Understanding Basic Accounting Principles and Basic Accounting

Basic accounting principles require that the financial statements report information that is primarily useful and understandable to financial statement users.

Accountants follow a common set of rules to create the financial statements. Without these basic rules in place, it would be difficult for lenders, investors, and other financial statement users to compare, analyze, or even trust the information reported on financial statements.

If one company, for example, reports sales or expenses differently from another company, this reporting difference can give the appearance of more profits for one company, when in fact profits are the same for both companies had they both used the same accounting methods. For this reason, rules are set in place to determine what activities to measure, when to measure them, and how to measure them.

Information can only be useful if it is both relevant and reliable.

What is relevant information?

Relevance includes any information that helps the financial statement user determine the value and performance of the company. Reporting the ratio of males to females working in the company is irrelevant. Reporting total salaries and wage of employees is relevant.

Similarly, reporting the type of machinery the company has is not relevant. Reporting the original cost of the machinery is relevant.

What is reliable information?

Basic accounting principles also centers on the reliability of the information reported. Companies report information that is not biased towards an objective, such as getting investors to invest in its stock, or creditors to lend the company money. Instead, financial reports are reliable when users can rely on the information to represent that which it is intended to represent.

Information that is reliable can be verified independently and repeatedly. Reliability is the main reason companies are audited. Auditing tests and verifies that the financial information reported is accurate, reliable, and represents what it claims to represent so that financial statement users can depend on it to make financial decisions.

Financial statements are only useful to financial statement users if they are understandable. To be understandable, financial statements must be consistent with past reports of the same company and comparable to other companies.

This means that the company must use the same accounting practices that it has been using for previous periods to remain consistent. In addition, it must use the same practices as other companies for the same transaction so the user of the information can make meaningful and useful comparisons.

The primary means of communicating useful financial information are the main business financial statements called the balance sheet, the income statement, and the statement of cash flows. Click the link above for a discussion of the basic financial statements and the purpose of each.

Basic Accounting Equation

Cash Accounting and Accrual Accounting