In this article, we will learn in-depth the role of accounting principles in the preparation of a statement of financial position.
What Role do Accounting Principles Play in the Preparation of a Statement of Financial Position?
Certain accounting principles are followed in the preparation of the Statement of Comprehensive Income and the Statement of Financial Position.
Following principles must be followed in order to determine accurate profit or loss and the value of assets and liabilities.
1) Business Entity Concept
According to this concept, the business is distinct from its owners. Only for this reason are all accounts kept in the name of the business and not in the names of the proprietors.
As a result, capital supplied by the proprietor is the liability of the business, and drawings by the proprietor are his own expense, reducing the value of capital.
2) Going Concern Concept
According to this concept, it is assumed that the business will continue indefinitely and is not organized for a specific time period.
That is, the business will continue indefinitely and there are no plans to shut it down.
According to this concept, income and expenses are classified as capital or revenue nature.
The Statement of Financial Position is prepared using capital nature items. Depreciation is calculated over the life of fixed assets, according to this concept.
If this concept does not exist, it is impossible to prepare financial statements and there is no need to charge depreciation.
3) Periodicity Concept
According to the going concern concept, the business will continue indefinitely with no end date.
However, we cannot wait indefinitely to know and understand the financial position of the company.
As a result, in order to know the financial condition of each year, we must prepare a comprehensive income statement and a statement of financial position.
An infinite amount of time can be divided into equal small parts. This small portion is referred to as periodicity. In general, periodicity denotes a year.
4) Accrual Concept
This concept is the opposite of the cash concept. Under the cash concept, only cash transactions are accounted for, on the other hand, in the case of the accrual concept, cash, and all other transactions will be accounted for.
According to this concept, when preparing the Statement of Comprehensive Income, outstanding references are added to related expenses that have already been paid, and outstanding incomes are added to related incomes that have already been received during the accounting year in question.
Under this concept, unearned income and prepaid expenses are shown as a deduction from the respective account head.
5) Conservatism Principle
According to this principle, in order to calculate profit, you must be conservative, i.e., anticipate no profit while accounting for all potential losses.
It means that if there is a possibility of loss in the future, a provision should be made, but anticipated profit should not be considered until it is realized.
If a profit or dividend is distributed in anticipation, it is effectively a breakdown of the business’s capital, which is not only against the company act but also detrimental to the company.
For example, provision for bad and doubtful debt is shown in the financial statement as probable losses. Closing stock is valued at a lower cost or market price.
6) Cost Price Principle
According to this principle, fixed assets are shown in the financial statement based on their historical cost, which is the price at which they were purchased.
Fixed assets are not shown at their current market value because they are purchased for long-term use in business rather than for trading.
The cost price denotes the amount sacrificed for acquiring the respective asset as well as any other necessary expenses incurred to make the asset usable for the business.
7) Consistency Principle
According to this principle, books of accounts are prepared and maintained using the same methodology each year.
It is because of the comparison and analysis of the years and inter-organization.
Otherwise, it is impossible to obtain a complete financial picture.
8) Materiality Convention
The accountant’s knowledge, experience, and intelligence are utilized in the recording of transactions under this convention.
When recording the transaction, the accountant considers the transaction’s materiality or immateriality.
For example, stationery items such as calculators, staple machines, and punch machines are purchased for long-term use in business, but because they are inexpensive, they are not classified as assets, and the cost is not amortized over the useful life; rather, they are classified as expenses for the fiscal year in question and are reported in the comprehensive income statement.
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