Your balance sheet will be stated as at a specific date. Your profit and loss account will include the revenue and costs for a period, usually a month or a year. This accounting concept is why it is essential to close off your accounts at the end of each month and year. The time period assumption is what dictates that your accounts are produced for particular periods. A company can enter into contracts, and a company can be sued. In law, a company is treated as a separate entity. This rule is what makes your accountants insist that you keep separate business and personal bank accounts. The economic entity assumption says that every business shall be treated as a separate entity from its owners. In other words, the monetary unit assumption ensures that you are not mixing up your apples and pears! So, if you purchase goods in a foreign currency, the cost will be converted to your home currency at the exchange rate prevailing when the purchase was made. This accounting principle is merely stating that all your transactions will be recorded in the same currency. The monetary unit assumption sounds very grand, but it is based on pure common sense. And, if you invoice customers in advance, then the income will only appear in your profit and loss account when the product or service is delivered. Work carried out on a project that has yet to be billed can also be treated as a type of inventory, called work-in-progress. Stock will be held on the balance sheet until it is used. Deferred Income, Inventory, and Work-in-ProgressÄeferred income, inventory, and work-in-progress are all related to the matching principle. Prepaying cost defers it until the item or service is used in the business.Ä£. Likewise, if you have paid in advance for a product or service, then your accountant will treat that as prepayment. In this case, the accrual would account for an expense for which you have not yet received a vendor invoice in the correct period. If you sold an item, the cost of which is not yet in your accounts, for example, your accountant will accrue for that cost. The matching principle refers to matching revenues with related costs in the relevant period. Prudence is erring on the side of caution and presenting a realistic picture of the financial state of a company. Prudence is what dictates that your accountant makes a provision for bad debts when you have no evidence to suggest that any of your sales invoices will not be paid. Prudence, or conservatism, is the accounting principle that drives your accountant sometimes to appear to be a bit of a pessimist! But the principle comes down to taking a conservative, cautious view of the financial affairs of a business. Here is an explanation of twelve of the fundamental accounting principles the business owners need to know. It will also help them understand the financial reports of other businesses. Knowing the principles that lie behind how financial statements are prepared will help a business owner make sense of their accounts. However, every entrepreneur will benefit from gaining an understanding of the basic accounting principles. You do not need to be an accountant to be able to run a business.
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