Accounting Principles

Accounting Principles

.Accounting follows a certain framework of core principles which makes the information generated through an accounting system valuable. Without these core principles accounting would be irrelevant and unreliable

These principals include:

1. Accrual Concept 

   Business transactions are recorded when they occur and not when the related payments are received or made. This concept is called accrual basis of accounting and it is fundamental to the usefulness of financial accounting information.

   Examples:

   An airline sells its tickets days or even weeks before the flight is made, but it does not record the payments as revenue because the flight, the event on which the revenue is based has not occurred yet. 

   An accounting firm obtained its office on rent and paid $120,000 on January 1. It does not record the payment as an expense because the building is not yet used. While preparing its quarterly report on March 31, the firm expensed out three months' rent i.e. 30,00 [$120,000/12*3] because 3 months equivalent of time has expired. 

   An accounting firm obtained its office on rent and paid $120,000 on January 1. It does not record the payment as an expense because the building is not yet used. While preparing its quarterly report on March 31, the firm expensed out three months' rent i.e. 30,00 [$120,000/12*3] because 3 months equivalent of time has expired.

2.Going Concern Concept

Financial statements are prepared assuming that the company is a going concern which means that the company intends to continue its business and is able to do so.
The status of going concern is important because if the company is a going concern it has to follow the generally accepted accounting standards.
The auditors of the company determine whether the company is a going concern or not at the date of the financial statements.

Examples

1. An oil and gas firm operating in Nigeria is stopped by a Nigerian court from carrying out operations in Nigeria. The firm is not a going concern in Nigeria, because it has to shut down.
2. A nationalized refinery is in cash flows problems but the government of the country provided a guarantee to the refinery to help it out with all payments, the refinery is a going concern despite poor financial position.
3. A bank is in serious financial troubles and the government is not willing to bail it out. The Board of Directors has passed a resolution to liquidate the business. The bank is not a going concern.
4. A merchandising company has a current ratio below 0.5. A creditor $1,000,000 demanded payment which the company could not make. The creditor requested the court to liquidate the business and recover his debts and the court grants the order. The company is no longer a going concern.

3.Business Entity Concept

In accounting we treat a business or an organization and its owners as two separately identifiable parties. This concept is called business entity concept. It means that personal transactions of owners are treated separately from those of the business.
Businesses are organized either as a proprietorship, a partnership or a company. They differ on the level of control the ultimate owners exercise on the business, but in all forms the personal transactions of the owners are not mixed up with the transactions and accounts of the business.

Examples

1. A CPA has 3 rooms in a house he has rented for $3,000 per month. He has setup a single-member accounting practice and uses one room for the purpose. Under the business entity concept, only 1/3rd of the rent or $1,000 should be charged to business, because the other 2 rooms or $2,000 worth of rent is expended for personal purposes.
2. The CPA received $900 bill for utilities. He paid the whole amount using his business account. $600 is to be considered a withdrawal because only $300 (1/3rd) related to business and the other $600 was for domestic purpose.
3. Assuming each public accounting business is required to pay $100 to a local association of CPAs each month. If the CPA pays that amount from a personal bank account the amount shall be considered additional capital.

4.Monetary Unit Assumption

In accounting we can communicate only those business transactions and other events which can be expressed in monetary units. This is called monetary unit assumption.
There are certain other frameworks for reporting business performance such as triple bottom line which focuses on "people, planet profit" the three pillars; corporate social responsibility reporting, etc. Accounting focuses on the financial aspects of the business and that too for matters which can be expressed in terms of currencies.
One aspect of the monetary unit assumption is that currencies lose their purchasing power over time due to inflation, but in accounting we assume that the currency units are stable in value. This is alternatively called stable dollar assumption.

However, there are exceptional circumstances called hyperinflation when the accounting standards require adjustment of prior period figures.

Examples

1. The company's property, plant and equipment on 2009 balance sheet amounted to $2 billion. During 2010 inflation was 10%. The monetary unit and stable dollar assumption prohibits any adjustment to current or prior period figures to account for the inflation.
2. The BP oil spill in Gulf of Mexico was a natural disaster but accounting only reports the financial impact in the form of claims paid, damages paid, cleanup costs, etc. This is due to the limitation imposed by the monetary unit assumption.

