BACKGROUND: ACCOUNTING

Companies' financial statements have to give a true and fair view (not the true and fair view) of
a company's profit and its assets and liabilities. This implies that there are various ways of doing
accounts, and indeed there are, but companies have to adopt certain principles: in the USA,
Generally Accepted Accounting Principles (GAAP), and in most of the rest of the world,
International Financial Reporting Standards (IFRS), previously known as International
Accounting Standards (IAS).
The time period principle is that accounts are always for the same length of time, usually 12
months. This prevents companies manipulating their accounts by changing the end of the
financial year to disguise bad periods. The consistency principle states that companies have to
use the same methods (e.g. of valuing depreciation and inventory) year after year. This enables
investors and the tax authorities to compare one year's results with another.
The separate entity principle is that a company is a legal person, separate from its owners,
with its own assets and liabilities. This means that stockholders have the privilege of limited
liability, and if the company goes bankrupt, they are only liable for the amount they paid for their
shares.
Accounts are usually prepared on the historical cost principle, which is that all assets are
stated at the value at which they were originally brought into the company. This means
companies do not need to calculate the current value of assets every year, although this can be
misleading in periods of high inflation. The going concern principle is that a company can and
will continue in business and pay its liabilities and creditors. This is why the current value of
assets is irrelevant: they are not for sale.
The matching principle is that revenue or income is recorded in the period it is generated,
along with related costs and expenditure. Examples of this principle are depreciation and
amortization, which are ways of matching the cost of a long-lasting asset over the period
during which it earns revenue. Conservatism or prudence means that you do not recognize
any income unless you are almost certain to receive it, and you record costs as soon as they
are incurred. This means that, if anything, companies should understate rather than overstate
profits.
Consolidation means bringing together the accounts of all a company's subsidiaries into a
single set.This allows stockholders to find out if an apparently profitable company has a non-
profitable subsidiary with huge liabilities.