Accrual Concept

Accrual concept is the most fundamental principle of accounting which requires recording
revenues when they are earned and not when they are received in cash, and recording
expenses when they are incurred and not when they are paid.

GAAP allows preparation of financial statements on accrual basis only (and not on cash
basis). This is because under accrual concept revenues and expenses are recorded in the
period to which they relate and not when they are received or paid. Application of accrual
concept results in accurate reporting of net income, assets, liabilities and retained earnings
which improves analysis of the companys financial performance and financial position over
different periods.

At the end of each reporting period, companies pass adjusting journal entries to record any
accruals, for example accrual of utilities expense, interest expense, accrual of wages and
salaries, adjustment of prepayments, etc.

Going Concern Concept

Going concern concept is a simple but very important financial accounting principle which
stipulates the basis on which financial statements are prepared depending on the likelihood of
the company continuing its normal course of business.

General purpose financial statements are prepared assuming that the company can and will
continue its business in the foreseeable future. If the company is not expected to continue
operations i.e. it is required (or reasonably expected) to wind up, its financial statements are
prepared using break-up basis. Foreseeable future normally means at least one year.

The assumption that a business is expected to continue in future affects the timing, nature and
amount on which accounting transactions are recorded. For example, one criteria for
classification of assets and liabilities into current and non-current is whether they are
realized/settled within normal course of business. In a non-going concern basis, income,
expenses, assets, liabilities and equity are recorded at values that reflect the winding up of
business, i.e. assets are recognized at values they are expected to fetch if sold right away, etc.

Management is required to assess at the date of financial statements whether a business is a

going concern. Some accounting frameworks require management to disclose their
assessment of going concern. Indicators that jeopardize the going concern status of a business
include: (a) situation where liabilities exceed assets, (b) default of a loan(s), (c) tax penalties,
heavy fines, etc., (d) very adverse regulations, (e) negative cash flows, (f) extremely adverse
legal claims, etc.

The auditors of the company are required to analyze the going concern status of a business.
Going concern concept is closely linked with business entity concept, materiality concept and
historical cost concept. For example, in assessing going concern, a business is looked at in
isolation of its owners, etc. (in line with entity concept); and only material reasons affect the
likelihood of continuing operations (in line with materiality concept), etc.

Business Entity Concept

In accounting we treat a business or an organization and its owners as two separately

identifiable parties. This concept is called business entity concept. It means that personal
transactions of owners are treated separately from those of the business.

Businesses are organized either as a proprietorship, a partnership or a company. They differ

on the level of control the ultimate owners exercise on the business, but in all forms the
personal transactions of the owners are not mixed up with the transactions and accounts of
the business.

Monetary Unit Assumption

In accounting we can communicate only those business transactions and other events which
can be expressed in monetary units. This is called monetary unit assumption.

There are certain other frameworks for reporting business performance such as triple bottom
line which focuses on "people, planet profit" the three pillars; corporate social responsibility
reporting, etc. Accounting focuses on the financial aspects of the business and that too for
matters which can be expressed in terms of currencies.

One aspect of the monetary unit assumption is that currencies lose their purchasing power
over time due to inflation, but in accounting we assume that the currency units are stable in
value. This is alternatively called stable dollar assumption.

However, there are exceptional circumstances called hyperinflation when the accounting
standards require adjustment of prior period figures.

Home > Financial Accounting > Principles > Time Period

Time Period Principle

Although businesses intend to continue in long-term, it is always helpful to account for their
performance and position based on certain time periods because it provides timely feedback
and helps in making timely decisions.

Under time period assumption, we prepare financial statements quarterly, half-yearly or

annually. The income statement provides us an insight into the performance of the company
for a period of time. The balance sheet (also known as the statement of financial position)
provides us a snapshot of the business' financial position (assets, liabilities and equity) at the
end of the time period. The statement of cash flows and the statement of changes in equity
provide detail of how the company's financial position changed during the time period.

One implication of the time period assumption is that we have to make estimates and
judgments at the end of the time period to correctly decide which events need to be reported
in the current time period and which ones in the next.

