Accounting Principles Explained With Pros & Cons

The guidelines that a business must abide by when disclosing financial information are known as accounting principles. Several fundamental accounting rules have evolved through widespread application. They serve as the cornerstone on which the entire set of accounting rules has been constructed.

The following are the most well-known of these rules:

Accrual Principles – Accounting Principles Explained

The idea here is that accounting transactions should be reported in the periods during which they actually happen rather than when there are related cash flows. The accrual basis of accounting is built on this. It is crucial to create financial statements that accurately reflect what occurred during an accounting period without being unnecessarily delayed or accelerated by the related cash flows.

For instance, if you disregarded the accrual principle, you would only record an expense when you paid for it, which could result in a significant delay due to the payment terms for the associated supplier invoice.

Pros and Cons of the Accrual Principle

The accrual principle is a fundamental accounting concept that dictates when revenues and expenses are recognized. According to the accrual principle, revenues are recognized when they are earned (not when payment is received), and expenses are recognized when they are incurred (not when they are paid).

Here are some pros and cons of the accrual principle:

Pros of the Accrual Principle

1. Accurate Financial Picture: The accrual principle provides a more accurate financial picture of a company’s health by matching revenues with the expenses incurred to generate them within the same accounting period. This facilitates better financial analysis and forecasting.

2. Revenue Recognition: It allows businesses to recognize revenue as soon as the product is delivered or the service is rendered, improving the company’s reported financial status even if the payment has not yet been received.

3. Tracking Payables and Receivables: Accrual accounting keeps detailed track of amounts owed by the company (accounts payable) and amounts owed to the company (accounts receivable), facilitating efficient debt management.

4. Compliance with Generally Accepted Accounting Principles (GAAP): In most jurisdictions, the accrual principle is not just recommended but required for businesses above a certain size. This makes it easier for investors, creditors, and other stakeholders to compare different companies’ financial statements.

Cons of the Accrual Principle

1. Complexity: The accrual principle can be more complex and time-consuming than cash accounting, as it requires tracking receivables and payables and making adjusting entries.

2. Cash Flow Misrepresentation: While the accrual method does a good job of matching income and expenses, it can sometimes provide a misleading picture of cash flow. A company might appear profitable on an accrual basis but be experiencing a cash shortage.

3. Increased Accounting Costs: Due to its complexity, accrual accounting might require a company to spend more on bookkeeping and financial management.

4. Potential for Manipulation: The accrual principle gives some leeway to management in deciding when to recognize revenues and expenses, which could potentially be used to manipulate financial results.

Despite its disadvantages, the accrual principle is widely considered to provide a more accurate representation of a company’s financial situation than the cash basis of accounting.

Conservatism Principle – Fundamental Accounting Principles Explained

This idea states that while revenues and assets should be recorded as soon as possible, expenses and liabilities should be recorded as soon as practicable. Due to potential delays in revenue and asset recognition, this gives the financial statements a more cautious tilt and could result in lower reported profits.

In contrast, this approach favors the earlier rather than the later recording of losses. This idea can be overused if a company consistently presents its results as worse than they actually are.

Pros and Cons of the Conservatism Principle

The conservatism principle is a fundamental accounting concept that directs the accountant to choose the method that results in less net income or less asset amount when there are several equally acceptable alternatives. It’s a principle of caution, anticipating possible future losses but not future gains. Here are some of the pros and cons of this principle:

Pros of the Conservatism Principle

• Risk Management: The conservatism principle helps to prevent overstatement of income and assets, providing a safety net against potential future losses. This reduces the risk of making decisions based on overly optimistic financial statements.

• Investor Confidence: By providing a more conservative picture of a company’s financial health, this accounting principle can help to build investor confidence, as the reported results are less likely to be inflated.

• Tax Advantages: In some cases, a conservative approach can result in tax advantages by reducing taxable income.

• Compliance with Accounting Standards: The conservatism principle is embedded in many accounting standards and practices, helping to ensure that the company’s financial reporting is in compliance with these rules.

