Accounting Principles

Accounting is governed by a set of common principles to ensure that accounting data is reliable, accurate, and can be compared. There is tremendous flexibility in how transactions can be handled, how accounts can be structured, and how reports can be presented, etc. These principles help ensure that the flexibility doesn’t compromise the integrity and value of the accounting data.

Generally Accepted Accounting Principles (GAAP)

Accounting transactions (at least in the U.S.) are expected to be handled according to Generally Accepted Accounting Principles (GAAP). Some transactions are easy to define such as cash sales, and expense payments, etc. Others, such as which depreciation method makes sense, how funds are disbursed to partners or owners, etc., have a lot of choices to handling them. As a general rule of thumb, transactions should be handled the same way everyone else does them. In the event of a government audit, if the accountant can show a transaction was handled the same way as other firms handled it (and that handling for the other firms was accepted/approved by the IRS), then the transaction will most likely be allowed.

The primary purpose of an accounting system is to allow decisions to be made either by the board, the owners, the stockholders or the investors, etc. The following principles ensure that the accounting system can be used by these decision makers.

Business Entity

The Business Entity concept means that the business is a separate entity from its owners (be it a sole proprietorship, partnership or corporation). Business transactions and personal transactions must be keep separate. For example, if a business is run from a rented home and uses one room for work purposes with the remaining four rooms used for living space, then only 20 percent of the rental can be considered a business expense. If the business paid the entire rent, then the other 80 percent would be considered a draw from equity for the owner.

Note: Because of the potential abuse of mixing personal expenses (i.e., those that are not tax-deductible) with business expenses (i.e., those that are tax-deductible), the IRS has strict rules for home offices and can more frequently audit these types of businesses.

Monetary Unit

The Monetary Unit concept means that the only transactions that can expressed in money terms are reported in the accounting system. Other events can happen that have a major impact on the business but cannot be expressed in monetary terms. These are not reported in financial statements unless financial impact can be shown.

For example, if we look at the hacked Sony database in response to “The Interview” movie, the company is facing a public relations problem. This is not reported; however, it can report the potential lost income due to the decision to not release the movie. When an oil spill occurs, companies face public relations issues as well but only actual costs (e.g., clean-up, and legal bills, etc.) are actually reported.

Note: Sony Pictures had their databases hacked and several upcoming movies were released to the Internet as well as demands that film The Interview be pulled. It was a publicized hack and response, with some people blaming North Korean hackers. The battle between Sony and hackers caused a lot of data to be released including salary information, phone numbers, etc. Although the data breach was substantial, people formed opinions about Sony’s decision to not release the movie to theatres.

Materiality Concept

The Materiality concept has to do with what information either a) belongs on financial statements or b) belongs in footnotes or c) doesn’t need to be included. Keep in mind that the purpose of financial reporting is to help people make decisions so any information found that could affect those decisions should be included.

Information that could have a major financial impact should be disclosed. For example, if a large portion of the company’s profits come from an overseas operation, and the company finds out that the foreign government is going to shut down that operation, this should be included in financial reports. However, if a shipping company used by the company is closing (so the company will need to start using a different shipping company, with minor changes in shipping cost), there is no need to include that information on a financial report.

Relevance/Reliability Concept

The Relevance/Reliability concept is a tricky balance for accounting reports. Information that helps decision makers who are reviewing the financial statements is always relevant but it might not be reliable. For example, a potential recall of a company’s products would be considered relevant; however, depending upon how likely the recall is, the information might not be reliable. A company has to decide the proper balance between the two.

For example, the company prepares its balance sheet as of year’s end. However, before the statements are released to the public, the company is negotiating a deal to sell a portion of the business but that deal is far from being complete and certain. The information is relevant but also might not be reliable. An accountant needs to decide whether or not the potential sale is likely to occur, in which case it is relevant to the statement. However, the accountant might also wait until sale details are closer to being finalized so that the information provided will be reliable.

Comparability Concept

The Comparability concept assumes that people who are reading the financial statements are likely to want to compare financial statements between accounting periods and, possibly, with other companies. It is important the accounting standards and policies between periods are consistent and, if any major policy or standard change occurs, they must be noted.

If an investor wanted to compare financial statements between two similar companies (and if both companies prepare their statements according to GAAP standards), the investor can make a reasonable comparison. However, if the investor is comparing financial statements between American firms that are using GAAP and European firms that are using International Accounting Standards (IAS), there could be some reporting differences that would hinder the comparison. This is why financial reports indicate the standard under which they were prepared.

Consistency Concept

The Consistency concept ensures that, once a particular accounting technique is adopted, it is used consistently for all future reporting. In addition, similar situations are expected to be handled the same way. If a company reports inventory by using first-in, first-out (FIFO) and takes depreciation by using the straight-line method, a person reading the report can reasonably expect that these methods will be used in the future and for all inventory and assets.

For example, assuming a company used straight-line deprecation on assets one year and switched to an accelerated method the following year, a person cannot compare the asset values and expenses between the two periods; such a change should be noted in a footnote.

Matching Principle

The Matching principle attempts to match revenues with the expenses that occurred to create the revenue. According to this principle, expenses are recorded in the books within the same period the revenue occurred. It is one of the main benefits offered by the accrual accounting method and it is a part of GAAP for most businesses.

Summary

In general, an accounting system should attempt to disclose all of the important information in a consistent fashion, which allows users of the data to make reliable decisions based on the data they find in the accounting statements. In the next chapter, we will look at some of the standard accounting reports that systems need to produce.