Basic Accounting Principles

Why This Matters

Accounting principles aren't just rules accountants follow—they're the foundation of every financial decision a business makes. When you're analyzing a company's performance, evaluating investment opportunities, or assessing creditworthiness, you're relying on these principles to ensure the numbers tell a true story. In Intro to Business, you'll be tested on how these principles work together to create reliable, comparable, and transparent financial information.

Here's the key insight: these principles exist to solve specific problems. Some ensure accuracy (catching errors before they spiral). Others guarantee consistency (so you can compare this year to last year). Still others protect against manipulation (preventing companies from inflating their success). Don't just memorize definitions—understand what problem each principle solves and when you'd apply it.

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Recording Transactions Accurately

These principles establish the mechanical foundation of accounting—how transactions get captured in the books so nothing slips through the cracks.

Double-Entry Bookkeeping

• Every transaction affects at least two accounts—this keeps the fundamental equation $\text{Assets} = \text{Liabilities} + \text{Equity}$ in balance at all times
• Debits must equal credits for every entry, creating a built-in error-detection system that flags mistakes in the trial balance
• Provides a complete financial picture by tracking where money comes from and where it goes, not just the net change

Historical Cost Principle

• Assets are recorded at original purchase price—what you actually paid, not what you think it's worth today
• Eliminates subjective valuations that could allow managers to inflate asset values and mislead stakeholders
• Creates an objective, verifiable record since purchase prices can be confirmed with receipts, contracts, and invoices

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Timing Revenue and Expenses

These principles answer a critical question: when should a transaction hit the books? The answer determines whether financial statements reflect reality or fiction.

Accrual Basis Accounting

• Revenues and expenses are recorded when earned or incurred—not when cash changes hands
• Provides accurate performance measurement because a sale counts when you deliver the product, even if payment comes later
• Aligns with GAAP requirements and is mandatory for most businesses beyond sole proprietorships

Revenue Recognition Principle

• Revenue is recognized when earned and realizable—meaning the work is done and collection is reasonably certain
• Prevents premature revenue booking that would make a company look more profitable than it actually is
• Critical for compliance with standards like ASC 606, which exam questions may reference

Matching Principle

• Expenses must be recorded in the same period as the revenues they generate—if you sell a product in March, the cost of making it belongs in March too
• Ensures profitability calculations are meaningful by pairing what you earned with what it cost to earn it
• Drives decisions about depreciation and amortization, spreading large costs over the periods they benefit

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Ensuring Comparability and Consistency

Financial statements are only useful if you can compare them—to last year, to competitors, to industry benchmarks. These principles make that possible.

Consistency Principle

• Same accounting methods must be used period to period—you can't switch depreciation methods just to boost this quarter's numbers
• Enables trend analysis so stakeholders can track whether performance is improving or declining over time
• Changes must be disclosed and justified in the notes to financial statements, alerting readers to potential comparability issues

Materiality Principle

• Only information significant enough to influence decisions needs detailed reporting—a $50 office supply purchase doesn't need its own line item
• Allows practical flexibility so accountants can focus energy on transactions that actually matter
• "Material" is relative to company size—$10,000 is material for a small business but immaterial for a Fortune 500 company

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Protecting Stakeholders

These principles exist to ensure financial statements don't mislead the people who rely on them—investors, creditors, employees, and regulators.

Full Disclosure Principle

• All relevant information must be included in financial statements or accompanying notes—no hiding bad news
• Extends beyond the numbers to include pending lawsuits, loan covenants, related-party transactions, and accounting policy choices
• Builds trust and credibility with stakeholders who need complete information to make sound decisions

Conservatism Principle

• Recognize potential losses immediately but delay recognizing gains until certain—when in doubt, err on the side of caution
• Prevents overstating financial health by building in a buffer against optimistic assumptions
• Guides inventory valuation through "lower of cost or market" rules that write down damaged or obsolete goods

Going Concern Principle

• Assumes the business will continue operating indefinitely—not liquidate tomorrow
• Affects how assets are valued because a factory has one value as an operating facility and a much lower value sold for scrap
• Must be disclosed if in doubt—auditors flag "going concern" warnings when a company may not survive the next year

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Quick Reference Table

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Self-Check Questions

1. Which two principles work together to ensure that a company's profit calculation accurately reflects what it cost to generate that revenue? How do they complement each other?

2. A company wants to switch from straight-line to accelerated depreciation. Which principle requires them to disclose this change, and why does it matter for financial statement users?

3. Compare the Conservatism Principle and the Revenue Recognition Principle. How do both principles protect stakeholders from overstated financial performance?

4. If an auditor discovers that a company may not survive the next 12 months, which principle requires this information to appear in the financial statements? What would change about asset valuations if this principle no longer applied?

5. A small business owner asks why she can't just record sales when customers pay. Explain which principle requires a different approach and what problem that principle solves.