Lecture Note 5: Basic Accounting Principles
Introduction
Accounting principles are the fundamental guidelines and rules that govern how financial
transactions are recorded and reported. These principles ensure consistency, reliability, and
comparability of financial information across businesses and industries.
1. Accrual Principle
Definition:
Revenue and expenses should be recognized in the period they are earned or incurred, not
necessarily when cash is received or paid.
Example:
A company performs services in December but receives payment in January. Under the accrual
principle, revenue is recorded in December.
2. Matching Principle
Definition:
Expenses should be recorded in the same period as the revenues they help generate.
Example:
If a business earns revenue from selling products in March, the cost of goods sold for those
products should also be recorded in March.
3. Going Concern Principle
Definition:
Assumes the business will continue to operate in the foreseeable future, without the need to
liquidate.
Implications:
- Assets are valued at historical cost, not liquidation value.
- Long-term liabilities remain classified as such.
4. Consistency Principle
Definition:
Once an accounting method is chosen, it should be applied consistently from one period to the next.
Example:
If a company uses straight-line depreciation, it should not switch to declining balance depreciation
without justification.
5. Prudence (Conservatism) Principle
Definition:
Accountants should exercise caution and avoid overstating income or assets. Potential losses
should be recognized immediately; gains only when realized.
Example:
If inventory is likely to sell below cost, the lower value should be recorded.
6. Historical Cost Principle
Definition:
Assets are recorded at their original purchase cost, not their current market value.
Example:
A building purchased for $500,000 is recorded at that amount even if its value increases.
7. Materiality Principle
Definition:
All significant information that could influence a decision-maker must be disclosed in financial
statements.
Example:
An error of $1 might be ignored in a billion-dollar company, but a $10,000 error must be corrected.
8. Entity Principle
Definition:
The business is treated as a separate entity from its owners or other businesses.
9. Monetary Unit Principle
Definition:
All transactions must be recorded using a stable and recognized currency, typically ignoring inflation
effects.
10. Time Period Principle
Definition:
The business's financial activities are divided into specific time periods, such as months, quarters, or
years.
Summary Table: Key Accounting Principles
Principle | Key Focus | Example Scenario
---------------------|--------------------------------------------|--------------------------------------------------
Accrual | Timing of revenue/expense recognition | Recording sales when earned, not paid
Matching | Aligning expenses with related revenue | COGS recorded in same period as
sales
Going Concern | Business continuity | Long-term liabilities treated as such
Consistency | Use of uniform methods | Same depreciation method each year
Prudence | Avoid overstatement | Writing down assets with potential losses
Historical Cost | Valuation based on original cost | Building recorded at purchase value
Materiality | Focus on significant data | Disclose large errors or irregularities
Entity | Business separate from owner | Owner's expenses not recorded in
business books
Monetary Unit | Use of consistent currency | Reports in dollars despite inflation
Time Period | Define timeframes for reporting | Annual financial statements
Conclusion:
Accounting principles are the backbone of reliable and comparable financial information.
Understanding and applying these principles helps ensure transparency, accuracy, and fairness in
financial reporting, which in turn builds trust among investors, regulators, and stakeholders.
