Accounting / Bookkeeping Basics: Different Types Of Accounting Principles

Effective Strategies of Accounting Principles
The success of a business lies on how effectively the principles of Accounting are strategized. Instead of taking a broader path on discussing it in general, it would be worthwhile to lay down the criteria, taking into account the different principles and how these principles are chosen to contribute towards the efficiency of a business.

The Accrual Principle
Accrual principle, as it already suggests, is a method that allows businesses to record their transactions as they happen rather than when the cash flow actually takes place. This type of accounting allows businesses to manage future investments based on the kind of cash flow that is expected to arrive.
Some of the ways in which Accrual Principle can be used effectively are:
-     Recording revenue at the time of invoicing a customer which can be different to the time the cash is received
-     Recording expense at the time it is incurred rather than the time it is paid
-    Recording bad debts at the time of invoice than to wait for the time it is evident that the customer has failed to pay
-     Recording depreciation of a fixed asset when it is still useful than representing it as an expense at the time it is bought
-     Recording commissions when it is earned and not the time when it is being paid for
-     Recording wages at the time it is earned and not at the time it is paid

The Cash Principle
Cash principle is a method that allows business to record their transactions when the cash flow takes place. This type of accounting displays the actual financial position of a business at any given point of time. Under the pretext of the above two methods, several strategies can be synthesized to optimize the effectiveness of a business. To be able to make the best choice between the principles, by any means, would be the first steps towards building a successful business. In a small scale business, the state of the business, whether profitable, is solely decided by the cash flow on a daily basis. These businesses depend completely on a day’s earning to invest further. Such businesses would benefit from choosing the Cash principle. Book keeping of the daily transaction would prove to be very important in deciding financial condition of the business. Businesses that depend on unitary goods and  services profit from using such methods. Alternatively, businesses that depend on multiple goods and services benefit from the Accrual method as investments are possibly made based on the revenue to be flowing later, after the transaction has occurred. Here further investments are made based on the revenue expected and planning for the future becomes a vital aspect of the business. Outside investors such as banks and lenders seek the predicted status of the business in deciding whether to invest that would account for further expansion. Choosing either one amounts to efficient accounting principles.
Further, in both types, automation proves to take a vital role in deciding future prospects. Automation saves time and energy and allows swift decision making. Analyzing trends through automated systems and planning according to predictions is one other major contributor towards effective Accounting Strategies. Again we have to remember that automating is not easy task. Choosing the right format based on the necessities of the business also contributes towards effective accounting strategies. Businesses, small or large, have to make informed decisions on the type of format that they want to use. There are several bookkeeping formats that could be customized to suit particular business models and an appropriate one will give an effective edge.

An example of cash accounting principles is a company X that has sold products for $20,000 in cash and this will be recorded under cash revenue transactions as the finished goods is sold for cash. If the company chose to sell partly (1/2) in cash and a portion  in credit, then only $10,000 will be recorded as cash. The remaining of $10000 given on credit will not be recorded. Now, in the case of on an equipment that has been in operations for a while now, every year the firm sets aside a depreciating cost of $3000 on the equipment. According to cash principles, the depreciation is not an expense and will not be recorded as expense as there is no cash involved. These principles make accounting easy and simple to understand. They increase understanding of liquidity of cash in the firm easier. They develop on single entry accounting that affects only one account and are not bound to follow the Matching Principle.

Few of the disadvantages of cash principles are they are not very accurate as recordings focus on cash and not the actual time that the value is gained or lost. Cash principles as mostly not recognized by Company acts can make it tough for large firms to follow. Unbiased auditors can involve unfair practices by not disclosing relevant profits or exaggerating expenses thus causing discrepancies in accounts reporting.
The cash principle will not work so well on large companies. It works better for medium sized firms that operate  under  sole proprietorship or when the transactions recorded are quite small and mostly involving cash only rather than credit transaction. It also goes with companies that do not need to record income statements, balance sheets and financial statements or those with a few fixed assets.

