Accounting Principles

Accounting Principles- Lecture-2

1. Money Measurement Concept

The money measurement concept states that a business should only record an accounting transaction if it can be
expressed in terms of money. This means that the focus of accounting transactions is on quantitative information,
rather than on qualitative information. Thus, a large number of items are never reflected in a company's accounting
records, which means that they never appear in its financial statements. Examples of items that cannot be recorded
as accounting transactions because they cannot be expressed in terms of money include:

 Employee skill level

 Employee working conditions
 Expected resale value of a patent
 Value of an in-house brand
 Product durability
 The quality of customer support or field service
 The efficiency of administrative processes

All of the preceding factors are indirectly reflected in the financial results of a business, because they have an
impact on either revenues, expenses, assets, or liabilities. For example, a high level of customer support will likely
lead to increased customer retention and a higher propensity to buy from the company again, which therefore
impacts revenues. Or, if employee working conditions are poor, this leads to greater employee turnover, which
increases labor-related expenses.

The key flaw in the money measurement concept is that many factors can lead to long-term changes in the financial
results or financial position of a business (as just noted), but the concept does not allow them to be stated in the
financial statements. The only exception would be a discussion of pertinent items that management includes in the
disclosures that accompany the financial statements. Thus, it is entirely possible that key underlying advantages of a
business are not disclosed, which tends to underrepresent the long-term ability of a business to generate profits. The
reverse is typically not the case, since management is encouraged by the accounting standards to disclose all current
or potential liabilities of a business in the notes accompanying the financial statements. In short, the money
measurement concept can lead to the issuance of financial statements that may not adequately represent the future
upside of a business. However, if this concept were not in place, managers could flagrantly add intangible assets to
the financial statements that have little supportable basis.

2. Accounting period
 This concept helps in estimating the profit or loss and financial position of a business for a particular
 period. If there are different accounting periods then various problems can arise like in the calculation of
profits, comparability of various incomes & expenses etc. Thus, to study the results of a business, the life of
a business is divided into short periods of equal length. Each such period is known as accounting period.
 While true profit or loss of a business can only be determined when the business finally closes down, it
would be unwise to wait for that. Accounting information is needed by all concerned on a regular basis and
should, therefore, be prepared on an ongoing basis. For the purpose of having a reliable and comparable set
of financial statements, the performance and position of a business is measured at the end of
predetermined periods called accounting periods.
 Generally, an accounting period is one year. Hence, an income statement shows the financial performance
over one year while a balance sheet shows the financial position at the end of a year. This year may not
necessarily be a calendar year. It may run from January to December, or from July of one year to June of the
next, or from October to September.
 The fact that financial statements are prepared in relation to an accounting period necessitates certain
adjustments. For example, when a car is bought its cost must be apportioned over the various accounting
 Accounting Principles

periods in which the said will be used. The accounting period principle requires that such adjustments be
judicially made and accounting record of them made accordingly.

3. Full Disclosure Principle

The full disclosure principle states that all information should be included in an entity's financial statements that
would affect a reader's understanding of those statements. The interpretation of this principle is highly judgmental,
since the amount of information that can be provided is potentially massive. To reduce the amount of disclosure, it is
customary to only disclose information about events that are likely to have a material impact on the entity's financial
position or financial results.

This disclosure may include items that cannot yet be precisely quantified, such as the presence of a dispute with a
government entity over a tax position, or the outcome of an existing lawsuit. Full disclosure also means that you
should always report existing accounting policies, as well as any changes to those policies (such as changing an asset
valuation method) from the policies stated in the financials for a prior period.

Several examples of full disclosure involve the following:

 The nature and justification of a change in accounting principle

 The nature of a non-monetary transaction
 The nature of a relationship with a related party with which the business has significant transaction volume
 The amount of encumbered assets
 The amount of material losses caused by the lower of cost or market rule
 A description of any asset retirement obligations
 The facts and circumstances causing goodwill impairment

You can include this information in a variety of places in the financial statements, such as within the line item
descriptions in the income statement or balance sheet, or in the accompanying disclosures.