Cons of the Conservatism Principle

• Understatement of Financial Performance: While it protects against overstatement, the conservatism principle can also lead to systematic understatement of a company’s financial performance and financial position. This can mislead stakeholders who are trying to assess the company’s financial health.

• Short-Term Focus: The conservatism principle can create a bias towards short-term results, as potential future gains are not recognized until they are realized. This can hinder long-term planning and investment.

• Conflicts with the Matching Principle: The conservatism principle can sometimes conflict with the matching principle (which stipulates that expenses should be recognized in the same period as the revenues they helped to generate) by recognizing expenses sooner than revenues.

• Potential for Manipulation: Management has the ability to manipulate conservatism, just like they can with any other accounting principle, in order to manipulate earnings, such as by setting aside excessive reserves for potential losses.

While the conservatism principle has its drawbacks, its overall aim is to provide a safety buffer and ensure that the financial statements do not overstate the company’s financial health. As with any accounting principle, it’s essential to apply it judiciously and in line with established accounting standards.

Consistency Principle – Accounting Principles Explained

This idea states that once you choose an accounting principle or approach, you should stick with it until a principle or method that is clearly superior emerges.

If the consistency principle is not followed, a corporation may alternate between several accounting treatments for its transactions, which makes it very challenging to determine its long-term financial outcomes.

Pros and Cons of the Consistency Principle

The consistency principle in accounting dictates that companies should use the same methods and procedures over time. This allows for more accurate comparison of financial statements across different accounting periods.

Pros of the Consistency Principle

• Comparability: Consistency allows investors, creditors, and other users of financial statements to make meaningful comparisons of a company’s financial performance over time.

• Reliability: When accounting methods are consistent, it enhances the reliability of financial information, as sudden changes in reported profits or losses are more likely to be due to changes in the company’s operations than its accounting methods.

• Simpler Financial Analysis: It’s simpler to analyze trends in revenue, cost, profit, etc., when the underlying accounting methods remain unchanged.

Cons of the Consistency Principle

• Inflexibility: The principle can limit a company’s ability to change its accounting methods in response to changes in business environment, technological advances, or new accounting standards.

• Not Always Reflective of Economic Reality: A company may stick with an outdated accounting method for the sake of consistency, even when a newer method could provide a more accurate representation of its financial performance.

• Manipulation of Financial Statements: Companies might use the consistency principle as an excuse not to change an accounting method that flatters their financial results, even when a more accurate method is available.

• Barrier to Improvement: Consistency can potentially become a barrier to improving financial reporting practices, as making changes could be seen as violating this principle.

While the consistency principle has its drawbacks, the benefits of comparability and reliability generally outweigh these drawbacks.

However, it’s important to note that consistency should not stand in the way of improving financial reporting or adapting to new accounting standards or changes in the business environment. The key is to clearly disclose any changes in accounting methods and their effects on the financial statements, so users can adjust their analysis accordingly.

Cost Principle – Accounting Principles Explained

The idea here is that a company should only record its assets, liabilities, and equity interests at the price paid at the time of purchase. As several accounting rules move in the direction of adjusting assets and liabilities to their fair values, this principle is losing some of its validity.

Pros and Cons of the Cost Principle

The cost principle, also known as the historical cost principle, is an accounting concept that states companies should record assets at their original cost. The cost includes all amounts necessary to get the asset ready for its intended use.

Pros of the Cost Principle

• Objectivity: The cost principle encourages objectivity because purchase costs are quantifiable and supported by records like invoices, receipts, and contracts.

• Simplicity: This principle makes the accounting process simpler as it uses the purchase price, which is a known quantity. It doesn’t require continuous reassessments of market value, which can be subjective and complex.

• Consistency: By using historical costs, it allows for consistency in reporting, making it easier to compare financial statements over time.

Cons of the Cost Principle

• Inaccurate Representation: The cost principle may not reflect the true economic value of an asset. An asset’s market value can greatly fluctuate over time due to various factors, such as inflation, market demand, obsolescence, etc. This could lead to a distortion in the balance sheet valuation if the asset’s current market value is significantly different from its historical cost.

• Lower Relevance: Information based on historical costs may be less relevant to decision-makers who are more interested in current and future amounts.