The Economic Entity Principle
Economic Entity Principle is another useful aspect of Accounting Principles. It states that all transactional activities in business should be differentiated from that of the owner or any other entity of the business. This principle takes a variety of forms based on the kind of business model ranging from sole proprietorship, corporation, and government agency to partnership. Maintaining transactions as separate records in terms of accounting records or bank accounts for each entity from that of the business allows to clearly distinguish the liabilities and the assets of the owners or business partners thus maintain transparency of cash flow. Economic Entity principle proves most fruitful in the case of a sole proprietorship, differentiating company transactions from the business owner’s own personal transaction as in this type of business cash flow can easily entwine. It has also proven to be useful for business that is young, as owners tend to mix up their personal expenses with that of the business.
The Economic Entity principles applied for a number of reasons as follows:
- Each business has its own tax levied separately
-     It calculates each economic entity separately and independent of the other thus giving a clearer picture of financial performance individually.
-     It calculates payouts due when a firm is liquidated.
-    in under scrutiny against a firm.
-     It creates boundaries for auditors to evaluate financial transactions separately for each business entity.

The Monetary Unit Principle
Monetary Unit Principle is yet another important factor deciding effective accounting principles, that states the transactions to be recorded should only be in terms of currency. Here less or no importance is given to intangible factors such as qualitative analysis of efficiency of the employees or the rating of the service provided on how satisfactory. It is also advised that when considering monetary unit principle, the unit of currency chosen to record the transaction remains stable over a long period of time, unaffected by global economic inflation. It is wise to choose a currency such as US dollar that has not had any drastic changes over the years. From this it is understood that in this principle, it is vital that an asset bought decades back remain close to its invested amount at present and that transactions be recorded in a currency that doesn’t undergo hyperinflation. In cases of changes business tend to review and reiterate their financial stance periodically. Let us take an example of a company that had acquired a factory in 1960s for about $50,000. Its value has appreciated to a great extent now. But the factory is valued to its initial cost in the financial records. This is due to inflation not taken into consideration when valuing the asset as per the monetary unit principle.

This principle also indicates that any transaction in monetary terms should be accounted in the book of accounts while any non-monetary transactions even if they are important should be excluded from the book of accounts.

The Conservatism Principle
Conservatism Principle, another influential factor of accounting principle revolves around the recording of liabilities, revenues and assets. This principle demands that the liabilities and expenditure be recorded instantaneously without delay but some amount of leniency in recording the revenues and assets can be allowed. This contributes to efficiency as the amount of cash outflow incurred also through loss apart from revenue and asset is an indication of caution. Businesses, more often than ever, show less chance of restoration after a great loss using the assets it owns. It becomes very important to know instantaneously when cash is to flow outside to reinstate to safety.

Cost principle

To supplement the idea of conservatism principle, Cost Principle lays its rules on how the assets, liabilities and equity is recorded, either recorded earlier or later. Efficiency is defined here when businesses employ efficient method of recording. This principle advises business firms to record any asset, liabilities, equity and revenues using the original cost to allow the actual spending capacity of a business to surface. But this principle loses its significance as businesses consider it invalid and subsequently the accounts are modified to bring about a fair value according concurrent monetary value of the possession in concern.  The cost principle doesn’t also allow the recording of anything that was not a result of transactions such as manpower and brand name that at times doesn’t express the actual position of a business in terms of the capacity it has to generate revenue.An example of the Conservatism Principle is an accounting entity should prioritize liabilities and be considered of high value, of an employee’s claim in a legal case. It should do so even if the case is not winning. Contrarily, this principle should recognize assets of an employee’s legal claim unless the court passes judgment. The asset is recognized at low value. This principle assumes entity overstates assets and revenues and understates expense and liabilities.

The principle can be summarized as follows:
-     Assets and Revenues are recognized at lowest values with the exception of being able to recognize reliably
-     Expense and Liabilities are recognized as soon as they face uncertainty.

The Consistency Principle
Consistency principle, one of the many accounting principles that causes a business to succeed would be the consistency principle. The underlying rule behind this principle is consistency. This principle states that any decision made in using a particular principle should remain consistent. Shifting from one principle to the other depending on the convenience can cause confusion in keeping track of all business transactions. When such a shift is bound to happen, there is all the more reason to lose track of how the business is running as we tend to lose comparability. Auditors also hold a universal opinion on keeping the principles in use consistent to affect change. Consistency principle  does not take effect when a company is bound to some strict adherence of other principles that disables the company’s ability to report a particular revenue or profit that exceeded the normally allowed. The indicator of such situation would be when a company was operational through its regular standards, yet a change was impelled upon by an unexpected profit. An example is when Company X uses IFRS to report Financial Statements. And IFRS supports depreciation policies to use the straight-line method to calculate depreciation year-on-year. However in subsequent years the company decides to change its method of depreciation to Declining balance. In such a case the company must apply with IAS 8 whatever the change is. All the changes will need full disclosure in the financial statements and information of how the change is affected.

