The Principles Of Accounting, or The Financial Commandments
While slightly humorous, it is only logical that accounting, an exact science of financial responsibility, has a governing body: the Financial Accounting Standards Board (FASB). FASB has the characteristics of a secret society: it is a non-government group comprised of only seven members, with whom the power to make and amend the more detailed principles of accounting primarily resides.
This may sound like something out of The Da Vinci Code, but these principles, along with other pre-established guidelines, provide a consistent and fair basis for accountants to follow; in other words, FASB is the exact opposite of an illegal organization. Needless to say, the general principles are the most fundamental and essential knowledge for those venturing down the exciting road of learning accounting. If these principles don’t satisfy your immediate appetite, whet your financial palette with this five-star introduction to accounting course.
An Expanded Introduction
FASB is powerful indeed, but as I quietly mentioned in the first paragraph, it is not responsible for what is known as the “generally accepted accounting principles” (GAAP). FASB hashes out the more detailed rules for the increasingly complex world and standards of business accounting. This article is primarily concerned with the GAAP, but it’s difficult to talk about accounting without mentioning FASB.
Whole books have been written about each of these principles, but at this point it’s more important to understand why they exist and what they do than all the historical and hypothetical implications. Why, then, do we have a need for the GAAP? Like any set of rules or principles, the GAAP exists to guide accountants when dealing with serious, public financials. They ensure both quality and fairness. When it comes time for a company to release its financial statements to the public, the accountants responsible for the job use, by requirement, the GAAP. When financial information becomes public, it is subject to these standards. Somewhat counter-intuitively, the accountant is not solely responsible for adhering to the GAAP. Company management, which is responsible for making available all necessary financial information, is also held accountable (no pun intended).
The GAAP might sound like over-kill if you view accounting as something as simple as fact-checking spreadsheets. But in fact there are many complex methods and practices that have been developed over the years and the GAAP helps accountants and companies attain something of vital importance: consistency. Yes, having consistent financials helps companies avoid falling into legal quandaries, but it also makes for easier and more accurate reporting when comparing one company to another, when evaluating year-to-year performance, when figuring out the industry standards, etc. And, like any vocabulary, they make accounting conversation possible. If you want to sound intelligent in an accounting conversation, boost your knowledge with this free post on accounting concepts that everyone should know.
Before I move on to the GAAP, I first want to make clear the expectations for which every accountant is held responsible. If the GAAP are the specific rules, then the expectations as a whole is a code of conduct. If you are not able to meet these expectations, then you are going to struggle to be taken seriously as an accountant. On the other hand, if you just want to gain some practical knowledge for your business, check out our this introduction to bookkeeping class.
Oh, but it’s more than just being reliable. Accountants like to be able to verify, and what they verify they want to be fact, not opinion. For example, let’s take something estimable: a mint condition 1962 Ferrari 250 GTO. Let’s say someone purchased this car for $1 million in 1985 and has held on to the car ever since. The current value of this car, according to recent reports, is upwards of $30 million. That’s a tempting number, but a true accountant will take the 1985 value over the current value any day of the week. Why? Because the $1 million actually happened; any accountant can look at records and verify that the car was purchased for this amount, that taxes were paid for this amount, and see that this is fact. Every accountant in the world who looks at these documents will get the same numbers: $1 million in 1985. If, however, you allowed every accountant to estimate the current value of this classic car, there would be quite a bit of diversification and, thus, the estimates would not be reliable.
This needs less explaining. Accountants simply and ultimately need to be consistent. This includes how they handle the GAAP (as you’ll see, one of these principles allows other principles to be broken, so accountants need to be consistent when they bend the rules). You will see in the GAAP that many assumptions are made; assumptions are only possible when there is consistency. If an accountant has been reporting certain activities, these are assumed to continue indefinitely. Any major changes that cannot be assumed practically need to have a blinking sign attached to them.
Similar to consistency, accountants need to ensure that their work can be widely compared. This is extremely important when people like investors compare financial statements. There are so many rules, especially for large companies and organizations, that things such as time period assumptions and matching principles (both discusses below) need to apply similarly to all companies, at all times, so that anyone could look at financial statements and compare companies that are not only unique, but in completely different markets. Think about the trouble you would run into if one company isn’t reporting expenses correctly and unknowingly reports incorrect numbers quarter to quarter. When this is the case, investors, owners and executives cannot make accurate decisions. It’s even wise for them to have a little accountant know-how themselves (which can be easily done with this accounting course specifically designed for managers).
The list of general principles is extensive, to say the least, as are its definitions. I have highlighted the primary principles below, but neither this list nor its definitions are comprehensive; they do, however, elucidate the core values.
