Summary of Accounting Principles

Although individual countries have traditionally enforced their own standards, there have been strenuous, if slow-paced, efforts to establish a global accounting framework, driven by the Financial Accounting Standards Board (FASB) in the USA and the International Accounting Standards Board elsewhere. The differences between the various standards are relatively minor and can be ignored for our purposes. The list below is not comprehensive and serves to give a ‘feeling’ for accounting practice.

The Revenue Recognition Convention

The revenue recognition convention provides that revenue be taken into the accounts (recognized) at the time the transaction is completed. Usually, this just means recording revenue when the bill for it is sent to the customer. If it is a cash transaction, the revenue is recorded when the sale is completed and the cash received.

The Matching Principle

The matching principle (sometimes referred to as accrual accounting) is an extension of the revenue recognition convention and states that the costs incurred in achieving revenues need to be accounted for in the same period as those revenues. For example, an organization pays for its energy quarterly, receiving the invoice from the energy company at the end of the quarter. However, the company draws up its accounts only one month into the quarter so, although it has used energy, it does not have an invoice. The accountants will therefore “accrue” the likely cost of the energy – that is, record an estimated expense in the accounts for the period. If a cost cannot be tied to a sale, then it is recognized as an expense in the period in which it is incurred. Prepaid expenses are entered as current assets, not expenses. You can probably see that the matching principle leaves lots of scope for interpretation and judgment. Whether (or how much of) an expense falls within a particular period is not always easy to ascertain and in some businesses can involve fine judgments about the use of resources – people, materials, energy, plant etc. Remember, ‘hard’ numbers don’t exist!

There is also an objectivity principle that comes into play quite often with the matching principle. Many marketers would argue that marketing will have an impact on sales for several years. An accountant, however, would say – “Yes, but if we asked 5 different marketers, they would all probably come up with different answers to how we should apportion the advertising expense. Therefore, since we cannot attribute the effects of the advertising to specific sales with any degree of objectivity, we will apply the whole expense to the year in which the advertising occurred.” In treating advertising as an expense rather than an investment, we see the principle of conservatism at work too. The accountant continues: “You cannot tell me which sales happened because of your advertising (or which would have happened in any case). So I must apply the principle of conservatism – after all, you could spend a £1 million on advertising and nobody buys a single product.” Very frustrating for marketers – and the reason why value principles (discussed in later sections of the book) are so important if marketers are to justify marketing investment.

The Business Entity Concept

In law a sole trader and his business are considered one and the same. Not so in accounting. The accounting for a business or organization must be kept separate from the personal affairs of its owner, or from any other business or organization. The balance sheet of the business must reflect the financial position of the business alone. Thus personal assets cannot appear on the business balance sheet. Similarly, personal expenses are not to be recorded in the income statement.

The Continuing Concern Concept

The continuing concern concept assumes that a business will continue to operate, unless it is known that such is not the case. You can see why this is an important principle if you think of how the value of inventory in a business would fall if it had to sell the inventory immediately.

The Principle of Conservatism

Accountants, when they make judgment calls (eg in the value of doubtful debtors), should do so in a way that neither overstates nor understates the affairs of the business or the results of operation. Generally this means that accountants will err on the side of caution.

The Time Period Concept

The time period concept provides that accounting take place over specific time periods known as fiscal periods. Thus an income statement must always state the period to which it relates. Simply stating the date on which it was prepared is of little value.

The Cost Principle

Under the cost principle, purchases must be entered at their cost price. Thus whilst you may have done the deal of the century and bought equipment worth £100,000 for £10,000, the amount that is entered into the accounts is £10,000.

The Consistency Principle

You can’t change how you measure things without good cause. For example, if you are depreciating an asset using the reducing balance method, you cannot suddenly change to straight line.

The Materiality Principle

You can bend the rules a little if keeping to the rules involves significant work and makes little material difference to the results. For instance a large corporation may treat a small asset transaction as an expense rather than go to the trouble of depreciating over a number of years.

The Full Disclosure Principle

No secrets! If you are involved in a lawsuit or a takeover – in other words something that could significantly affect the future performance of the business – then you should disclose this. Generally this will be in the form of a note to the accounts.