Now that you have completed your look at the balance sheet, we will turn our attention to the basics of accounting. It is important that you go back to read about the balance sheet before continuing, it will help you to develop a clearer understanding of what will be discussed in the sections to come. Accounting can be as complicated as it can be simple. In preparing accounts it is important that certain principles be adhered to, these are commonly referred to as generally acceptable accounting principles (GAAP). When accounts are prepared using the principles listed below, they are said to be “prepared based on generally accepted accounting principles” or GAAP. The Principles 1. The Accrual principle 2. Historical cost principle 3. Consistency Principle 4. Prudence Principle 5. Materiality Principle 6. Matching Principle 7. Going Concern Concept 8. Conservative Principle 9. Separate Legal Entity Concept The Accrual Principle The Accrual Principle may be called the mother of all accounting principles. It ensures that revenues and expenses are booked (recorded) when earned and incurred and not necessarily when cash is exchanged. The Accrual principle therefore brings into play other important principles such as Revenue Recognition and Matching (see below). The company will therefore book revenue when the sale is made (based on the principles of revenue recognition) and will book expenses when incurred and against the revenue it helped to generate (The Matching Principle – see below). Historical Cost Principle Accountants use historical cost in preparing accounts. This is a simple concept that means that the data you see on say a balance sheet is recorded at the historical cost. The historical cost is therefore the cost at the time the company or entity completed the transaction. Historical cost accounting is therefore the opposite of current cost accounting. Current cost accounting would record account transactions at the current (the cost at the time the financials were prepared) cost. Consistency Principle The consistency principle is just as the name suggests. It requires that accounts be prepared using the same method from period to period. Changes are inevitable, however when these changes are made the accountant is required to explain the change in the notes to the financials. This principle is very important, as different methods of preparing the accounts may render completely different results. This would make it difficult for users of the financials to accurately interpret the financial results. Without the consistency principle, unscrupulous accountants would be able to change methods in an attempt to manipulate the results. The consistency principle also ensures that the method used to allocate cost is the same method used to establish the value of assets. Separate Legal Entity Concept It is important that the accounts of the business be kept separate from the personal accounts of the owners. The business is what is referred to as a separate legal entity and maintains its separate accounts. For those with advanced knowledge in accounting, you will realize that this applies not only to small companies but to large complicated companies as well. For example, the payment of dividends which is a transaction between the business and its owners (basically the owners withdrawing cash or other assets from the business) is not treated as an expense, but as distribution to owners. The Going Concern Concept The going concern concept is all about the assumption that the business will continue into the foreseeable future. At first glance, this may be considered mundane, however it is important that the going concern status of the business be extremely clear. Where it is known that the business will not continue to operate it should be clearly stated as well. For a business that is not a going concern, the value of the assets will be determined differently than for a going concern. This will therefore affect any analytical review of the accounts. Go to part 2