5. Time Period Principle

Although businesses intend to continue in long-term, it is always helpful to account for their performance and position based on certain time periods because it provides timely feedback and helps in making timely decisions.
Under time period assumption, we prepare financial statements quarterly, half-yearly or annually. The income statement provides us an insight into the performance of the company for a period of time. The balance sheet (also known as the statement of financial position) provides us a snapshot of the business' financial position (assets, liabilities and equity) at the end of the time period. The statement of cash flows and the statement of changes in equity provide detail of how the company's financial position changed during the time period. One implication of the time period assumption is that we have to make estimates and judgments at the end of the time period to correctly decide which events need to be reported in the current time period and which ones in the next.
Revenue recognition and matching principles are relevant to time period assumption. Revenue recognition principle provides guidance on when to record revenue while matching concept tells us how to reach an accurate net income figure by creating 1-1 correspondence between revenues and expenses.

6.Revenue Recognition Principle

Revenue recognition principle tells that revenue is to be recognized only when the rewards and benefits associated with the items sold or service provided is transferred, where the amount can be estimated reliability and when the amount is recoverable.
Accrual basis of accounting is used in recognizing revenue which tells that revenue is to be recognized ignoring when the cash inflows occur.

Examples

A telecommunication company sells talk time through scratch cards. No revenue is

1. recognized when the scratch card is sold, but it is recognized when the subscriber makes a call and consumes the talk time.
2. A monthly magazine receives 1,000 subscriptions of $240 to be paid at the beginning of the year. Each month it recognizes revenue worth $20,000 [($240 ÷ 12) × 1,000].
3. A media company recognizes revenue when the ads are aired even if the payment is not received or where payment is received in advance.

In case where payment is received before the event triggering recognition of revenue happens, the debit goes to cash and credit to unearned revenue. In case the event triggering revenue recognition occurs before payment is received, the debit goes to accounts receivable and credit to revenue.
Revenue is the item which is the easiest to misstate, hence more stringent rules and guidance is required in this area. IAS 18 Revenue deals with recognition of revenue.

 7. Full Disclosure Principle

Full disclosure principle is relevant to materiality concept. It requires that all material information has to be disclosed in the financial statements either on the face of the financial statements or in the notes to the financial statements.

Examples

1. Accounting policies need to be disclosed because they help understand the basis of accounting.
2. Details of contingent liabilities, contingent assets, legal proceedings, etc. are also relevant to the decision making of users and hence need to be disclosed.
3. Significant events occurring after the date of the financial statements but before the issue of financial statements (i.e. events after the balance sheet date) need to be disclosed.
4. Details of property, plant and equipment cannot be presented on the face of the balance sheet, but a detailed schedule outlining movement in cost and accumulated depreciation should be presented in the notes.
5. Tax rate is expected to change in near future. This information needs to be disclosed.
6. The draft for a new legislation is presented in the legislative of the country in which the company operates. If passed, the law would subject the company to significant cleanup costs. The company has to disclose the information in the notes.
7. The company sold one of its subsidiaries to the spouse of one of its directors. The information is material and needs disclosure.

 8. Historical Cost Concept

Accounting is concerned with past events and it requires consistency and comparability that is why it requires the accounting transactions to be recorded at their historical costs. This is called historical cost concept.
Historical cost is the value of a resource given up or a liability incurred to acquire an asset/service at the time when the resource was given up or the liability incurred.
In subsequent periods when there is appreciation is value, the value is not recognized as an increase in assets value except where allowed or required by accounting standards.

Examples

1. 100 units of an item were purchased one month back for $10 per unit. The price today is $11 per unit. The inventory shall appear on balance sheet at $1,000 and not at $1,100.
2. The company built its ERP in 2008 at a cost of $40 million. In 2010 it is estimated that the present value of the future benefits attributable to the ERP is $1 billion. The ERP shall stand on balance sheet at its historical costs less accumulated depreciation.

The concept of historical cost is important because market values change so often that allowing reporting of assets and liabilities at current values would distort the whole fabric of accounting, impair comparability and makes accounting information unreliable.

