Accounting (0452) | Accounting principles

IGCSE Accounting (0452) Study Notes: Accounting Principles and Policies (Chapter 7)

Hello future accountant! Welcome to one of the most important theoretical chapters in the IGCSE syllabus: **Accounting Principles and Policies**.

Don't worry, this chapter is less about calculations and more about understanding the fundamental rules and ideas that accountants follow worldwide. Think of these principles as the foundation and guidelines that ensure all financial statements are honest, consistent, and useful. Learning these rules will help you understand *why* we do what we do in accounting!

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7.1 The Core Accounting Principles

Accounting principles (sometimes called concepts) are the basic rules that accountants follow when preparing financial statements. They provide a framework to ensure that financial information is presented fairly.

1. Business Entity Principle (Separate Entity)

What it means:

The business is treated as completely **separate** from its owner(s).

This means that the owner's personal transactions (like buying groceries or paying their home rent) must not be mixed with the business's transactions.

Key Application: When the owner takes goods or cash for personal use, this is recorded as Drawings, reducing the Owner's Equity, demonstrating the separation.

Analogy: Imagine your business has its own dedicated bank account and wallet. Your personal wallet is completely separate—even if you are the one holding both.

2. Duality Principle (Dual Aspect)

What it means:

Every single transaction has **two** effects (a debit and a credit) on the financial records.

This is the principle that underpins the entire Double Entry System.

Key Application: This principle leads directly to the Accounting Equation always balancing:
Assets = Liabilities + Owner’s Equity

3. Going Concern Principle

What it means:

It is assumed that the business will continue to operate for the foreseeable future and will **not** be forced to close down or significantly reduce its scale of operations.

Key Application: Because we assume the business will continue, we record non-current assets (like machinery) at their cost (less depreciation) rather than their immediate sale value. If the business was expected to close soon, we would value everything at its immediate liquidation (sale) value.

4. Historic Cost Principle

What it means:

Assets are recorded in the accounting records at their **original purchase price** (the cost incurred when they were acquired).

Key Application: If a building was bought 20 years ago for $100,000, it remains recorded at $100,000 (less depreciation), even if its current market value is $500,000.

Limitation: This principle provides reliable (factual) data but might not provide relevant (up-to-date) data for decision-making.

5. Money Measurement Principle

What it means:

Only transactions or events that can be expressed in **monetary terms** (currency) are recorded in the books of account.

Key Application: You record the purchase of a machine ($5,000), but you cannot record the skill of your manager or the morale of your workforce, even though they are important to the business.

Common Mistake: Thinking inflation is ignored. While accounts ignore changes in the purchasing power of money, this principle simply states the need for a common unit of measure ($ or £).

6. Matching Principle (Accruals)

What it means:

Revenues (income) earned must be matched against the **expenses incurred** to earn that revenue in the **same accounting period**.

Key Application: This is why we make adjustments for Accruals (expenses incurred but not yet paid) and Prepayments (expenses paid but not yet incurred) to ensure profit is calculated accurately for the period.

Analogy: If you sold 100 cakes in January, you must include the cost of all the flour, sugar, and electricity used to bake those 100 cakes in your January expenses, regardless of when you physically paid the bills.

7. Prudence Principle (Conservatism)

What it means:

Accountants should be cautious (prudent) when making estimates. They should **anticipate all foreseeable losses** but only recognise profits when they are realised (earned).

Key Application:

1. Valuing inventory at the **lower of cost and net realisable value**.
2. Creating a Provision for doubtful debts to cover expected irrecoverable amounts.

Mnemonic: It's the "Better safe than sorry" rule. Never overstate assets or profits, and never understate liabilities or losses.

8. Realisation Principle

What it means:

Revenue is recognised (recorded as income) only when the transfer of goods or services to the customer has taken place, and the **right to receive payment is established**.

Key Application: If a customer places an order in December but receives the goods in January, the sale is recorded in January when the goods are delivered (realised), not in December when the order was placed.

9. Consistency Principle

What it means:

Once an accounting method or policy is chosen, it should be applied consistently from one accounting period to the next.

Key Application: If a business chooses the Straight-Line method for depreciation, it should continue to use that method in future years. If they change it, they must disclose why.

Why is this important? Consistency allows for easy **comparison** of results year-on-year. If you keep changing your rules, your profits one year won't mean the same thing the next year.

10. Materiality Principle

What it means:

Accountants only need to worry about items that are **significant** (material) enough to influence the decisions of a user.

Key Application: A business might buy a $5 stapler. Technically, this is a non-current asset, but recording and depreciating it separately would take too much time and would not affect the overall financial picture significantly. Therefore, the cost is treated immediately as a revenue expense (stationery).

The rule of thumb: If leaving it out or treating it incorrectly would change someone’s decision about the business, it is material.

Quick Review: Memory Aid for Principles

To help remember the main principles (though you must know them all!):

• Duality
• Business Entity
• Going Concern
• Money Measurement
• Historic Cost
• Consistency
• Prudence
• Matching

Key Takeaway for 7.1: Accounting principles are the mandatory rules that ensure fair and consistent reporting. They explain *why* assets are recorded at cost (Historic Cost) and *why* we adjust for things like prepaid expenses (Matching).

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7.2 Accounting Policies and Objectives

While principles are the rules that everyone must follow, **Accounting Policies** are the specific methods or procedures management chooses to apply those principles (e.g., choosing a specific method of depreciation).

When choosing policies, management is often influenced by **International Accounting Standards (IAS)**, which aim to standardise accounting practices globally.

Objectives in Selecting Accounting Policies

When preparing financial statements, the goal is always to provide information that is useful. The following four objectives (or qualitative characteristics) are key aims when choosing how to present data:

1. Relevance

What it means: Accounting information is **relevant** if it is capable of influencing the economic decisions of users.

For information to be relevant, it must be provided in a timely manner and help users predict future outcomes or confirm past predictions.

Example: If management is deciding whether to launch a new product, the financial statement showing current cash levels is highly relevant to their decision about funding.

2. Reliability

What it means: Information is **reliable** if it is free from significant error and bias, and users can depend on it to represent what it claims to represent.

This objective supports the **Prudence** principle—by being cautious (prudent), we increase reliability because we don't overstate profits or assets.

Example: The historic cost principle increases reliability because the original price is verifiable (can be proven with an invoice).

3. Comparability

What it means: Users should be able to compare the financial statements of the entity:

1. Over time (e.g., this year versus last year).
2. Against other, similar entities (Inter-firm comparison).

This objective is directly supported by the **Consistency** principle. If a business consistently uses the straight-line depreciation method, its statements are comparable over time.

4. Understandability

What it means: The information must be presented in a clear and concise manner, classified and characterised clearly so that users who have a reasonable knowledge of business and accounting can understand it.

Key Application: This explains why we use standard formats like the Income Statement and Statement of Financial Position, as defined terms and layouts help all users understand the data quickly.

Key Takeaway for 7.2: Accounting policies are the specific methods chosen by management. These choices must aim to make the resulting financial statements **Relevant**, **Reliable**, **Comparable**, and **Understandable**.