• Potential for Overstated Assets: If the value of an asset declines over time (for instance, due to damage, obsolescence, or changes in the market), the cost principle could result in overstatement of the asset’s value on the balance sheet.

While the cost principle has its limitations, it provides a clear and objective method for recording the value of assets. However, other accounting principles and practices, such as impairment tests for long-lived assets and market value reporting for particular types of financial assets, frequently supplement it to provide a more complete picture of a company’s financial position.

Economic Entity Principle – Accounting Principles Explained

This idea states that a business’s transactions should be kept separate from those of its owners and other companies. This avoids the mixing of assets and liabilities among many companies, which can pose significant challenges when an audit of a startup company’s financial statements is performed for the first time.

Pros and Cons of the Economic Entity Principle

The economic entity principle, also known as the business entity principle, is a fundamental accounting principle that dictates that businesses must be accounted for separately from their owners. This means that the personal transactions of owners should not be mixed with the transactions of the business they own.

Pros of the Economic Entity Principle

• Clarity in Financial Reporting: By keeping business transactions separate from personal transactions, this principle ensures clear and precise financial reporting. It allows stakeholders to analyze the business’s performance without the confusion of unrelated personal transactions.

• Legal Protection: It upholds the legal distinction between a company and its owners. In the case of corporations, this can protect the owners’ personal assets from the company’s liabilities.

• Simplified Tax Reporting: This principle simplifies tax reporting as personal and business transactions are not intermingled.

Cons of the Economic Entity Principle

• Complexity for Small Business Owners: For small businesses and sole proprietorships, strictly adhering to the economic entity principle can add complexity. These business owners often use personal assets for business purposes and vice versa, which can make separating transactions challenging.

• Increased Record-Keeping: This principle may require more rigorous record-keeping and bookkeeping to ensure that all transactions are correctly categorized as either personal or business.

• Potential for Misinterpretation: In situations where owners have heavily invested personal assets in a business or have significant personal guarantees on business debts, the separation of personal and business finances may not fully represent the financial risk of the owner.

Despite these potential drawbacks, the economic entity principle is widely considered a cornerstone of accurate and reliable financial accounting. It is a fundamental rule that underpins the creation of financial statements and informs decisions made by investors, creditors, and other stakeholders.

Full Disclosure Principle – Accounting Principles Explained

This idea states that all information that could affect a reader’s comprehension of a business’s financial statements should be included in or provided alongside them. Accounting standards have substantially expanded this idea, which calls for a staggering amount of informational disclosures.

Pros and Cons of the Full Disclosure Principle

The full disclosure principle is an accounting guideline that requires companies to provide all necessary information in their financial statements and other related disclosures. This information should be sufficient for a reader to gain a complete understanding of the company’s financial health.

Pros of the Full Disclosure Principle

• Enhanced Transparency: The full disclosure principle encourages transparency, making it easier for investors, creditors, and other stakeholders to make informed decisions.

• Improved Investor Confidence: Full disclosure helps maintain investor confidence in the company. When investors have a clear understanding of a company’s financial position, they’re more likely to invest.

• Prevents Fraud and Misrepresentation: By requiring all pertinent information to be disclosed, this principle can help prevent fraudulent reporting or misrepresentation of the company’s financial condition.

Cons of the Full Disclosure Principle

• Information Overload: While full disclosure is meant to inform, the sheer amount of information that can be disclosed under this principle may overwhelm some users, making it hard for them to sift through the details and understand the essential points.

• Competitive Disadvantage: Disclosing detailed information about a company’s financial situation or strategies could potentially give competitors an advantage.

• Increased Costs: The time, effort, and resources required to gather, verify, and report detailed information can increase a company’s operating costs.

• Potential for Misuse of Information: There’s always a risk that information disclosed could be misused. For instance, competitors might use it or uninformed investors might interpret it incorrectly, leading to poor decisions.

Despite these potential downsides, the full disclosure principle is essential to ensuring that companies provide accurate, comprehensive, and transparent information to stakeholders. It’s a fundamental element of a well-functioning capital market system.

