When processing a company’s financial transaction, accounting strictly follows numbers of principles referred to as accounting principles. Most of these principles come from the assumptions that I have discussed in the previous post.
“What is the difference between those assumptions and the principles you’re discussing now?” You probably wonder.
Both terms are often used interchangeably thus are confusing but here how you can see both terms:
The assumptions are basic ideas about how the companies are organized and operated. The ideas serve as a disclaimer for the accounting’s limitation as a result of the way companies organize and operate. If accounting is a person, it would say “okay, I can make accurate financial statements as long as my assumptions about how the company organize and operate are true (or followed.)”
While the principles I am discussing later in this post serve as doctrines and commandments to the accounting people about “what to do” and “what to not do” to keep the promise for presenting accurate financial statements.
I am not a professor but hopefully, you get my point.
Here are the accounting principles:
1. Historical Cost Principle
This principle dictates accountants to record company’s assets at the purchase price plus other costs related to the effort of making the assets ready-for-use (if occur,) which are historical and referred to as acquisition cost.
To reflect the use of the asset, the accountants allocate a certain portion of the acquisition cost referred to as depreciation, in periodical basis, throughout the economic life of these assets.
The amount of depreciation is calculated by using certain methods and results in two things:
(a) depreciation cost that reduces the company’s profit for the period; and
(b) accumulated depreciation that reduces the book value of company’s long-term assets.
FYI: Make yourself familiar with the following accounting lingo:
Acquisition Cost is the purchase price of an asset plus the cost of making that asset ready-for-use.
Depreciation is an accounting method that regularly allocates acquisition cost of long-term assets into periods throughout the economic use of the assets.
Depreciation Cost is a portion of acquisition cost that is charged to a certain reporting period of income statements and reduces the company net income (profit.)
Accumulated Depreciation is a contra-account of long-term assets which is total depreciation charge accumulated up to the date of the balance sheet and reduces the book value of that assets.
Book Value is net value of an asset presented in the company’s balance sheet (book value = acquisition cost – accumulated depreciation).
Fair Market Value is the current market price of an asset or liabilities.
For example, ABC Corp purchased a machine for $25000 on 03/01/2008. In addition to the purchase, ABC Corp also paid an external engineer for $1000 to install the machine.
Following on this principle, ABC Corp’s accountant recorded acquisition cost of the machine as “Properties Plan and Equipment,” under the ABC Corp’s Long-term Assets, at $26000 (=25000+1000.) To reflect the use of the machine during 2008, the accountant had to allocate depreciation by 12/31/2008, let say $3000.
So the accountant record depreciation cost on the debit side and accumulated depreciation on the credit side, $3000 each. The former reduced profit by 3000 for the period and the later decrease long-term asset by the same amount.
If ABC Corp issues financial statements on monthly basis for its management review, the accountant has to allocate the acquisition cost of the machine every month (usually prior to the closing date,) until the $26000 has been completely allocated and has a book value of $0. If it is a publicly-held company, the accountant then has to do the same on quarterly and annually basis.
Note, however, that land’s value increases from year to year so it is non-depreciable and this starting to attract pro-and-contra in the public opinion. The contrarian questions, “why is such undervaluation method is used?” and the pro answers with 2 major reasons:
- It represents the easiest measurement method without the need for constant appraisal and revaluation; and
- Marking assets up to fair value allows for management discretion and subjectivity, which GAAP attempts to minimize by using historical cost.
For these reasons, the International Accounting Standard Board (IASB) recently released IFRS 13 which requires internationally-operated entities to represent their assets at current market price referred to as “Fair Market Value.” Even the FASB (U.S.,) recently, also released a so-called “accounting standard codification” (ASC) that requires publicly-held companies in the U.S. to represent fair market value on its assets and liabilities.
2. The Revenue Recognition Principle
Accrual basis of accounting assumption is one of the most important concepts in accounting that governs the company’s timing in recording its revenues (i.e., sales) and associated expenses (see also the subsequent principle).
The revenue principle requires accountants to record revenues only when it is completely earned and measurable.
For example, the following transactions occurred in the operation of the ABC Corp, a manufacturer:
- November 10, 2016, received 100 pcs order of merchandises @$100, with a 30-days credit term.
- December 14, 2016, completed the production and knew the cost of making the merchandise was $6000
- December 15, 2016, 95 pcs of the order was shipped to the customer.
- January 14, 2017, received the payment.
From the above situation, when should ABC Corp record revenue?
ABC Corp’s accountant only records revenue on December 15′ 2016 because only on that date the ABC Corp transferred the ownership of the merchandises (completely earned) and only on that date also it knew the exact amount of the revenue earned (measurable) which was $9500 (=95 pcs x $100.)
3. The Matching Principle
Dictated by the “accrual assumption,” this principle requires accountants to record (or “to match”) the costs associated with making a product with the revenue generated from that product during the same period.
From the previous example, ABC Corp’s accountant recorded the cost of goods sold on December 15, 2016, because the accountant has known the cost which was $6000 and able to match it to the revenue on that date.
