Accounting principles: the fundamental elements of the world view that governs everything we do in finance and accounting.
Let me walk you through seven core accounting principles:
Conservatism, also known as prudence
Consistency
Full disclosure
Going concern
Matching
Materiality, and
Objectivity
⏱️TIMESTAMPS⏱️
00:00 Accounting principles introduction
00:47 Conservatism principle
01:53 Consistency principle
03:06 Full disclosure principle
04:12 Going concern principle
05:16 Matching principle
05:58 Materiality principle
07:22 Objectivity principle
Using any of these terms knowledgeably in a conversation with finance and accounting people can help to get things done accurately and efficiently.
For each accounting principle, let’s discuss the main idea, the definition of the principle, and an example of how it can be used.
Conservatism, or prudence. The main idea is that it’s better to be safe than sorry. According to the conservatism principle, all anticipated or probable losses are recorded as and when they occur, while anticipated profits are not recorded, but only when the profits are earned. Here’s an example of how to apply this accounting principle. Two recent payments to a supplier have been returned by the bank with a message “account unknown”. Follow-up e-mails and phone calls to the supplier have remained unanswered. What should we do with the money? If we are unable to pay the supplier, should we record this as a “gain”? No, we shouldn’t. At least, not yet. According to the conservatism / prudence principle, we should keep the liability on the books. For example, this supplier could be in receivership, with a bankruptcy lawyer in the process of identifying all assets of the company in liquidation, including what is on their balance sheet accounts receivable towards us.
The consistency accounting principle: achieving a high level of performance which does not vary greatly in quality over time. Transactions and valuation methods are treated the same way from year to year.
Full disclosure. The truth, nothing but the truth, and the whole truth. All financial information regarding business transactions must be given in full.
The going concern principle. The main idea: to be, or not to be? Is this company alive and well? Is its heart beating at a steady pace? Or more formally: going concern means a business is financially stable and can operate with the expectation of indefinite existence… or at least for the foreseeable future. The opposite of going concern would be bankruptcy or foreclosure.
The matching principle. What belongs where, and when?
Revenues and any related expenses (like cost of goods sold) are to be recognized together in the same reporting period, and/or expenses should be recorded during the period in which they are incurred. Here’s an example of this accounting principle. The company pays a supplier upfront for a two-year maintenance contract. Should we record the full invoice as expense in the current period? No, according to the matching principle we expense 1/24th of the contract every month.
And now for my personal favorite: the #accountingprinciple of materiality! I have used this many times over the years in my defense. The main idea of materiality is that we are born to be awesome, not perfect. We try to avoid mistakes, yet they do occasionally happen, and some mistakes are more painful than others. Materiality is the threshold above which missing or incorrect information in financial statements is considered to impact the fair and accurate representation of the financial situation.
Objectivity. Verifiable facts versus subjective opinions or biases. According to this accounting principle, the accounting data should consistently stay accurate, be free of personal opinions, and be supported by independent and unbiased evidence.
Philip de Vroe (The Finance Storyteller) aims to make accounting, finance and investing enjoyable and easier to understand. Learn the business and accounting vocabulary to join the conversation with your CEO at your company. Understand how financial statements work in order to make better investing decisions. Philip delivers #financetraining in various formats: KZread videos, livestreams, classroom sessions, and webinars. Connect with me through Linked In!
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