9.Matching Principle

In order to reach accurate net income figure, the expenses incurred to earn the revenues recognized during the accounting period should be recognized in that time period and not in the next or previous. This is called matching principle of accounting.

Examples

1. $2,000,000 worth of sales are made in 2010. Total purchases of inventory were $1,000,000 of which $100,000 remained on hand at the end of 2010. The cost of earnings is $2,000,000 revenue is $900,000 [$1,000,000 minus $100,000] and this should be recognized in 2010 thereby yielding a gross profit of $1,100,000.
2. A hospital pays $20,000 per month to 5 of its doctors. Monthly sales are $500,000. $100,000 worth of monthly salaries should be matched with $500,000 of revenue generated.

Matching principle is relevant to the time period assumption, the revenue recognition principle and it is at the heart of accrual basis of accounting.

10. Relevance and Reliability

 Relevance and reliability are two of the four key qualitative characteristics of financial accounting information. The others being understandability and comparability.

Relevance requires that the financial accounting information should be such that the users need it and it is expected to affect their decisions.
Reliability requires that the information should be accurate and true and fair.
Relevance and reliability are both critical for the quality of the financial information, but both are related such that an emphasis on one will hurt the other and vice versa. Hence, we have to trade-off between them. Accounting information is relevant when it is provided in time, but at early stages information is uncertain and hence less reliable. But if we wait to gain while the information gains reliability, its relevance is lost.

Examples

1. After the balance sheet date but before the date of issue a company wants to dispose of one of its subsidiaries and is in final stages of reaching a deal but the outcome is still uncertain. If the company waits they are expected to find more reliable information but that would cost them relevance. The information would be outdated and no longer very relevant.
2. After the balance sheet date during the time when audit is carried out, it becomes clear which debts were realized and where were not hence it improves the reliability of allowance for bad debts estimate but the information loses its relevance due to too much time being taken. Timeliness is key to relevance.

11. Materiality Concept

Financial statements are prepared to help the users with their decisions. Hence, all such information which has the ability to affect the decisions of the users of financial statements is material and this property of information is called materiality.
In deciding whether a piece of information is material or not requires considerable judgment. Information is material either due to the amount involved or due to the importance of the event.

Examples

1. The government of the country in which the company operates in working on a new legislation which would seriously impair the company's operations in future. Although there are no figures involved but the impact is so large that disclosure is imminent.
2. The remuneration paid to the executives and the directors is material.
3. The accounting policies are material because they help the users understand the figures.

Materiality might be based on a percentage of sales such as 0.5% of sales or on total assets. Materiality is helpful in determining which figures are to be reported on income statement and balance sheet and which one in the notes. It is also helpful in helping decide which items should appear as line items and which ones are aggregated with others.

12. Substance Over Form

While accounting for business transactions and other events, we measure and report the economic impact of an event instead of its legal form. This is called substance over form principle. Substance over form is critical for reliable financial reporting. It is particularly relevant in case of revenue recognition, sale and purchase agreements, etc.

Examples

A lease might not transfer ownership to the leasee but the leasee has to record the leased items as an asset if it intends to use it for major portion of its useful life or where the present value of lease payment is fairly

1. equal to the fair value of the asset, etc. Although legally the leasee is not the owner, so the leased item is not his asset, but from the perspective of the underlying economics the leasee is entitled to the benefits embedded in the use of the item and hence it has to be recorded as an asset.
2. A company is short of cash, so it sells its machinery to the bank and obtains it back on a lease. It is called sale and leaseback. Although the legal ownership has transferred but the underlying economics remain the same and hence under the substance over form principle the sale and subsequent leaseback are considered one transaction.
3. If two companies swap their inventories they will not be allowed to record sales because not sales has occurred even if they have entered into valid enforceable contracts.

 13. Prudence Concept

 Accounting transactions and other events are sometimes uncertain but in order to be relevant we have to report them in time. We have to make estimates requiring judgment to counter the uncertainty. While making judgment we need to be cautious and prudent. Prudence is a key accounting principle which makes sure that assets and income are not overstated and liabilities and expenses are not understated.