Revenue recognition and matching principles are relevant to time period assumption.
Revenue recognition principle provides guidance on when to record revenue while matching
concept tells us how to reach an accurate net income figure by creating 1-1 correspondence
between revenues and expenses.

Revenue Recognition Principle

Revenue recognition principle tells that revenue is to be recognized only when the rewards
and benefits associated with the items sold or service provided is transferred, where the
amount can be estimated reliability and when the amount is recoverable.

Accrual basis of accounting is used in recognizing revenue which tells that revenue is to be
recognized ignoring when the cash inflows occur.

Examples

1. A telecommunication company sells talk time through scratch cards. No

revenue is recognized when the scratch card is sold, but it is recognized
when the subscriber makes a call and consumes the talk time.

2. A monthly magazine receives 1,000 subscriptions of $240 to be paid at the

beginning of the year. Each month it recognizes revenue worth $20,000
[($240 12) 1,000].

3. A media company recognizes revenue when the ads are aired even if the
payment is not received or where payment is received in advance.

In case where payment is received before the event triggering recognition of revenue
happens, the debit goes to cash and credit to unearned revenue. In case the event triggering
revenue recognition occurs before payment is received, the debit goes to accounts receivable
and credit to revenue.

Revenue is the item which is the easiest to misstate, hence more stringent rules and guidance
is required in this area. IAS 18 Revenue deals with recognition of revenue.

Full Disclosure Principle

Full disclosure principle is relevant to materiality concept. It requires that all material
information has to be disclosed in the financial statements either on the face of the financial
statements or in the notes to the financial statements.
Examples

1. Accounting policies need to be disclosed because they help understand

the basis of accounting.

2. Details of contingent liabilities, contingent assets, legal proceedings, etc.

are also relevant to the decision making of users and hence need to be
disclosed.

3. Significant events occurring after the date of the financial statements but
before the issue of financial statements (i.e. events after the balance
sheet date) need to be disclosed.

4. Details of property, plant and equipment cannot be presented on the face

of the balance sheet, but a detailed schedule outlining movement in cost
and accumulated depreciation should be presented in the notes.

5. Tax rate is expected to change in near future. This information needs to be

disclosed.

6. The draft for a new legislation is presented in the legislative of the country
in which the company operates. If passed, the law would subject the
company to significant cleanup costs. The company has to disclose the
information in the notes.

7. The company sold one of its subsidiaries to the spouse of one of its
directors. The information is material and needs disclosure.

Historical Cost Concept

Accounting is concerned with past events and it requires consistency and comparability that
is why it requires the accounting transactions to be recorded at their historical costs. This is
called historical cost concept.

Historical cost is the value of a resource given up or a liability incurred to acquire an

asset/service at the time when the resource was given up or the liability incurred.

In subsequent periods when there is appreciation is value, the value is not recognized as an
increase in assets value except where allowed or required by accounting standards.

Examples

1. 100 units of an item were purchased one month back for $10 per unit. The
price today is $11 per unit. The inventory shall appear on balance sheet at
$1,000 and not at $1,100.

2. The company built its ERP in 2008 at a cost of $40 million. In 2010 it is
estimated that the present value of the future benefits attributable to the
ERP is $1 billion. The ERP shall stand on balance sheet at its historical
costs less accumulated depreciation.
The concept of historical cost is important because market values change so often that
allowing reporting of assets and liabilities at current values would distort the whole fabric of
accounting, impair comparability and makes accounting information unreliable.

Matching Principle

Matching principle is one of the most fundamental principles in accounting. It requires that a
company must record expenses in the period in which the related revenues are earned.
Matching concept is at the heart of accrual basis of accounting.

It is important to match expenses with revenues because net income, i.e. the net amount
earned in a period, is calculated by subtracting expenses from revenues. If expenses are not
properly recorded in the correct period, the net income for a particular period may be either
understated or overstated and so are the related balance sheet balances.

Matching principle is what differentiates the accrual basis of accounting from cash basis of
accounting. It requires recognition of revenues and expenses regardless of the actual receipt
of cash from revenues and actual payment of cash for expenses.

