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Accounting principles – Transcript
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- The conservatism principle dictates that anticipated or probable losses are recorded when they occur, while anticipated profits are only recorded when earned.
- The consistency accounting principle requires that transactions and valuation methods are treated the same way from year to year.
- The matching principle requires that revenues and related expenses are recognized together in the same reporting period or incurred period.
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Accounting principles: the fundamental elementsof the world view that governs everything we do in finance and accounting. Let me walk you through seven core accountingprinciples: Conservatism, also known as prudenceConsistency Full disclosureGoing concern MatchingMateriality, and ObjectivityUsing any of these terms knowledgeably in
a conversation with finance and accountingpeople can help to get things done accurately and efficiently. For each accounting principle, let’s discussthe main idea, the definition of the principle, and an example of how it can be used.
Conservatism, or prudence. The main idea is that it’s better to besafe than sorry. According to the conservatism principle, allanticipated or probable losses are recorded as and when they occur, while anticipatedprofits are not recorded, but only when the profits are earned.
Here’s an example of how to apply this accountingprinciple. Two recent payments to a supplier have beenreturned by the bank with a message “account unknown”. Follow-up e-mails and phone calls to the supplierhave remained unanswered.
What should we do with the money? If we are unable to pay the supplier, shouldwe record this as a “gain”? No, we shouldn’t. At least, not yet. According to the conservatism / prudence principle,we should keep the liability on the books.
For example, this supplier could be in receivership,with a bankruptcy lawyer in the process of identifying all assets of the company in liquidation,including what is on their balance sheet accounts receivable towards us.
The consistency accounting principle: achievinga high level of performance which does not vary greatly in quality over time. Transactions and valuation methods are treatedthe same way from year to year. Let’s take an example relating to depreciation.
In year one, all fixed assets of the companyare depreciated based on the “straight line” method. In year two, after careful review, the depreciationpolicy is changed for vehicles only. These are now depreciated based on mileage,which is deemed a more accurate and appropriate method.
In year three, the depreciation for vehiclesis calculated to be very high, due to the high mileage. As the business doesn’t really like theoutcome of the calculation, can we switch back to “straight line” depreciation forvehicles? No, you can’t just jump back and forth betweendifferent methods of recording significant transactions.
You need to apply consistency of method, sothe financial statements are comparable year over year. That doesn’t mean you can NEVER change yourapproach, but only when you have a solid reason to do so.
Full disclosure. The truth, nothing but the truth, and thewhole truth. All financial information regarding businesstransactions must be given in full. An example of the full disclosure accountingprinciple.
Various lawsuits have been filed against thecompany regarding product quality. The company and outside legal counsel considerthe lawsuits “without merit”. They believe there are no reasonable or factualgrounds to support the underlying claim.
Should we then simply ignore the lawsuitsin the financial reporting? No! We need the truth, nothing but the truth,and the whole truth. It is important for users of the financialinformation to see the full picture, and for that we need full disclosure.
In the annual reports of publicly listed companies,the section called “Commitments and Contingencies” (in the notes to the financial statements)is actually one of the most interesting ones to find out what kind of trouble the companymight be in!
The going concern principle. The main idea: to be, or not to be? Is this company alive and well? Is its heart beating at a steady pace? Or more formally: going concern means a businessis financially stable and can operate with the expectation of indefinite existence…or at least for the foreseeable future.
The opposite of going concern would be bankruptcyor foreclosure. Here’s an example of testing for the goingconcern principle. What if:a major customer has gone bankrupt, it’s questionable whether outstanding accountsreceivable will be paid, and it’s unlikely that another customerof this size will be found.
Can we assume the business operates as “goingconcern”, and prepare the financial statements accordingly? That’s a question that is not easy to answer. The company should probably disclose thatthere is substantial doubt about the entity's ability to continue as a going concern.
The matching principle. What belongs where, and when? Revenues and any related expenses (like costof goods sold) are to be recognized together in the same reporting period, and/or expensesshould be recorded during the period in which they are incurred.
Here’s an example of this accounting principle. The company pays a supplier upfront for atwo-year maintenance contract. Should we record the full invoice as expensein the current period? No, according to the matching principle weexpense 1/24th of the contract every month.
And now for my personal favorite: the accountingprinciple of materiality! I have used this many times over the yearsin my defense. The main idea of materiality is that we areborn to be awesome, not perfect.
We try to avoid mistakes, yet they do occasionallyhappen, and some mistakes are more painful than others. Materiality is the threshold above which missingor incorrect information in financial statements is considered to impact the fair and accuraterepresentation of the financial situation.
An example of the materiality principle. Ten thousand dollars of expenses have beenincorrectly recognized as Cost Of Goods Sold instead of Selling, General and Administrativeexpenses. Does this impact the “fair and accuraterepresentation”?
First of all, at least the ten thousand dollarsis in the income statement, and didn’t accidentally end up on the balance sheet. Second, is classifying the amount in the wrongexpense category “material” or not?
That very much depends on the size of thecompany and its financials. Yes, it would be “material” for a companywith $200K in revenue. No, it would not be “material” for a companywith $2B in revenue.
Objectivity. Verifiable facts versus subjective opinionsor biases. According to this accounting principle, theaccounting data should consistently stay accurate, be free of personal opinions, and be supportedby independent and unbiased evidence.
A real life example. There is a rusty machine in the factory thathasn’t operated in three years but still has a value on the books. The plant manager says: “it’s a good machinethat we will certainly use again”. What should the finance director do?
Keep the machine at its current value in thebooks? Once again, it depends… We certainly need a business plan: when canproduction be resumed, and what is the product margin. If we can’t come up with a solid businessplan based on realistic assumptions, then a write-off or asset impairment would be appropriate.
Want to learn more about business, finance,accounting and investing? Then subscribe to the Finance StorytellerYouTube channel, and start watching the next video in the recommendations on the screen. Thank you.