purposes.
Objectivity is another important principle. As a result of the objectivity principle, the financial statements are made free of biases and opinions. In doing so, the financial statements can be more reliable and transparent. This principle also ensures that all units are unbiased and free from pressure from the management or from external parties. This principle can make all the difference between a successful business and a failed one. For example, a multi-million dollar enterprise can expense a few hundred thousand dollars of assets during a year. Similarly, an enterprise can round numbers to the nearest million or thousand dollars.
Profit is the difference between a business’s income and expenses. Profit is also called the bottom line, and is the difference between revenue and COGS. Revenue, on the other hand, is the money that comes from sales before expenses. The five principles of accounting govern every step of the process. They help accountants accurately represent a business’s financial position. So, it’s a good idea to know the basics. And work with your accountants on the basis of these principles.
Revenue recognition also involves the concept of realization. Revenue is recorded when legal title of the product is transferred to the buyer. If the business has made a profit, it should record the profit. Otherwise, it would have to cease operations. Revenue should only be recorded when the company has earned substantial money. Similarly, losses should be recorded early to minimize liabilities. Accounting reconciliation is a tough concept to measure. In many cases, this principle is violated.
