Basic Principles of Accounting Every Entrepreneur Should Know

What are Principles of Accounting?

Accounting principles refer to the standards which set a guideline about accounting over the preparation as well as presentation of financial information. Such principles are the base of accurate, consistent, and reliable financial reporting. The accounting principles in India, as understood and accepted, line up with globally accepted GAAP as well as IFRS.

Accounting principles are what make the balance sheet and income statements, among others, realistic reflections of the real financial position of a business. Compliant adherence to these principles avails businesses of the benefits of gaining the stakeholders' credibility and making prudent financial decisions while ensuring strict compliance with regulatory standards.

There are nine basic accounting principles underlying all financial transactions. To an entrepreneur, understanding these principles would help keep accurate records and understand financial statements, thereby making proper financial decisions.

Accrual Principle

Under the accrual principle, revenues and expenses are recognized based on realization and not based on cash realization. This ensures that financial statements accurately reflect a company's true financial situation.

• Example: A company completes a project in March but receives the payment in April. The revenue will have to be recorded in March as well.
• Benefit: The accrual principle provides a true income statement and expenses during a period and increases the reliability of financial statements.

Consistency Principle

Under this Principle, the business has to use the same accounting methods and procedures within a specified time. In case there is a change, such a change has to be disclosed in the financial statement.

• Example: A firm taking its depreciation following the straight-line approach should continue using the same method in order not to be inconsistent.
• Benefit: It is made simpler to carry out and compare financial statements over time, adding value to understanding performance trends.

Going Concern Principle

It assumes that a business will continue to exist in some form of activity forever unless evidence to the contrary exists. It is this principle that justifies using original cost rather than liquidation value as the measure of valuing assets.

• Example: The organization may place the value of its machines at historical cost if it expects that they will be used for a long time.
• Benefit: This is because it enables long-term planning and asset management, thus helping enterprises plan their financial strategy with stability.

Matching Principle

As per this, Expenses should be recorded in the same period as the revenue they help generate according to the matching principle, or in other words, this principle is what gives proper assessment to profitability.

• Example: An advertising cost spent during January to boost sales in January should be accounted for in January, Cost aligns with the revenue generated.
• Benefit: It ensures that expenses and revenues are matched, thus giving a much clearer view of the financial performance.

Cost Principle

The cost principle dictates that assets be shown at the historical cost incurred during acquisition and not at a currently prevailing market price. This would ensure that no business inflates an asset's value.

• Example: Suppose that one buys a piece of land for ₹15 lakh. The above would be recorded at ₹15 lakh, irrespective of what the market value is today.
• Benefit: It retains objectivity since the valuations of assets are based on actual transactions and are reliable.

Materiality Principle

According to the materiality principle, all information in financial statements should be disclosed if it is regarded as material. However, trivial details that would likely not affect decisions taken may sometimes be omitted.

• Example: Minor stationery items can just be added to a broad expense category instead of listing every little item.
• Benefit: This would benefit by offering practicality in financial reporting, in which reports focus on the information most influencing business decisions.

Prudence Principle (Conservatism Principle)

The prudence principle encourages conservatism, where the revenues and assets are not overstated, and potential losses and liabilities are kept on record.

• Example: If a firm expects loss, then it should immediately account for the loss, but account for potential revenues only when assured.
• Benefit:  It encourages prudence in finance that will not overstate its assets but rather state the liabilities low.

Full Disclosure Principle

The full disclosure principle is that businesses ought to be clear and open about disclosing their statements regarding their financial information.

• Example: If a company changes the method of depreciation, that should be presented on the financial statements.
• Benefit: It makes stakeholders understand where the company stands in terms of finances, hence increasing transparency and thus building trust.

Revenue Recognition Principle

Revenue recognition principle, revenue can only be recognized when earned and realized regardless of the time when payment was received.

• Example: A company selling a product in April but expecting payment in May should recognize the revenue from the sale when the sale occurred in April.
• Benefit: This benefit ensures that revenues are reported accurately and revenues are not recognized too early; hence, income rightly flows with the delivery of services or products.

Importance of Accounting Principles

Apart from compliance, accounting principles are significant in terms of decision-making, transparency, and sustainable growth. Here's why they matter.

Facilitating Informed Decision-Making

Precise financial statements prepared based on accounting principles are reliable sources of data used by entrepreneurs while making strategic decisions.

• Data-Driven Decisions: The availability of good quality financial data facilitates the study and appraisal of business performance, formulating goals, and making investment decisions.
• Risk Mitigation: Account transparency will allow entrepreneurs to identify possible risks in the financial records and, thus, lead to the development of more resilient business practices.

Enhancing Transparency & Credibility

Accounting principles create trust among the investors that the financial statements depict a truthful and accurate view of a business enterprise's financial scenario.

• Investor Confidence: Positive and believable reporting will boost investor confidence, and therefore funds will be raised more easily.
• Improved Stakeholder Relations: Open records show trust and foster better relationships with investors, creditors, and employees.

Enabling Comparability & Benchmarking

Standardized principles allow a company to compare the performance of the business for different periods and with the best in the industry. Through this, entrepreneurs can easily identify areas that need growth.

• Historical Comparisons: The principle of consistency allows comparisons that might be meaningful in historical terms.
• Industry Benchmarking: Comparability enables businesses to compare their position with competitors.

Supporting Long-Term Financial Planning

Accounting principles essentially provide that the accrual of revenue and expenses and all assets have to be accounted for in accounting, which is always very vital for achieving long-term financial planning.

• Cash Flow Management: Correct revenue recognition and proper accrual practices help provide cash flow projections.
• Profitability Analysis: Applying the principles of matching and prudence in analyzing profitability ensures that there is a sensible usage of resources.

Conclusion

The nine major accounting principles will guide entrepreneurs in the process of developing financial systems for their respective firms. From accrual and consistency to prudence and recognition of revenue, these principles provide a uniform approach to recording and analyzing financial information. Accounting principles make entrepreneurs more transparent, accurate, and aware of the financial performance of their business. If you are a commerce student, you can learn more about this on Plutus Education. Mastering these principles is not just compliance for Indian entrepreneurs but a way to make the business sustainable and growth-oriented.