Examples

1. Bad debts are probable in many businesses, so they create a special contra-account to accounts receivable called allowance for bad debts which brings the accounts receivable balance to the amount which is expected to be realized and hence prevents overstatement of assets. An expense called bad debts expense is also booked to stop net income from being overstated.
2. Some liabilities are contingent upon future occurrence or non-occurrence of an event such a law suit, etc. We judge the probability of occurrence of that event and if it is more than 50% we record a liability and corresponding expense at the most likely amount. Hence, we stop liability and expense from being understated.
3. Periodic evaluations of assets are made to make sure their carrying value does not exceed the benefits expected to be derived from the asset, and if it does exceed, the impairment of fixed asset is recorded by reducing its carrying amount.

14. Understandability Concept

 Understandability is one of the four qualitative characteristics of financial accounting information. The other being relevance, reliability, timeliness, faithful representation, comparability and materiality. Understandability refers to the quality of financial information which makes it understandable by people with reasonable background knowledge of business and economic activities.

Understandability requires the information presented in financial reports to be concise, complete and clear in presentation. The information should be presented so as to facilitate the user of the information.However, understandability never prescribes any complex information to be omitted altogether due to its underlying difficulty in understanding. It just requires us to disclose the information systematically instead of presenting it haphazardly.

Examples

Understandability would require the financial statements to be identified by presenting the name of the financial statement, the name of the entity and the period covered by the statement.
Understandability also requires the notes to be properly numbered and cross-referred to the original balance sheet and income statement items. For example the note number of disclosure on leases should be mentioned in front of the lease payable line item appearing on the face of a balance sheet.
Financial instruments and derivatives are specialized instruments which require rigorous understanding of finance to properly understand the underlying economics. In such complexity we cannot omit the disclosure because it is not easily understandable.

15. Comparability Principle

Comparability is one of the key qualities which accounting information must possess. Accounting information is comparable when accounting standards and policies are applied consistently from one period to another and from one region to another. The characteristic of comparability of financial statements is important because it allows us to compare a set of financial statements with those of prior periods and those of other companies.

Examples

1. We can compare 20X2 financial statements of ExxonMobil with its 20X1 financial statements to know whether performance and position improved or deteriorated.
2. We can compare the ExxonMobil financial statements with that of BP if both are prepared in accordance with same set of accounting standards, such as IFRS or US GAAP, etc.
3. When preparing 20X3 financial statements we are required to present with each of the 20X3 figure the corresponding 20X2 figures. This is done to add the characteristic of comparability to the financial statements.

Accounting standards are intended to outline the best accounting treatment so that companies follow them and hence accounting information is understandable, relevant and reliable and comparable. Consistency means that the accounting policies should be changed only when there are valid grounds for such a change.

16. Consistency Concept

The concept of consistency means that accounting methods once adopted must be applied consistently in future. Also same methods and techniques must be used for similar situations.

It implies that a business must refrain from changing its accounting policy unless on reasonable grounds. If for any valid reasons the accounting policy is changed, a business must disclose the nature of change, the reasons for the change and its effects on the items of financial statements.
Consistency concept is important because of the need for comparability, that is, it enables investors and other users of financial statements to easily and correctly compare the financial statements of a company.

Examples

1. Company A has been using declining balance depreciation method for its IT equipment. According to consistency concept it should continue to use declining balance depreciation method in respect of its IT equipment in the following periods. If the company wants to change it to another depreciation method, say for example the straight line method, it must provide in its financial report, the reason(s) for the change, the nature of the change and the effects of the change on items such as accumulated depreciation.
2. Company B is a retailer dealing in shoes. It used first-in-first-out method of inventory valuation in respect of shoes at Branch X and weighted average inventory valuation method in respect of similar shoes at Branch Y. Here, the auditors must investigate whether there are any valid reasons for the different treatment of similar inventory located at different locations. If not, they must direct the company to use any one of the valuation method uniformly for the whole class of inventory.

 

These principles are the building blocks that form the basis of more complex and specialized principles called GAAP or generally accepted accounting principles such as the International Financial Reporting Standards, US GAAP, etc. They deal with matters like accounting for revenue, accounting for income taxes, accounting for business combinations, etc.

 

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