Going Concern Principle – Accounting Principles Explained

This idea states that a company will probably continue to exist for some time. This indicates that postponing the recognition of some costs, such as depreciation until subsequent periods might be acceptable. If not, you would have to record every expense right away and not postpone any of them.

Pros and Cons of the Going Concern Principle

The going concern principle is an accounting concept that assumes a company will continue its operations into the foreseeable future. This means the business is viewed as capable of meeting its financial obligations and continuing its operations.

Pros of the Going Concern Principle

• Basis for Asset Valuation: Under the going concern principle, assets are recorded based on their original cost, not on their liquidation value, which would often be lower.

• Long-Term Planning: This principle allows companies to make long-term operational plans and investments since it assumes the company will continue to operate indefinitely.

• Investor Confidence: When a company is viewed as a going concern, it can enhance investor confidence as it indicates the company is expected to meet its obligations and continue its operations.

Cons of the Going Concern Principle

• False Security: The going concern principle may provide a sense of security even when a company is facing significant financial difficulties. This can lead to misjudgments about the company’s ability to continue its operations.

• Delayed Recognition of Financial Problems: If a company is assumed to be a going concern despite serious financial distress, it may delay necessary actions such as restructuring, seeking new funding, or making hard decisions about cost-cutting.

• Potential Misinterpretation of Financial Statements: If a company is facing financial issues but is still treated as a going concern, stakeholders may not fully comprehend the severity of the financial situation, which could lead to misinformed decisions.

In cases where the company’s ability to continue as a going concern is doubtful, auditors must note this in their audit reports. This underscores the need for accurate financial reporting and full disclosure to ensure that investors and other stakeholders can make informed decisions.

Matching Principle – Accounting Principles Explained

This idea states that all expenses that are related to an income should be recorded at the same time. As a result, you record income from the sale of inventory items at the same time as you charge inventory to the cost of goods sold. The accrual basis of accounting is founded on this. The matching principle is not utilized in cash basis accounting.

The matching principle is an accounting principle that dictates that a company should recognize expenses in the same accounting period in which the related revenues are earned. In other words, it matches expenses to related revenues to show the true profitability of the company during a specified time period.

Pros and Cons of the Matching Principle

Pros of the Matching Principle

• Accurate Financial Reporting: By recognizing expenses and revenues in the same period, the matching principle provides a more accurate view of a company’s profitability during a specific period.

• Better Decision Making: It allows management, investors, and creditors to make informed decisions about the company’s performance and future prospects based on accurate profit figures.

• Tax Compliance: The matching principle is also used in tax accounting to determine taxable income, and following it can help ensure compliance with tax laws.

Cons of the Matching Principle

• Complexity: The matching principle can complicate the accounting process. Determining when to recognize revenues and expenses can be particularly complex for long-term contracts and for transactions that span multiple accounting periods.

• Subjectivity: The principle can introduce a level of subjectivity into financial reporting. Determining when revenue is earned and when expenses are incurred can sometimes require judgment, and different accountants might make different decisions in similar situations.

• Potential for Manipulation: Because the recognition of revenues and expenses can be somewhat subjective, the matching principle can potentially be used to manipulate a company’s reported profits. By choosing when to recognize revenues and expenses, management might be able to shift profits between accounting periods.

Despite these potential disadvantages, the matching principle is a cornerstone of accrual accounting and is widely regarded as essential for accurate and consistent financial reporting. It allows for better comparison of financial results across periods and facilitates more informed decision-making by all stakeholders.

Materiality Principle – Accounting Principles Explained

This idea states that a transaction should be included in the accounting records if doing so would have influenced how someone reading the company’s financial statements would have made a decision. Some of the more modest controllers have been known to keep track of even the tiniest transactions because this is a really nebulous concept that is challenging to measure.

Pros and Cons of the Materiality Principle

The materiality principle is an accounting principle that suggests that an entity’s financial statements should disclose all materially relevant items. A detail is considered material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements.

Pros of the Materiality Principle

• Improved Decision-Making: By focusing on material items, this principle ensures that users of financial statements receive all relevant information for decision-making.

