Accounting principles

Accountants have agreed to certain ground rules that are called Assumptions, Principles and Concepts. Some of these may seem obvious to you, but nevertheless need to be written down to ensure that preparers and users of accounts have a clearly defined common foundation and language.

What we measure
We start by drawing certain boundaries, in order to make clear what we will and won’t be measuring in Accounting.

Entity
The organisation must be treated as a separate entity or “person” distinct from its owners, and from any other organisation. Sometimes in real life there may be some blurred edges (for example small owner-managed traders), but for accounting purposes we must be able to make a clean distinction between the organisation, its owners, its customers, partners and suppliers.

Accounting Periods
Financial performance, (for example Profit) can only be measured over a fixed period of time, which we call an accounting period (usually 1 year). The length of these periods should remain the same. At the beginning and end of each accounting period we should prepare a balance sheet and financial performance analyses the changes from one balance sheet to the next. If the period between the balance sheets was indeterminate, then performance would be meaningless - like asking "how far did you walk?" without specifying when the walking took place.

Going Concern Assumption
We assume that the organisation is not about to go bankrupt or stop trading for any other reason. The value of the assets (e.g. stocks, buildings) of an organisation can reduce significantly if the organisation stops trading and has to sell everything in a rush.If we have reason to believe that the organisation will have to stop trading in the near future, then prudence dictates that the going concern assumption cannot apply.

Quantitative
Accountants are boring people, only really interested in bean counting, so they measure only numerical, quantitative matters. We aren’t saying anything about qualitative things such as customer satisfaction, quality of service, or social/environmental impact: these things are important, but outside the scope of financial accounts.

Money Measurement Concept
As well as restricting themselves to numerical things, accountants further make the assumption that everything they need to measure can be converted into money equivalents. For example we convert a computer into an amount of money that approximates to its value. If we can't value it, we can't include it in the accounts. Sometimes there are things that we know are valuable, but have no clue what that value is. For example what is the value of years of research poured into the development of a new drug, or of a well-known brand name? Accountants may be boring, but they can also be quite creative in trying to work out the value of things that don't have an obvious price tag. This happens when they (or the powers above them) are eager to show the value of these intangible assets. Where there is a will, there is a way.

Matching (or Accruals) Concept
A benefit should be matched with the costs incurred in generating it. Income and expenditure related to each other should be shown together in the same accounting period, even if the receipt and payment of the cash actually occur in different periods.This is really really important to grasp, since it takes us away from a simple approach to accounting that measures everything in terms of cash moving in and out of the business. One simple example to illustrate this. Just before the end of the accounting period a hospital pharmacy buys and pays for a large consignment of drugs. None of the pills are dispensed in that year, they are used in the following accounting period. Although the cash payment was in year 1, the accountant insists that an adjustment must be made to treat the payment as if it was made in year 2, to match the year in which the income from the drugs will be received. The matching concept gives a much fairer view of financial performance.

Double entry
Every transaction has two aspects: benefit is received and payment is made. For example if we buy a computer the total value of computers goes up, but the amount of cash goes down. The normal method of accounting in use worldwide recognises this dual aspect.

Historic Cost
The value of any item is changing all the time, with inflation, wearing out (of equipment or vehicles), changing supply and demand (e.g. for second hand vehicles). We can’t keep changing the values of all the assets on our balance sheet (even if we knew what the latest true value was) so to simplify things we usually choose the Historic Acquisition Cost as a reasonable starting point for valuation (i.e. the price we paid for the asset). Sometimes this must be adjusted, and we do take into account the gradual decrease in value of equipment etc, as it grows older through depreciation. In times of high inflation it may be necessary to abandon this concept and adopt another based on current value accounting. This introduces a number of complexities into the financial statements, and most organisations try to avoid this.

Materiality
This is another simplification, without which it would be impossible to prepare or read accounts. Only transactions that are significant in relation to the size of the organisation need to be included. This means that we don’t need to make a bookkeeping entry every time someone takes a pencil from the stationery cupboard. Whether or not something is material may depend on the size of the organisation. A small charity may need to prepare its accounts accurate the nearest Rupee, but a multi-national company will round its figures to Lakhs or even Crores, this level of accuracy will be quite acceptable, and makes the accounts much easier to read.

Realisation Principle
This principle helps us to decide when a transaction should be included in the accounts. For example, we decide to buy a computer and place an order in January. The computer arrives in February, and we finally pay the invoice in March. In which month will we show the transaction? The Realisation principle tells us to include the transaction in the accounts at the point when ownership of the asset passes from one party to another (usually when the goods are received).

Ethical Measurement
It is possible to tell the truth, but in such a way that people get a false impression. This third set of concepts is concerned with producing accounts that people can rely on, and which won’t mislead. In cases where there is doubt, the rule is “safety first”.

Prudence
Means that if we are in doubt over the cost or value of something we should take a pessimistic view, and understate our net asset value and our profits, rather than risk over-stating them. It is better for people who rely on the accounts to have a nice surprise rather than a nasty one. For example if we are waiting for a bill from a contractor who has been working for us, we should include an estimate in the accounts based on the maximum cost we expect to have to pay. We should also include information about the possible effect of contingencies such as outstanding legal action in which the organisation is involved.

Consistency
Means that we should apply the same policies and rules in preparing our accounts every year, not changing them to suit ourselves or the weather. Otherwise the accounts cannot be compared from one year to the next.

Objectivity
Means ensuring that no personal preferences or interests are allowed to affect our judgment. As far as possible the accounts should be based on externally verifiable calculations, not our personal ideas. Two different people preparing the accounts from the same base data should normally come up with the same results.

Relevance
Is similar to Materiality. We should be careful not to swamp people with irrelevant data so that they are unable to “see the wood from the trees”. The financial statements should be helpful summaries, comprising relevant information arranged in a meaningful and clear way. They should include everything that is necessary to understand the position, but not lots of extra unnecessary information.