Accounting Principles (Word Scrambles with Coaching)

Accounting principles are the general guidelines that companies must follow when reporting their financial results. Accounting principles range from basic, underlying concepts to detailed, complex rules.

Example: Basic principles include the cost principle, full disclosure, going concern, economic entity, revenue recognition, and more.

The monetary unit assumption means that all financial transactions are reported in a currency.

Example: U.S. companies report its transactions in U.S. dollars.

The matching principle or expense recognition principle requires that expenses be recorded in the same accounting period as the related revenues. If this cause-and-effect relationship is absent, costs are expensed when they are used up, or when the future benefit cannot be determined. This ensures proper matching of costs and revenues on the income statement.

Example: Wages paid to employees in January for work done in December must be recorded as a December expense to properly match the cost to the December sales revenue or with the period when they were incurred.

The historical cost principle states that acquired assets and incurred liabilities must be recorded at their actual cost when the transaction occurred, not at their replacement cost.

Example: Land purchased five years ago for $10,000 is still recorded at the historical cost of $10,000 on the balance sheet, even if its replacement cost is $25,000.

Industry practices may impact the way certain transactions are accounted for. The industry practices often occur in businesses which are regulated by the government.

Example: Public utilities will have some unique accounting and financial reporting practices since its rates are regulated by government agencies.

The materiality concept allows for some accounting principles to be overlooked when an amount is insignificant. One critreria for determining if an amount is insignificant or immaterial is if the amount would not change an investor’s decision.

Example: A large corporation’s financial statement will likely report amounts to the nearest million dollars. Often, plant assets with a cost of less than $1,000 are expensed immediately when purchased instead of depreciating them over several years.

The economic entity assumption requires that the transactions of a business be kept separate from the personal transactions of its owners or other businesses. This provides a distinct reporting entity for accounting purposes.

Example: An owner’s personal expenses must not be mixed with the expenses of the business on the company’s income statement. The financial statements for several corporations under the control of one owner will be consolidated into one set of financial statements.

The conservatism principle advises accountants to err on the side of caution and not record income or assets when uncertainty exists. When there is doubt on how to report a transaction, the accountant should choose the one that results in lower asset values and/or lower income.

Example: Probable losses from lawsuits should be reported immediately, but potential gains are not reported until actually realized.

The full disclosure principle requires that financial statements (which includes the notes to the financial statements) include all relevant information that would impact a reader’s understanding and financial decisions.

Example: Pending lawsuits against the company, lease commitments, and changes in accounting methods must all be disclosed in the footnotes, when they are not reported directly in the financial statements.

The periodicity assumption requires companies to report financial results at regular time intervals.

Example: Companies often report financial statements monthly, quarterly and annually to give regular updates to stakeholders, rather than just once a year. Corporations with common stock that is publically traded are required to publish annual and quarterly financial statements.

The cost principle requires that acquired assets be recorded at their cash or cash-equivalent amount paid at the time of the transaction. This provides an objective, verifiable value.

Example: A building purchased for $500,000 cash plus a promissory note payable for $300,000 (with interest at the current market rate) is recorded at the cost of $800,000.

The matching principle aims to match expenses with the revenues they helped generate in the same accounting period. This provides a more accurate picture of a company’s profitability each period.

Example: Sales commissions expense should be recorded in the same period as the related sales revenue. This is the case even if the commission is paid in the accounting period after the sales.

The conservatism principle states that when uncertainty exists, the accountant should select the alternative that will result in lower income and lower asset values. Losses and liabilities should be recorded immediately if they are probable.

Example: Inventory should be written down from its cost to its lower net realizable value. However, inventory should not be written up to an amount greater than cost.

The materiality concept allows strict accounting rules to be ignored for insignificant, immaterial amounts that would not impact an investor’s decision.

Example: Many manufacturers will expense small tools immediately instead of depreciating them over many years.

The Financial Accounting Standards Board (FASB) is the private U.S. organization that sets the accounting standards in the United States (The standards are known as U.S. GAAP).

Example: The FASB may issue a new lease accounting standard requiring most leases to be recorded on the balance sheet as assets and liabilities.

The going concern assumption assumes that a company will remain in business for the foreseeable future. This validates the historical cost principle (as opposed to reporting assets at their higher fair market values.)

Example: Since a company is assumed to be continuing in business, it can report assets at historical cost on the balance sheet rather than liquidation value.

The full disclosure principle requires that a company’s financial statements (including the notes to the financial statements) report all relevant information.

Example: Significant accounting policies like depreciation methods, inventory valuation methods, and revenue recognition practices are described in the first footnote in a company’s financial statements.

The Securities and Exchange Commission (SEC) is the U.S. government agency that regulates U.S. public companies and enforces accounting standards and disclosures for their external financial reporting.

Example: The SEC requires public companies to file quarterly (10-Q) and annual (10-K) financial reports, which include audited annual financial statements.

Under the accrual basis of accounting, revenues are reported when earned, regardless of when cash is received.

Example: Interest earned in December is reported on December’s income statement even if the interest is received in January.

The monetary unit assumption assumes that a country’s currency is stable over time, meaning the purchasing power doesn’t change. This justifies combining dollars from different time periods.

Example: A building purchased 20 years ago for $1,000,000 and a recent addition for $2,000,000 are combined to be $3,000,000 in the accounting reports. This is done even though the purchasing power of today’s dollar is a small fraction of the dollar from 20 years ago.