In order to apply the matching principle, management of a company is required to apply

judgment to estimate the timing and amount of revenues and expenses. Prudence concept,
which is a related accounting principle, requires companies not to overstate revenues,
understate expenses, overstate assets and/or understate liabilities.

In line with the materiality concept, a company is not required to trace every dollar of
expense to every dollar of revenue because the cost of doing so would exceed the potential
benefit.

Examples
Example 1: When a company makes sales, majority of it are against credit, i.e. where the
customer receives delivery of goods or services but promises to make the payment, say
within 30 days. In accordance with revenue recognition principle, revenue is recognized
when the delivery is made. Now, there is a risk that the customers may not pay the amount
due against those sales, which results in the company writing off the account receivable as
bad debts expense. The possibility of bad debts exists when the sale is made, so expense
should be recognized right at that moment when the sale is made. Recognizing bad debts
expense requires considerable estimation.

Example 2: Company B generates $2,000,000 in revenue in 2010. Total purchases of

inventories were $1,000,000 of which $100,000 remained on hand at the end of 2010. The
cost of sales should be reflected in the income statement at $900,000 [$1,000,000 minus
$100,000]. The companys gross profit for 2010 should be $1,100,000 (=$2,000,000 minus
$900,000). The main point is to subtract only that much expense in a particular period which
is related to the revenues earned in that period. Since $100,000 worth of inventories are to be
sold in next period, they should not be subtracted from revenue for the current period.
Example 3: A hospital pays $20,000 per month to 5 of its doctors. Monthly sales are
$500,000. $100,000 worth of monthly salaries should be matched with $500,000 of revenue
generated.

Relevance and Reliability

Relevance and reliability are two of the four key qualitative characteristics of financial
accounting information. The others being understandability and comparability.

Relevance requires that the financial accounting information should be such that the users
need it and it is expected to affect their decisions.

Reliability requires that the information should be accurate and true and fair.

Relevance and reliability are both critical for the quality of the financial information, but both
are related such that an emphasis on one will hurt the other and vice versa. Hence, we have to
trade-off between them. Accounting information is relevant when it is provided in time, but at
early stages information is uncertain and hence less reliable. But if we wait to gain while the
information gains reliability, its relevance is lost.

Examples

1. After the balance sheet date but before the date of issue a company wants
to dispose of one of its subsidiaries and is in final stages of reaching a deal
but the outcome is still uncertain. If the company waits they are expected
to find more reliable information but that would cost them relevance. The
information would be outdated and no longer very relevant.

2. After the balance sheet date during the time when audit is carried out, it
becomes clear which debts were realized and where were not hence it
improves the reliability of allowance for bad debts estimate but the
information loses its relevance due to too much time being taken.
Timeliness is key to relevance.

Materiality Concept

Financial statements are prepared to help its users in making economic decisions. All such
information which can be reasonably expected to affect decisions of the users of financial
statements is material and this property of information is called materiality. Materiality is a
key concept in accounting because it helps accountants and auditors in deciding which
figures need separate reporting and what is the maximum amount above which errors or
omissions should be avoided at all costs.

Deciding whether a piece of information is material or not requires considerable judgment.

Information can be material either due to size of the amounts involved or due to the nature of
the event.
Example: Materiality due to size
Maldives Plcs total sales for the financial year 2012 amounts to $100 million and its total
assets are $50 million. The companys external auditors have found out that $3 million worth
of sales shouldnt be recognized in financial year 2012 because the risks and rewards inherent
in the sales have not been transferred.

This amount of $3 million is material in the context of total assets of $50 million. The
company should adjust its financial statements.

Examples: Nature of the event

1. EW Casinos Corporation operates in a country which is about to enact a

new legislation which would seriously impair the company's operations in
future. Although there are no figures involved, the disclosure of the
development is required in the financial statements for the period on
account of materiality because the new legislation can potentially end the
revenues and profits earned from the country.

2. The remuneration paid to a companys executives and directors is material

due to qualitative reasons (even it is not material quantitatively). It is
because the investors would like to make sure that the management is not
overcompensating itself.

