Why do we need Principles?
To ensure that financial statements are reliable, comparable, and understandable, accountants follow a set of rules known as Generally Accepted Accounting Practice (GAAP).
1. Business Entity
The business is treated as being separate from its owner. This is why "Drawings" exist—the owner is taking back their own investment from a separate entity.
2. Going Concern
The assumption that the business will continue to operate for the foreseeable future. If we didn't assume this, we would have to value all assets at their "forced sale" value.
3. Historical Cost
Assets are usually recorded at their actual purchase price (cost) rather than what they might be worth today. This provides objective evidence.
4. Prudence
Accounts should not overstate profits or assets. We must record all possible losses immediately but only record profits when they are certain. (e.g., valuing Inventory at the lower of Cost or Net Realisable Value).
5. Accruals (Matching)
Revenue and expenses are recognized when they are earned or incurred, not necessarily when cash changes hands. This links directly to our work on Accruals and Prepayments.
Practice Question
Identify the accounting principle in each situation:
- Recording drawings when the owner takes cash
- Creating provision for doubtful debts
- Using the same depreciation method every year
Scenario Challenge
A trader buys a machine for $5,000. A year later, it is worth $6,000, but he keeps it in the books at $5,000. Which principle is he following?
View Correct Answer
Correct Answer: B. Historical Cost requires recording assets at their original cost price.