- Economic Entity Assumption
This principle separates entities from one another, as well as businesses from business owners. Let’s look at separating entities first. This means keeping separate financial records for economic entities such as businesses, religious institutions, hospitals, government and social organizations, etc. In other words, financial transactions must correspond to the entity they are serving. You would not lump together the financials of two businesses just because it’s easier (which isn’t even logical, if you think about a bedding company and a software company trying to combine statements).
Separating businesses from their owners is fairly logical, as well. Even still, you hear of owners using public businesses to buy personal assets all the time; this, of course, is illegal. Owners cannot write their assets or liabilities as part of their company’s financial records. Interestingly, a business and its owner can be considered one entity for legal proceedings, but when it comes to accounting, they must be considered separately. To learn more about the ethics of accounting, take a gander at this accounting ethics training course, which allows you to earn 4 CPE credits as you make yourself more credible.
- Time Period Assumption
True to its name, the Time Period Assumption assumes that businesses can (and should) report lengthy financial activities in shorter, respective time frames. The key here is that the accountant takes extreme care in specifying these time periods. You can see this most easily in estimated taxes. If you were reporting estimated taxes for the first quarter, then naturally you would specify a time period of Jan 1. – March 31, or three months ended March 31. You would not specify a one year period. Speaking of which . . . need tax advice? This post is full of tips you can put a price tag on.
But the time period assumption is also in place because many businesses make investments that last for extremely long periods of time; five, ten, twenty years. If you had a one million dollar investment that you were hoping would last you ten years, it would not be sensible to report the entire investment in one quarter; this very poor quarter would presumably be followed by 40 strangely profitable quarters (10 years = 40 quarters). Thus, once a time frame has been established, the accountant follows other GAAP and FASB guidelines in appropriating each time period’s transactions.
- Monetary Unit Assumption
The Monetary Unit Assumption says two things:
1) Only economic activity that can be measured in currency (e.g. U.S. dollars) can be recorded. This means that you cannot quantify something such as a valuable executive and his or her fabulous money-making decisions. You cannot “price” a customer base or a new marketing campaign (although you can put a price on what you paid an external marketing firm). Due to the subjective nature of such things, they do not need to be recorded on financial statements. Things can get tricky with start-ups, when so much value is so hard to grasp. You can get a handle on applying principles to start-ups with this five-star finance and accounting course for start-ups.
2) Inflation does not apply to accounting. Odd as it may seem, if accountants from a company such as Coca-Cola were comparing statements from 1930 to 1990, they would not take inflation into account. They could ten dollars from 1930, add it to ten dollars from 1990, and the result would be twenty unadjusted U.S. dollars. To put this another way, the U.S. dollar is assumed to have steady purchasing power for the duration of its existence. This rule is necessary for a variety of reasons, but because the value of the dollar fluctuates day-to-day, it makes the impossible task of real-time value much more wieldy.
Similarly, you cannot report multiple currencies on a financial statement. If one economic event is recorded in U.S. dollars, everything else must be recorded in U.S. dollars.
- Full Disclosure Principle
This should almost top our list, because it is both obvious and moral. The Full Disclosure Principle requires businesses to report such information as pertaining to lawsuits and other legal matters, performance history, deals-in-the-works, etc. Aside from being the right thing to do, it informs investors of all the possibilities a company faces. If a company is being sued for all its worth, then an investor is not only going to want to wait to see if the company survives the lawsuit, but whether or not the lawsuit is indicative of company practices. Any and all of such information is presented in the form of footnotes.
- Matching Principle
In its simplest form, the matching principle matches expenses to revenues during the same time frame. But it’s trickier than just matching expense statements to revenue statements. For example, if an employee works the last two weeks of the year (Dec. 17 – Dec. 31), but isn’t paid until some time in January, the expense needs to be reported in December and the unpaid amount is recorded as a liability. The same is true of delayed commissions, bonuses, sales, insurance premiums, supplies, etc. So if you’re a small business and you aren’t sure, better to double check your numbers with this small biz doers guide to accounting.
There is a vague similarity between the Matching Principle and the Monetary Unit Assumption. Just as you cannot quantify something such as an executive’s brain power and record that on financial statements, neither can you quantify the cost/revenue distribution of things like advertising campaigns and properly “match” it to a respective time frame. In such instances, the accountant can only record the expense (in the executive’s case, his or her salary; in the ad’s case, how much it cost to implement but not how much business it generated).