The full disclosure concept is not usually followed for internally-generated financial statements, where management
may only want to read the "bare bones" financial statements.

4. Materiality Principle

Materiality is the threshold above which missing or incorrect information in financial statements is considered to
have an impact on the decision making of users. Materiality is sometimes construed in terms of net impact on
reported profits, or the percentage or dollar change in a specific line item in the financial statements. Examples of
materiality are as follows:

The materiality concept or principle is an accounting rule that dictates any transactions or items that significantly
impact the financial statements should be accounted for using GAAP exclusively. In other words, if a transaction or
event happened during the year that would affect how an investor would view the company, it must be accounted
for using GAAP on the financial statements.

Transactions or events that are deemed to be not material can be ignored because they won’t affect how investors
and creditors view the financial statements to make their decisions. Non-material transactions are usually small or
have very little impact on the overall company bottom line.

It might be helpful to look at a few examples.

Example

Assume Bill’s Dry Cleaning service has annual revenues of $40,000. He decides to upgrade his equipment during the
year and replaces one of his dryers for $15,000. This is a significant event in the company’s year because investors
and creditors will definitely want to know about a purchase that equals over 30 percent of annual revenues. This
 Accounting Principles

asset should be capitalized and placed on the balance sheet. Based on the preceding examples, it should be clear
that sometimes even quite a small change in financial information can be considered material, as well as a simple
omission of information.

After a year of having the new dryer, Bill had a belt go out on it. It cost him $250 to have the machine repaired. This
is not a significant event. It doesn’t really matter how Bill records this transaction. He can expense it in the repairs
and maintenance account, or he can capitalize it and add it to the asset. It is not material. Either way investors or
creditors’ opinions of the financial statements and health of the company will not change no matter how he records
this transaction.

In short, the materiality concept is concerned about events that are significant in nature and affect how end users
view the financial statements.

5. Prudence or Conservatism Principle

The idea of conservatism suggests that you, as a business, should anticipate and record future losses rather than
future gains. The principle of conservatism in accounting gives guidance when recording cases of uncertainty or
estimates. In other words, you should always lean towards the most conservative side of any transaction.

In situations where uncertainty exists and there is doubt between two reasonable alternatives for recording an item,
according to the conservatism principle your accountant should always choose the “less favourable” outcome. This
could mean minimising profits by recording estimated expenses or losses, and not recording the estimated gains or
revenues.

 If there is uncertainty about a loss or potential loss - then you should record it.
 If there is uncertainty about a gain or potential gain - then you should not record it.
 And of course, if there is certainty about a gain - then you should record it.

Here is an example to show when the conservatism principle is used, and what situations it is relevant for:
A cosmetic company Beauty Pacific, Inc. is in the process of a patent lawsuit against another cosmetic company Pure
Pacific, Inc.

Beauty Pacific, Inc anticipate winning the patent claims as well as a large settlement.
Beauty Pacific, Inc. cannot report the gains in their financial statements as long as this gain is still uncertain. By
recording the large settlement win, their financial statements could mislead their users, so it should not be recorded
until it is certain.
If Beauty Pacific, Inc. anticipate losing the patent claims, and might also have to pay out a large settlement, then
they should record this loss in the notes of the financial statement. Whether they end up winning or losing the
lawsuit, Beauty Pacific, Inc. should take the most conservative approach. Their financial statement users should be
made aware of any potential large losses that the company might experience in the future.

This is also known as “playing it safe”, or taking the least optimistic approach to a situation, assuming that losses will
be incurred and therefore adjusting the financial statements accordingly. The purpose of this is to ensure that a
business’s financial statements are reliable.

Another way of looking at the conservatism principle is that losses or expenses are recorded as soon as they are
incurred, whereas profits or gains are recorded only when they have been received.
6. Historical Cost Concept

Historical cost is the original cost of an asset, as recorded in an entity's accounting records. Many of the
transactions recorded in an organization's accounting records are stated at their historical cost. This concept is
clarified by the cost principle, which states that you should only record an asset, liability, or equity investment at its
original acquisition cost.
 Accounting Principles

A historical cost can be easily proven by accessing the source purchase or trade documents. However, historical cost
has the disadvantage of not necessarily representing the actual fair value of an asset, which is likely to diverge from
its purchase cost over time. For example, the historical cost of an office building was $10 million when it was
purchased 20 years ago, but its current market value is three times that figure.