The Full Disclosure Principle
Transparency of a company’s financial condition is one major contributor towards a company’s success, and this becomes possible when a company adheres to Full Closure principles. In this principle, the company is liable of being transparent with all its financial statements and make known the company’s prevailing conditions to all those who are necessitated by the progress of the company. This principle plays an important role in determining whether stakeholders can afford to invest in the company. By implementing the disclosure principle, the people who are willing to invest are not misled and decisions can be made through thorough analysis of what would incur. Following the disclosure principle, the company is required to disclose details of accounting policies; where and when a principle is substituted for another; financial statements; inventory losses; how transactions take place; details of asset retirement obligations; VAT changed expected in the future; the tangible properties that constitute the company; the kind of agreements that the owners and shareholders have; and all the liabilities; their proceedings that have been taken legally.

For example, Company A buys a property. A by  passer experiences a fall and gets injured. The injured is suing the owner of the property for negligence. The principle of full disclosure assures the by passer will win the case the next year. This is due to the requirement where Company X has to compulsorily disclose, and anticipated losses include that of the lawsuit in the footnotes of their financial statement and this is a must irrelevant to the loss being finalized or confirmed as yet.

The Going Concern Principle
A complementary concept to the disclosure principle is the Going Concern Principle in business that assumes that a company under function will remain in function forever or for a predictable amount of time until the objectives of the company are met. It is also very important for the reason that accrual Principle is only possible based on the assets of the company owned by individual entities of the company. If the assumption of the Going Concern Principle is broken, then it is most like that the company is under bankruptcy and is going to undergo liquidation.

This is the reason why the Going Concern Principle becomes complementary to the disclosure principle as it assures the amount of transparency allowed by the disclosure principle informing the financial condition of the company. The Going Concern principle is also essential in terms when investments are to be made on the potential of the company to sustain.

The Matching Principle
The Matching Principle as the phrase suggests is an accounting principle that instructs the expenses incurred to a business at a said period of time to match with the revenue generated at the same period of time. This further works hand in hand with the accrual principle, which allows the expenses and the income to be adjusted minimally to tally the balance sheet for a stipulated period. When recording the transactions of a business it is advisable to make sure that all expenses together with the revenue earned be placed in the same pool of time frame to make sure of the prevailing condition of the business. In case the expense incurred doesn’t link directly to the revenue generated, the expense should be recorded in the time before which it is exhausted. Contrarily, if a gain of expenditure cannot be predicted in the foreseeable future, the expense should be recorded as such in the same period and should be duly charged. This helps business keep their records clean and aids to efficient accounting principles.

The Materiality Principle
Materiality Principle, one principle deciding factor of effective strategies is a concept that decides how worthy for a business to run are the recorded factors. Materials that do not cause a significant change in the way the business is run or materials that are considered too trivial to influence the running of the business do not fall under this category. Again the information provided, as it makes sense to the objective of the audience, decides if a certain factor is materialistic or immaterial. We should also note that any material whose record informs the potential prospects of a business in terms of loans and credit fall under the materials to be considered. An auditor viewing the statement, from its prime role can decide whether the transactions recorded account or be material or immaterial.

The Reliability Principle
Reliability principle, another effective strategy in sustaining a business, is a concept that makes sure that the transactions recorded as part of the accounting scheme are evidence that are factual, provided by other credible components or entities of the business such as banks, suppliers, valuation experts and clients whose supplied documents carry a greater value in assessing the financial stance of the company than the documents compiled internally by the firm. Some such documents could be purchase orders and receipts, cancelled checks, statement of accounts from banks, reports of appraisal and promissory notes. The limitation of this principle is when the firm records the reserves as forms have to potentially keep record of an allowance for accounts in doubt or the sales return reserve that are considered more of an opinion than a fact. In such cases, these documents should be backed up by thorough analysis based on trends that  had been experienced in the past that could prove to be a substantiation of the claim.