Take the hypothetical scenario where you are told to compare apples with oranges. Any sane person can tell that it is not wise to compare apples with oranges. The same rule also applies to financial accounting. Just imagine how the situation would be if every organization started following its own format for creating Accounting Financial Statements! Financial Statements are prepared by accountants and the intention of the statements is to convey the organization's financial information to the relevant stakeholders.
Since financial statements are extremely important for any business, the rules being followed for its preparation are also uniform. Generally Accepted Accounting Principles (GAAP) which is a common set of accounting standards dictates how financial statements are prepared. Accounting Principles form the basic foundation of the accounting system.
Though the majority of businesses have an in-house finance team for managing accounts, it is still important for the founder of the business to have a basic know-how of financial accounting. Below are some of the basic conditions that accounting principles need to satisfy:
- There should be consistency
- The information that is being covered in the financial statements should be useful to the stakeholders
- It is not meant to be complex and information in it should be explanatory
- It should be able to reflect the prospects of the business
Accounting Conventions are common practices that are used as guidelines when a financial transaction is recorded in the accounting system. It is not necessary that Accounting Conventions have universal application.
Common Accounting Conventions
Below are some of the common accounting conventions:
- Convention of Consistency – Accounting rules cannot be changed on the fly from one period to another. The working rules that are followed should be consistent and cannot be changed arbitrarily without informing the relevant stakeholders who use the accounts.
- Convention of Disclosure – Every vital piece of information about the business should be reflected in the financial statements. The disclosure can be made via footnotes to accounts.
- Convention of Conservatism – As the name indicates, a conservative approach is taken while preparing the financial statements. Hence, the financial statements take into consideration all the prospective losses, leaving aside the prospective profits.
- Conversion of Materiality – As per this principle, any material/items that can have a significant impact on the business & its revenues should be disclosed in the financial statements.
To understand the nitty-gritty of financial statements and accounting principles, you must know about the widely accepted accounting concepts. It is important to have an in-depth knowledge of accounting concepts to understand accounting principles.
Below are some of the commonly used Accounting Concepts:
- Periodicity Concept – As per this concept, accounts should be prepared each year. In India, the financial year (1st April – 31st March) is considered the calendar year for preparing accounts.
- Matching Concept – Expenses that match the revenue of that period should only be used in the preparation of financial statements for that financial year.
- Realization Concept – As per this concept, any change in the value of a business asset should be recorded only when the business realizes it.
- Entity Concept – As per this concept, the business entity is rightly considered a separate identity apart from its owner.
- Accrual Concept – As per this concept, a record of transactions should be entered as & when they occur. Hence, there is no need to wait till the time; the actual cash equivalent is paid/received.
- Going Concern Concept – This concept implies that the business entity will continue its operations in the future. It's an assumption that the business will run for long-time and basis this all other adjustments like assets are recorded at actual cost, not as per the market value, depreciation is factored, etc.
To summarize, businesses must choose the right accounting software or ERP system that is suited for their business. Good ERP system like Tally.ERP 9 can be used for not only making financial statements but also for making business-critical decisions!
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