According to the accounting standards, historical costs require some adjustment as time passes. Depreciation
expense is recorded for longer-term assets, thereby reducing their recorded value over their estimated useful lives.

Historical cost differs from a variety of other costs that can be assigned to an asset, such as its replacement cost
(what you would pay to purchase the same asset now) or its inflation-adjusted cost (the original purchase price with
cumulative upward adjustments for inflation since the purchase date).

Historical cost is still a central concept for recording assets, though fair value is replacing it for some types of assets,
such as marketable investments. The ongoing replacement of historical cost by a measure of fair value is based on
the argument that historical cost presents an excessively conservative picture of an organization.

7. Matching Concept

The matching principle simply states that related revenues and expenses should be matched in the same period. So,
an expense should be recorded in the same period as the corresponding revenue. The matching principle requires
that revenues and any related expenses be recognized together in the same reporting period. Thus, if there is a
cause-and-effect relationship between revenue and certain expenses, then record them at the same time. If there is
no such relationship, then charge the cost to expense at once. This is one of the most essential concepts in accrual
basis accounting, since it mandates that the entire effect of a transaction be recorded within the same reporting
period.

Here are several examples of the matching principle:

Commission. A salesman earns a 5% commission on sales shipped and recorded in January. The commission of
$5,000 is paid in February. You should record the commission expense in January.

Employee bonuses. Under a bonus plan, an employee earns a $50,000 bonus based on measurable aspects of her
performance within a year. The bonus is paid in the following year. You should record the bonus expense within the
year when the employee earned it.

Wages. The pay period for hourly employees ends on March 28, but employees continue to earn wages through
March 31, which are paid to them on April 4. The employer should record an expense in March for those wages.

The matching principle is an accounting principle that requires expenses to be reported in the same period as the
revenues resulting from those expenses. In other words, the matching principle recognizes that revenues and
expenses are related. Businesses must incur costs in order to generate revenues.

8. Revenue Recognition Concept

The revenue recognition principle is a cornerstone of accrual accounting together with the matching principle. They
both determine the accounting period in which revenues and expenses are recognized. According to the principle,
revenues are recognized when they are realized or realizable, and are earned (usually when goods are transferred or
services rendered), no matter when cash is received. In cash accounting – in contrast – revenues are recognized
when cash is received no matter when goods or services are sold.

Cash can be received in an earlier or later period than obligations are met (when goods or services are delivered) and
related revenues are recognized that results in the following two types of accounts:
 Accounting Principles

Accrued revenue: Revenue is recognized before cash is received.

Deferred revenue: Revenue is recognized after cash is received.

Revenue realized during an accounting period is included in the income.

9. Verifiable Objective Concept

The Verifiable Objective Concept holds that accounting should be free from personal bias. Measurements that are
based on verifiable evidences are regarded as objectives. It means all accounting transactions should be evidenced
and supported by business documents.

These supporting documents are:

 Cash Memo
 Invoices
 Sales Bills, etc.

These supporting documents provide the basis for accounting and audit.

10. Dual aspect or Duality principle

The dual aspect concept of accounting relates to the idea of double entry bookkeeping. Every transaction affects the
business in at least two aspects. These two aspects are equal and opposite in nature.

To ensure a comprehensive and complete record, it is necessary to make two entries to record each transaction. This
concept is based on the assumption that business never truly owns anything. Anything that it has (namely assets), it
owes it either to outsiders (i.e., liabilities) or to the owner who is also a separate person (i.e., capital). Hence
whenever a business gets anything, it must record both facts – an increase in asset and an increase in liability or
capital.

The accounting equation is considered to be the foundation of the double-entry accounting system. The accounting
equation shows on a company's balance sheet whereby the total of all the company's assets equals the sum of the
company's liabilities and shareholders' equity.

Accounting Equation Formula