3. The accounting policies are material and cant be omitted because they
help the users understand how the management arrived at the amounts
presented in the financial statements.

Materiality Estimates
Accounting frameworks and standards have avoided setting any quantitative guidance for
materiality because materiality always depends on the nature of the amount (such as how
reliability it is possible to calculate/estimate the amount) and on other related circumstances.

In practice accountants and auditors need some crude estimate as quantitative threshold of
materiality. They estimate it either as some percentage of a net measure such as 0.5% of net
income or as percentage of some gross measure such as 5% of total assets.

Some accounting and financial reporting standards do provide some quantitative guidance.
For example, accounting standards on segment reporting treat segments with revenue or
assets greater than 10% of total revenue/assets as reportable segments.

Substance Over Form

Substance over form is an accounting principle which recognizes that business transactions
should be accounted in accordance with their (economic) substance instead of their (legal)
form. Economic substance refers to the underlying economic or commercial purpose of a
business transaction apart from its legal or tax considerations. Legal form refers to
interpretation of a business transaction in accordance with the applicable business laws.
While accounting for business transactions and other events, substance over form principle
requires accountants to measure and present the economic impact of an event instead of its
legal form. Substance over form approach is critical for preparation of true and fair financial
statements. It is particularly relevant while accounting for revenues, sale and purchase
agreements, leases etc.

Substance over form principle is recognized by all major financial reporting frameworks,
namely the International Financial Reporting Standards (IFRS) and US GAAP, etc. External
auditors are required to attest that companies recognize all business transactions in
compliance with the substance over form concept.

Example 1
ABC, Inc. is an airline which has obtained 5 jets from DEF, Inc. on lease under following
conditions:

The jets shall be available only to ABC, Inc. for the next 10 years (useful
life is 12 years)

The jets shall be modified to meet specific requirements of ABC, Inc.

ABC, Inc. shall make quarterly payments which when discounted

appropriately equals the cost of the jet plus other related costs

The ownership of the jets shall remain with DEF, Inc. over the life of the
lease and the physical custody of the jets shall be transferred back to DEF,
Inc. at the end of the lease term.

Identify the economic substance of the transaction and demonstrate how it differs from its
legal form.

Solution

In accordance with the terms of the lease agreement, the jets remain in ownership of DEF,
Inc. throughout the lease term so the legal form of the contract/agreement dictates that ABC,
Inc. should not record them as asset on its balance sheet. However, when we analyze the
economic effects of the lease agreement, we see that it has put ABC, Inc. in control of the
economic benefits inherent in the use of jets for major portion of the lease term because it has
full control on the use of the jets. Further, the present value of lease payment is fairly equal to
the fair value of the jets, etc., which means that ABC, Inc. has undertaken a liability equal to
the cost of the jets by entering into the agreement. The transaction is best reflected in the
financial statements by showing the jets as assets and also presenting a corresponding lease
liability.

Example 2
A food-processing company has cash flow problems, so it sells its fleet of delivery trucks to a
bank and gets it back on a lease. The transaction is called sale and leaseback. Although the
legal ownership of the assets has transferred but the underlying economics remains the same
and hence under the substance over form principle the sale and subsequent leaseback are
looked at as one transaction. The company cannot just remove the fleet from its balance sheet
because the legal ownership has changed. It will continue to recognize the fleet as an asset
and shall also record a lease liability that arise out of the associated lease-back.

Example 3
If two companies swap inventories of identical nature, legally the ownership of goods has
changed, but there is no commercial purpose of the transaction because it does not generate
any profit or loss. Substance over form principle disallows recognition of revenue by any of
the companies even if they have entered into valid enforceable contracts.

Home > Financial Accounting > Principles > Comparability

Comparability Principle

Comparability is one of the key qualities which accounting information must possess.
Accounting information is comparable when accounting standards and policies are applied
consistently from one period to another and from one region to another. The characteristic of
comparability of financial statements is important because it allows us to compare a set of
financial statements with those of prior periods and those of other companies.