Another example would be the expenditures that occur in the first year of operation of a company where revenue have not even existed yet. Let’s say ABC Corp launched on April 10, 2010. It started to pay payroll for 15 employees on April 25, 2010, for $25000, but the ABC corp has not even made any revenues at all. Could ABC Corp record the $25000 as payroll expenses?
The answer is, NO! Because an expenditure could be recognized as a cost/expense only when it could be “matched to” a revenue that has been earned for that cost. Instead, the ABC Corp would record the expenditure as “Prepaid Costs/Expenses” on the assets for the time being and matched it to a revenue earned in the next period.
Note here that “prepaid cost/expense” is not an expense, it is an expenditure that has not been charged yet OR, you can see it as a future expense that paid in advance, therefore, is grouped in the assets.
FYI: The IAS 18 (of IFRS) provides accountants with even more clearly guidelines on when a revenue can be recognized. Revenue arising from the sale of goods for example, “could only be recognized when all of the following criteria have been satisfied:
- the seller has transferred to the buyer the significant risks and rewards of ownership;
- the seller retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold;
- the amount of revenue can be measured reliably;
- it is probable that the economic benefits associated with the transaction will flow to the seller; and
- the costs incurred or to be incurred in respect of the transaction can be measured reliably.”
For revenue arising from the rendering of services, particularly when a company uses the percentage-of-completion method, the standard requires that “it should be recognized by reference to the stage of completion of the transaction at the balance sheet date and the following criterions are met:
- the amount of revenue can be measured reliably;
- it is probable that the economic benefits will flow to the seller;
- the stage of completion at the balance sheet date can be measured reliably; and
- the costs incurred, or to be incurred, in respect of the transaction can be measured reliably.”
4. The Full Disclosure Principle
In a personal life, what if I told you that I do a simple business, pocket $15000 per month profit, have increased my saving account from zero to seven figures so far, and now would like to invite you to join the business, would you say “yes”?
Of course not, or at least not that soon, even if you’re interested in my business. Instead, you would ask me where the $15K profit number come from; what I’ve invested, what I did, what I sold, who bought my product/services, and etcetera.
In short words, you would ask me a “full disclosure” that backed up my statements, before deciding whether or not to join my business.
That is also true in the real business world. The users of a company’s financial statements come from many different backgrounds. Some of them are non-financial geek which need financial information as clear as possible for making a decision. Moreover, accountants have many different alternative methods to account transactions that result in different numbers.
For example, ABC Corp’s financial statements show $15 million net income (profit) on the income statements and own $2 million inventory on the balance sheet. An investor would ask, what method was used by the ABC Corp to count its inventory cost flow? Was it an average OR first-in-first-out method?
There is no way for external users to know which method have been used by reporting company to come up with the financial statements’ number unless the accountant provides them with an explanation.
Under the full disclosure principle, accountants of a company must reveal all relevant economic information related to the numbers presented in the financial statements. The following disclosures should be presented in addition to the financial statements:
- Statement of compliance (with IFRS or GAAP)
- Notes to financial statements, which is a supporting information for items presented in the financial statements
- Supplementary information, which is a summary of significant accounting policies applied
5. The Conservatism Principle
In accounting, certain measurements cannot be performed completely accurately or certainly to happened.
For example, ABC Corp sold merchandise for $2000 to a customer with 30-days credit term. So its bookkeeper recorded revenue on the credit side and receivable on the debit side, $2000 each. At the end of the period, ABC Corp’s balance sheet shows a $65000 Accounts Receivable balance.
The $65000 itself is accurate, well backed up with ‘customers purchase orders-shipping slips-and-invoices,’ and everything was adequately verified but, who can guarantee that every penny of the receivable is collectible? What if a customer or two file bankruptcy later on?
That means some of the $65000 are uncertainty collectible. For such uncertainty, this principle requires accountants to utilize conservative estimates and judgments.
The conservatism principle dictates that revenues and assets should not be overstated, while expenses and liabilities should not be understated.
So, on the first side, ABC Corp should reserve a certain portion of the receivable as possibly become a bad debt in the future and referred to as “Allowance For Doubtful Accounts,” let’s say $1500. On the other side, ABC Corp would also need to eventually charge (or expensed) that allowance into the ABC Corp’s net income for the same amount and referred to as “Bad Debt Expenses.” The former reduces ABC Corp’s Accounts Receivable balance on the balance sheet and the later reduces ABC Corp’s Net Income on the Income Statements.
That way, the conservatism principles is well followed by the ABC Corp.
“Allowance For Doubtful Accounts” is management’s estimate of the amount of accounts receivable that will not be paid by customers which become a reduction (or contra account) of the total amount of accounts receivable appearing on a company’s balance sheet.
“Bad Debt Expenses” is management’s estimate of the amount of accounts receivable that will not collectible in the future and charge to the company’s net income as an expense.
There are several possible ways to estimate the allowance for doubtful accounts and bad debt such as risk classification, Pareto analysis, and historical percentage. Though, the historical percentage is the most popular among the three. Using this method, if a certain percentage of accounts receivable became bad debts in the past, then the company will use the same percentage in the future.