• Simplified Financial Reporting: The materiality principle reduces the complexity of financial reporting by allowing minor items to be disregarded. It prevents financial statements from being cluttered with insignificant details.

• Cost Efficiency: It can save time and resources by allowing companies to disregard trivial amounts that would not significantly affect users’ decisions.

Cons of the Materiality Principle

• Subjectivity: The definition of what is considered “material” can be subjective and varies depending on the context and the user of the information. This can lead to inconsistent application of the principle.

• Potential for Misuse: The materiality principle could potentially be used to justify omitting or misstating information that, while not significant on its own, could collectively be significant if such omissions or misstatements are made systematically.

• Lack of Transparency: In some cases, the omission of seemingly immaterial individual transactions might prevent stakeholders from getting a complete picture of the company’s financial situation, particularly if those transactions are part of a larger pattern.

While the materiality principle has its potential drawbacks, it plays a critical role in making financial reporting more efficient and focused on what’s most important to users of financial statements. Proper judgment and ethical practices are important to ensure it’s applied appropriately and does not lead to misrepresentation or omission of significant information.

Monetary Unit Principle – Accounting Principles Explained

According to this idea, a corporation should only keep track of transactions that can be expressed in terms of a specific unit of currency.

So, whereas the value of a business’ quality control system is not recorded, it is simple to record the purchase of a fixed asset because it was bought for a specified amount. This idea prevents a company from making many assumptions when determining the value of its assets and liabilities.

Pros and Cons of the Monetary Unit Principle

The monetary unit principle is a basic accounting principle that states a business should only record economic data that can be expressed in terms of money. This principle provides a common basis for expressing and comparing economic events and transactions.

Pros of the Monetary Unit Principle

• Simplification: This principle simplifies the accounting process by limiting what needs to be recorded and reported, making the financial statements easier to understand.

• Consistency: Using a monetary unit provides a consistent measure that allows for comparison across different periods and companies.

• Quantification: It allows all items, whether assets, liabilities, revenues, or expenses, to be quantified in monetary terms, making it possible to summarize and analyze a wide range of different kinds of economic activities.

Cons of the Monetary Unit Principle

• Inflation/Deflation Ignorance: This principle doesn’t take into account the changes in the value of money over time due to inflation or deflation. This means the financial statements might not reflect the true purchasing power of money at different points in time.

• Exclusion of Non-Monetary Information: The monetary unit principle excludes important non-monetary information like the value of human capital, brand reputation, or customer satisfaction, which might be important for a complete understanding of a company’s financial health and future prospects.

• Subjectivity in Estimations: Certain aspects of a business, like the valuation of certain types of assets or liabilities, can be hard to quantify accurately and may involve subjective judgments or estimations.

While the monetary unit principle has its drawbacks, it is a fundamental part of financial accounting. It provides a common basis for recording, reporting, and comparing financial information and thus plays an essential role in the functioning of financial markets and the economy as a whole.

Reliability Principle – Accounting Principles Explained

According to this idea, Only confirmed transactions should be documented. A supplier invoice, for instance, provides conclusive proof that an expense has been recorded. Auditors are particularly interested in this idea since they are often looking for proof to justify transactions.

Pros and Cons of the Reliability Principle

The reliability principle, also known as the objectivity principle, is a concept in accounting that states that financial reporting should be based on evidence that can be independently verified. This helps ensure that the information presented is free from bias and can be relied upon by users of financial statements.

Pros of the Reliability Principle

• Promotes Trust: The reliability principle promotes trust among users of financial statements. They can trust that the information presented has been independently verified and is free from bias.

• Enhances Comparability: Since this principle mandates the use of verifiable evidence, it makes the financial statements of different companies more comparable because it ensures that similar transactions are recorded in a similar manner.

• Prevents Fraud: The requirement of independent verification can help prevent and detect fraudulent financial reporting.

Cons of the Reliability Principle

• Limits the Use of Estimates: While estimates are necessary in many areas of accounting, they are inherently subjective and may not meet the strict standards of the reliability principle.