- Accrual Basis Accounting
Accrual Basis Accounting is what we discussed in the matching principle. It refers to the actual financial events as they happen as opposed to when the cash actually changes hands (which would be Cash Basis Accounting). By practicing accrual basis accounting, accountants track revenue when it is earned rather than when it is received. Even small businesses can start practicing accrual basis accounting by learning to operate accounting software, such as this training guide to learn QuickBooks Pro 2014.
Cash basis accounting records revenues only when the company actually receives the money, and similarly only records expenses when the money is deducted (or equivalent). This is not common practice.
- Revenue Recognition Principle
This might start sounding repetitious, but I will try to further elucidate how this principle, the matching principle and the accrual basis accounting procedures relate.
The Revenue Recognition Principle recognizes revenue when it is earned, but more specifically, when the work that is being paid for is completed, or when the service that is being paid for has been rendered, or when the product that is being paid for is delivered, etc. etc. etc. This principle is kind of like an addendum to accrual basis accounting. Let’s look at an example that should help clarify things:
Imagine a deal is made in August where one company is selling another company 500 units of product. Let’s say the deal is made in August, the products don’t arrive until October, and payment isn’t received until November. When does the company that is selling record the financial event? Under the revenue recognition principle, they would record it in October, when the actual products have been delivered. Interestingly, if the product had been paid for in advance (say, in August), but the product isn’t delivered until October, then the event is still recorded in October even though cash changed hands two months previous.
- Principle of Conservatism
The Conservatism Principle comes in to play when there are two possible ways to report a financial event (almost without exception this applies to estimable events). The principle of conservatism says that accountants must record the more conservative estimate, but please understand that this is different from saying that accountants must act conservatively. This introduction to financial accounting class will help give you a better understanding of these practices.
The main reason this principle exists is to make sure that losses are not underestimated. The principle does not apply to gains. The popular example is cars under warranty. Based on historical evidence, say a company’s best selling car has been getting steadily more reliable and therefore fewer and fewer people are bringing their cars in under warranty. This means less money is going to paying for the labor and parts required to fix cars “for free.” However, just because the return rate has dropped from 10% to 8% to 6% over the past three years does not allow the accountant the right to estimate that this year’s warranty return rate will be 4%. It should, at the very least, be 6%. There’s really no harm in over-estimating losses, because in the end the difference is usually recovered and this is a way of preparing companies for worst-case-scenarios.
Subsequently, it makes sense that gains cannot be over-estimated, as this is only a recipe for financial disaster.
- Principle of Materiality
After detailing all of these rules and guidelines, we come to the Principle of Materiality, which allows accountants to ignore any accounting principle for financial events that are deemed insignificant. This is also a matter of relativity.
Take, for example, a very small company: a local bookstore. The bookstore’s accountant might see an expense for $0.05 for a pencil. Things can start getting ridiculous if the accountant has to match this expense and then create a time period for it. Who cares? Not even the IRS. If the bookstore secretly has several thousand of these purchases, the accountant would be considered incompetent if he or she deemed each individual expense small enough to waive. If the bookstore purchased several thousand dollars of pencils, then that should obviously be recorded and in compliance with accounting principles. If they only had a few of these little five cent purchases, then the accountant is breaking no laws by ignoring other accounting principles. That’s because it is not considered misleading or dishonest if the expense is extremely and relatively small.
I might interrupt myself right here to say that tiny expenditures should not be ignored just because they can be. I’m just saying that it would not be unethical for an accountant to make this decision if he or she decided that it was in compliance with the general code of conduct and the GAAP. Any doubts should be verified and, for do-it-yourself accountants, I recommend educating yourself with this business expenses training course.
This gets interesting for larger businesses, as financial statements report amounts to the nearest dollar, thousand, or even million depending on the size of the company. So accountants for very large companies have to be careful, because this doesn’t just apply to waiving a single pencil purchase. Imagine a company as large as Google purchases a $5000 conference table. This table is expected to last ten years, which means that by following the other principles of accounting, an accountant would record this as a $500 expense every year for the next ten years. But Google has billions of dollars of revenue and expenses ever year, so the accountant is allowed to record the entirety of this relatively small amount in the year in which it is purchased.
If you still think accounting is for you, there’s a lot you can do to increase your market value. The first thing I would suggest is finding out even more; there’s so much great material available on the internet. You can find professional advice concerning every aspect of accounting, from what the job market looks like to a day in the life. If you’re primarily concerned with how to become an accountant, you can check out this spot-on blog article on (you guessed it) the simple steps you can take for a fulfilling career as an accountant. But when it comes to taking a legitimate step forward, you can start earning credentials with this CFA level 1 accounting course.
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