Auditors have well known this allowance as a risky area where the management of a company possibly alters their financial results by manipulating the size of this account. During an audit session, auditors look for this issue by comparing the size of the allowance to gross sales over a period of time, to see if there are any major changes in the proportion.
6. The Materiality Principle
This principle says that a company may ignore other principles (or even the standard in whole) if the amount OR transaction OR discrepancy, in question, is small enough (or “immaterial“) that the financial statements will not mislead internal and external users.
For example, ABC Corp’s purchased office supplies for $200.25 but the bookkeeper incorrectly record the “office supplies expense” for $200.35. The $0.10 different is considered as “immaterial” so the ABC Corp’s accountant did not make a correction entry, he just ignored it.
Note, however, that materiality isn’t always about dollar numbers addition or dollar numbers omission. Instead, it is about how significant that addition/omission could mislead the users of financial statements in making decision.
For example, an expense of $100 in a multi-billions corporation such as General Electric may be immaterial, and, if it were forgotten OR recorded incorrectly, then no practical difference would result. However, an expense of the exact same amount could be considered as material in the case of a small business that earns $1000 net income.
In the auditing area, the objective of a financial statements audit is to enable the auditor to express an opinion whether the financial statements are prepared, in all material respects, in conformity with an identified financial reporting framework such as the GAAP.
SEC’s Staff Accounting Bulletin (SAB) No. 99, “Materiality,” provides auditors with clear pointers for presentation purposes that an item representing at least 5% of total assets should be separately disclosed in the balance sheet. However, the guidance clearly expresses that it is not about numbers or percentage, but it is rather about the intention behind the addition or omission. Here are what it has to say when considering materiality beyond numbers:
- whether the misstatement arises from an item capable of precise measurement or whether it arises from an estimate and if so, the degree of imprecision inherent in the estimate;
- whether the misstatement masks a change in earnings or other trends;
- whether the misstatement hides a failure to meet analysts’ consensus expectations for the enterprise;
- whether the misstatement changes a loss into income or vice versa;
- whether the misstatement concerns a segment or other portion of the registrant’s business that has been identified as playing a significant role in the registrant’s operations or profitability;
- whether the misstatement affects the registrant’s compliance with regulatory requirements;
- whether the misstatement affects the registrant’s compliance with loan covenants or other contractual requirements;
- whether the misstatement has the effect of increasing management’s compensation – for example, by satisfying requirements for the award of bonuses or other forms of incentive compensation; and
- whether the misstatement involves concealment of an unlawful transaction.
IFRS’s “Conceptual Framework 3 (Paragraphs QC6 to QC11) provides guidance to the consideration of materiality. Information is said to be material if omitting it or misstating it could influence decisions that users make on the basis of an entity’s financial statements. Put differently, “materiality is an entity-specific aspect of relevance, based on the size, or magnitude, or both,” of the items to which financial information relates.
FYI: While the IASB has refrained from giving quantitative guidance for the mathematical calculation of materiality, some method were suggested by academia such as 2 followings methods in a study funded by the Norwegian Research Council (“Materiality in a Financial Statement Audit,” by Sage Pastel):
1. Single rule methods:
- 5% of pre-tax income;
- 0.5% of total assets;
- 1% of equity;
- 0.5% of total revenue.
2. variable-size methods:
- 2% to 5% of gross profit if less than $20,000;
- 1% to 2% of gross profit, if gross profit is more than $20,000 but less than $1,000,000;
- 0.5% to 1% of gross profit, if gross profit is more than $1,000,000 but less than $100,000,000;
- 0.5% of gross profit, if gross profit is more than $100,000,000.
And an old “Discussion Paper 6: Audit Risk and Materiality” (July 1984) offers a suggested range for the calculation of materiality. Based on the audit risk, the auditor will select a value inside this range:
- 0.5% to 1% of gross revenue;
- 1% to 2% of total assets;
- 1% to 2% of gross profit;
- 2% to 5% of shareholders’ equity;
- 5% to 10% of net profit.
In short, the assessment of what is material, where to draw the line between a transaction that is big enough to matter or small enough to not matter, depends upon factors such as the size of the organization’s revenues-and-expenses and is ultimately a matter of professional judgment.
1. Accounting follows numbers of key principles which are the foundation of the accounting standard. So important that you can see them as doctrines and commandments of the accounting about “what to do” and “what to not do” to generate accurate financial statements.
2. Historical cost principle mandates accountants to record company’s assets at the purchase price plus other costs related to the effort of making the assets ready-for-use (if occur,) which are historical.
3. The revenue recognition Principle requires accountants to record revenues only when it is completely earned and measurable.
4. The matching principle requires accountants to record (or “to match”) the costs associated with making a product with the revenue generated from that product during the same period.d reliably.”
5. The full disclosure principle requires accountants to reveal all relevant economic information related to the numbers presented in the financial statements.
6. The conservatism principle requires that revenues and assets should not be overstated, while expenses and liabilities should not be understated.
7. The materiality principle requires that a company may ignore other principles (or even the standard in whole) if the amount OR transaction OR discrepancy, in question, is small enough (or “immaterial”) that the financial statements will not mislead internal and external users.