Examples

1. We can compare 20X2 financial statements of ExxonMobil with its 20X1

financial statements to know whether performance and position improved
or deteriorated.

2. We can compare the ExxonMobil financial statements with that of BP if

both are prepared in accordance with same set of accounting standards,
such as IFRS or US GAAP, etc.

3. When preparing 20X3 financial statements we are required to present with

each of the 20X3 figure the corresponding 20X2 figures. This is done to
add the characteristic of comparability to the financial statements.

Accounting standards are intended to outline the best accounting treatment so that companies
follow them and hence accounting information is understandable, relevant and reliable and
comparable. Consistency means that the accounting policies should be changed only when
there are valid grounds for such a change.

Consistency Concept

The concept of consistency means that accounting methods once adopted must be applied
consistently in future. Also same methods and techniques must be used for similar situations.
It implies that a business must refrain from changing its accounting policy unless on
reasonable grounds. If for any valid reasons the accounting policy is changed, a business
must disclose the nature of change, the reasons for the change and its effects on the items of
financial statements.

Consistency concept is important because of the need for comparability, that is, it enables
investors and other users of financial statements to easily and correctly compare the financial
statements of a company.

Examples

1. Company A has been using declining balance depreciation method for its
IT equipment. According to consistency concept it should continue to use
declining balance depreciation method in respect of its IT equipment in the
following periods. If the company wants to change it to another
depreciation method, say for example the straight line method, it must
provide in its financial report, the reason(s) for the change, the nature of
the change and the effects of the change on items such as accumulated
depreciation.

2. Company B is a retailer dealing in shoes. It used first-in-first-out method of

inventory valuation in respect of shoes at Branch X and weighted average
inventory valuation method in respect of similar shoes at Branch Y. Here,
the auditors must investigate whether there are any valid reasons for the
different treatment of similar inventory located at different locations. If
not, they must direct the company to use any one of the valuation method
uniformly for the whole class of inventory.

Prudence Concept

Accounting transactions and other events are sometimes uncertain but in order to be relevant
we have to report them in time. We have to make estimates requiring judgment to counter the
uncertainty. While making judgment we need to be cautious and prudent. Prudence is a key
accounting principle which makes sure that assets and income are not overstated and
liabilities and expenses are not understated.

Examples

1. Bad debts are probable in many businesses, so they create a special

contra-account to accounts receivable called allowance for bad debts
which brings the accounts receivable balance to the amount which is
expected to be realized and hence prevents overstatement of assets. An
expense called bad debts expense is also booked to stop net income from
being overstated.

2. Some liabilities are contingent upon future occurrence or non-occurrence

of an event such a law suit, etc. We judge the probability of occurrence of
that event and if it is more than 50% we record a liability and
corresponding expense at the most likely amount. Hence, we stop liability
and expense from being understated.
 3. Periodic evaluations of assets are made to make sure their carrying value
does not exceed the benefits expected to be derived from the asset, and if
it does exceed, the impairment of fixed asset is recorded by reducing its
carrying amount.

Understandability Concept

Understandability is one of the four qualitative characteristics of financial accounting

information. The other being relevance, reliability, timeliness, faithful representation,
comparability and materiality. Understandability refers to the quality of financial information
which makes it understandable by people with reasonable background knowledge of business
and economic activities.

Understandability requires the information presented in financial reports to be concise,

complete and clear in presentation. The information should be presented so as to facilitate the
user of the information.

However, understandability never prescribes any complex information to be omitted

altogether due to its underlying difficulty in understanding. It just requires us to disclose the
information systematically instead of presenting it haphazardly.

Examples
Understandability would require the financial statements to be identified by presenting the
name of the financial statement, the name of the entity and the period covered by the
statement.

Understandability also requires the notes to be properly numbered and cross-referred to the
original balance sheet and income statement items. For example the note number of
disclosure on leases should be mentioned in front of the lease payable line item appearing on
the face of a balance sheet.

Financial instruments and derivatives are specialized instruments which require rigorous
understanding of finance to properly understand the underlying economics. In such
complexity we cannot omit the disclosure because it is not easily understandable.