• May Exclude Relevant Information: Some information that could be relevant to users of financial statements might not be included if it can’t be independently verified. This could potentially limit the usefulness of the financial statements.

• Increases Costs: The process of gathering and verifying evidence can be time-consuming and costly. Small businesses, in particular, may find the costs of adhering to the reliability principle to be burdensome.

In summary, the reliability principle contributes to the integrity and usefulness of financial reporting. While it has some potential drawbacks, these are generally outweighed by the benefits of having financial information that users can trust and rely upon.

Revenue Recognition Principle – Accounting Principles Explained

This idea states that revenue should only be recognized once the business has effectively finished the earning process. Because so many people have strayed from the guidelines of this idea to engage in reporting fraud, numerous standard-setting organizations have amassed a vast quantity of knowledge on what constitutes appropriate revenue recognition.

Pros and Cons of the Revenue Recognition Principle

The revenue recognition principle is a cornerstone of accrual accounting together with the matching principle. It dictates that revenue should be recognized and recorded when it is realized or realizable and when it is earned, not when cash is received.

Pros of the Revenue Recognition Principle

• Accurate Representation of Financial Events: By recording revenue when it’s earned rather than when cash changes hands, the revenue recognition principle can give a more accurate picture of a company’s financial performance.

• Improved Decision-Making: With a more accurate representation of revenue, businesses, investors, and creditors can make better-informed decisions.

• Facilitates Comparability: The principle allows for more accurate comparison of financial performance across different businesses and periods, as it ensures that revenue is recognized consistently.

Cons of the Revenue Recognition Principle

• Complexity: The process of recognizing revenue can be complex, particularly in the case of long-term contracts or transactions involving multiple deliverables.

• Subjectivity: The principle often requires management to make estimates and judgments, which can introduce a level of subjectivity to the revenue recognition process.

• Potential for Revenue Manipulation: Given its complexity and subjectivity, the revenue recognition principle can potentially be used to manipulate reported earnings. For instance, a company might recognize revenue prematurely to boost its financial results.

Despite these challenges, the revenue recognition principle remains key to accurate and consistent financial reporting. It allows for meaningful analysis and comparison of financial performance across companies and over time, enhancing transparency and trust in the financial reporting process.

The recent adoption of more comprehensive revenue recognition standards, such as IFRS 15 and ASC 606, aims to provide clearer guidance and reduce the potential for manipulation.

Time Period Principle – Accounting Principles Explained

This idea states that a company should present the outcomes of its operations over a set time frame. Although it may be the most obviously clear accounting principle of them all, the goal is to provide a uniform collection of comparable periods that are helpful for trend research.

Pros and Cons of the Time Period Principle

The time period principle, also known as the periodicity principle, is an accounting principle that allows the activities of a business to be divided into specific time intervals such as months, quarters, or years. These intervals, or periods, are typically of equal length, facilitating comparison.

Pros of the Time Period Principle

• Regular Reporting: The time period principle ensures that financial information is reported on a regular basis, providing stakeholders with timely updates about the financial performance and position of a company.

• Comparability: It allows for the comparison of financial information across different time periods, making it easier to identify trends and make forecasts.

• Performance Evaluation: Regular reporting enables businesses to evaluate their performance, make informed decisions, and set future goals.

Cons of the Time Period Principle

• Artificial Segmentation: While it’s useful for analysis and reporting, the segmentation of a business’s life into arbitrary time periods is somewhat artificial. Not all business processes neatly start and end within these time periods.

• Potential Distortion: This principle can sometimes distort the financial results of a company, particularly if significant transactions occur near the end or the beginning of a reporting period.

• Short-term Focus: Regular reporting can sometimes lead to a short-term focus, potentially causing management to make decisions that boost short-term results at the expense of long-term success.

Overall, while the time period principle has some potential downsides, it’s an essential part of financial reporting that helps ensure regular, consistent, and comparable financial information is provided to the users of financial statements.

Accounting Principles- Explained w Pros & Cons- Recommended Reading

1. Ledger Account Example & Explanation

2. EBIT and EBITDA: Essential Metrics for Business Profitability

3. From Insight to Impact: Optimizing Net Working Capital