Golden Rules of Accountancy Explained Simply

The Going Concern Principle is a fundamental assumption in accounting that a business will continue operating indefinitely.This principle affects how we record long-term transactions. For example, when purchasing expensive equipment, we spread the cost over its useful life.Under the going concern principle, we record this machine at its historical cost and depreciate it over ten years, assuming the business will operate long enough to utilize the full asset life.Similarly, when taking out long-term loans, we record them based on the full repayment schedule, assuming the business will continue operating to make all payments.The going concern principle significantly impacts how we value assets and liabilities. Let's compare going concern valuation with liquidation valuation.This principle has wide-reaching effects on financial statements. It influences how we record assets, liabilities, and various other accounting entries.Understanding the going concern principle is crucial for proper accounting practices and financial reporting.The consistency principle requires companies to use the same accounting methods from one period to another.When methods remain consistent, like using straight-line depreciation across multiple years, financial statements are easily comparable.However, if a company changes methods, like switching to double-declining depreciation, it becomes difficult to compare results accurately.Let's examine how different depreciation methods affect the numbers. With straight-line depreciation, the expense is the same each year.But with double-declining depreciation, the expense varies significantly each year, making year-to-year comparisons challenging.This graph shows how the two methods produce very different expense patterns over time. The blue line represents straight-line depreciation, while the red line shows double-declining.Changing methods mid-stream would make it impossible to determine if changes in financial results are due to actual business performance or just accounting method changes.The matching principle requires that expenses be recorded in the same period as the revenue they helped generate.Let's look at a product sale that occurs in December. The company incurs various expenses across different months to make this sale possible.In November, the company pays two thousand dollars for marketing and eight thousand dollars for manufacturing costs.In December, the product is sold for fifteen thousand dollars, with one thousand dollars in delivery costs.According to the matching principle, all expenses that helped generate this December sale must be recorded in December's books.This ensures accurate profit calculation for December. The total revenue of fifteen thousand dollars minus all related expenses of eleven thousand dollars shows a profit of four thousand dollars.Remember, it doesn't matter when these expenses were paid - what matters is when the revenue they helped generate was earned.This principle prevents distortion of financial results across different periods.The Historical Cost Principle states that assets should be recorded at their original purchase price.For example, if a building was purchased for one million dollars in 2018, that's the value that appears in the accounting records.Even if the market value increases to one point five million dollars by 2023, the historical cost principle requires us to maintain the original purchase price in our books.Let's see how this appears in the balance sheet.The building remains recorded at its historical cost of one million dollars, even though its current market value is one point five million.However, there are some important exceptions to the historical cost principle.Certain financial instruments must be reported at their current market value. These include trading securities, available-for-sale securities, and derivatives.Let's look at how the historical cost principle applies to different types of assets.Whether the market value goes up or down, the historical cost remains unchanged in the financial statements.In double entry accounting, every transaction affects at least two accounts.When a business makes a cash sale of one thousand dollars, we debit Cash and credit Sales Revenue for the same amount.Let's look at a more complex transaction. When a business purchases inventory on credit.A five thousand dollar inventory purchase on credit results in a debit to Inventory and a credit to Accounts Payable.Notice how the accounting equation remains balanced. Assets increase by five thousand dollars, and Liabilities increase by the same amount.Now let's examine a transaction that affects three accounts: purchasing equipment with both cash and a loan.When purchasing ten thousand dollars of equipment, paying four thousand in cash and financing six thousand with a note, we debit Equipment and credit both Cash and Notes Payable.The double entry system provides a built-in verification method. Total debits must equal total credits, ensuring accuracy in our records.