In accountancy, there are a number of basic accounting principles and principles that you must adhere to. The IFRS (International Financial Reporting Standards), among others, is based on these principles. This ensures that not every company can just share their financial data in their own way, which can mislead you as an investor. In this blog post, I will list all accounting principles and principles. I explain why this principle/principle was introduced and what the principle in question entails.
The 6 most important basic principles and principles of accounting are: the consistency principle, the matching principle, the Going Concern principle, the materiality principle, the historical cost principle, and the prudence principle. These principles ensure a fair and comparable way of financial reporting.
I go through the 6 principles and principles in this order:
- Principle of consistency
- Matching principle
- Going Concern principle
- Principle of materiality
- Historical cost principle
- Prudence principle
Principle of consistency
The principle of consistency means that the same techniques and methods of calculating and reporting financial information must be used in the financial statements as in previous and subsequent years. This ensures that the annual accounts of companies are comparable from year to year. In this way, investors, management and other stakeholders can compare the various financial statements with each other, and identify a potential growth or contraction in performance.
It also helps to avoid confusion in the assessment and compilation of the financial statements. Due to the principle of consistency, the processing of annual accounts is more efficient because the accountants ‘know where they stand’, so to speak. The calculations and methods of reporting remain the same, so no time is needed to learn new actions or ways of thinking.
One example is a company’s consistent choice to use the FIFO (First In First Out) method of calculating inventory. It is not desirable to use FIFO one year and LIFO (Last In First Out) the next. This is inconsistent. The IFRS has even banned the LIFO method, because it could cause companies to shift profits (earnings management, is it legal?).
The matching principle
The matching principle describes that the costs and revenues must be ‘matched’ to each other in the period in which these revenues are actually realized. It provides a consistent way of posting costs. The matching principle is an elaboration of the cost-side allocation principle. The matching principle is also related to the ‘Revenue Recognition principle‘. The matching principle is best understood with a number of examples:
Example matching principle 1
Suppose you have an invoice for the energy bill for the coming year and you pay in advance. This means that you have already paid for energy for the entire year, but have not yet received it. The matching principle then says that you can spread the costs of the invoice over the entire year, per month for example.
For example, you don’t book a cost of 1200 in January, but a cost of 100 every month. This means that you only book the cost when you have actually received the energy each month (the transaction has been completed for the month in question). This provides a more realistic picture of a company’s financial condition.
So here you match the costs to the period to which they relate. This is also known as period matching.
Example matching principle 2
Suppose a furniture company receives an order in December 2023 for a sofa of 5000 euros. The furniture makers will start working on the sofa and will be able to deliver the sofa to the customer in February 2024. The customer pays the 5000 euros when the sofa is delivered.
In December 2023, the furniture makers have already bought all the necessities and therefore incurred costs of 1500 euros. You can only book these costs when the income is booked (i.e. when the bank has been delivered). So even if you spent the money in 2023, it doesn’t count as a cost until 2024.
Timeline bookings:
Purchase stock 2023: Debit Inventory (+1500) ——– Credit Cash (-1500)
Delivery of bank and payment received 2024: Debit Cash (+5000) ——- Credit Turnover (+5000)
————————————————————–Debit Cost of Sales (+1500) —— Credit Inventory (-1500)
This means that you are only allowed to book the costs in the period in which the actual turnover is realised. In this way, you match the costs to the turnover. This is also known as product matching.
Example matching principle 3
Another example is with employee bonuses. This example is, in a way, the reverse of the example above. In this case, the obligation has already been met, but payment has not yet been made. Suppose a company has promised a bonus for its employees for achieving a certain goal in the year 2023.
This bonus will be paid in February 2024. In this case, you still book the cost of the bonus in the year 2023, instead of the year 2024, because the bonus applies to achieving the goal in 2023. Even though the company won’t pay this until 2024.
In this example, you match the costs to the revenue (indirect influence on the revenue in 2023, employees provided the labour for the bonus in 2024) in 2024. This is period matching.
Going Concern principle
The going concern principle is the assumption that the company will continue to carry out its activities in the near future. So, that the company does not go bankrupt. This means that the investor can assume that the company will still book current accounts or prepaid costs in the future.
This principle is important and goes hand in hand with the matching principle. For example, the continuity principle is assumed when distributing the prepaid energy bill mentioned in Example 1. Without the continuity principle, this would be impossible, if the company does not assume that it will still exist in a year’s time, it would never (in this case) pay an energy bill in advance.
Materiality principle
Next in the list of important accounting principles is the materiality principle. This principle states that all items that can in any way influence the decision-making of the investor/user must be disclosed in the annual report (also related to the ‘Full Disclosure principle’). This also works the other way around, a company does not have to provide information in the annual report that is not important for the decision-making of users. An auditor does not have to correct minor inaccuracies.
The materiality principle also means that you book some items ‘differently’. For example, a purchase of such a small amount does not have to be depreciated over the entire economic life. You don’t have to write off a new pen, but you can book it directly as a cost. This is despite the fact that assets must ‘always’ be booked as assets.
You also don’t have to put this pen separately on the balance sheet, but you can merge it with multiple office supplies under ‘company assets’.
Please note: this is different for every company. Suppose an 8-year-old child buys this pen. He spends half of his pocket money on this, which makes the purchase of his pen material. As a result, the 8-year-old child would hypothetically mention the pen separately in his balance. This works the same with different sizes of companies.
Moreover, this principle is relevant not only to monetary issues, but also to non-monetary issues. More and more companies are including information about their sustainability in their annual reports, which has even been mandatory for large listed companies in the European Union since 2017.
The rising trend of sustainability has caused many companies to consider their sustainability actions material enough to mention. In addition, there is also an increasing demand from the investors’ side for reports on the sustainability of a company.
The materiality principle therefore ensures that all and only relevant information is mentioned in the annual report.
Historical Cost principle
This principle assumes that all assets on the balance sheet (with the exception of shares, bonds, accounts receivable, cash and prepayments) are recorded at the value for which these assets were purchased. Any depreciation due to, for example, obsolescence of the asset is recorded separately as (in this case) depreciation gets deducted from the historical value. For example, you can see the historical value, the depreciation (depreciation or amortization), and the book value in the financial statement.
The historical cost principle is used in the asset, rather than the current market value, as this is simpler. Determining the market value can be complex and is open to estimates. As a result, this can differ greatly from the actual value. Because everyone uses the historical cost principle, it is easier for the company, and for the investor, to determine the current value of the company’s assets.
IFRS does make an exception for certain assets such as financial instruments and investments, which must be valued according to the fair value principle.
Prudence principle / Conservatism principle
The principle of prudence is one of the basic principles for determining profit. The principle of prudence means that income/profits may only be recorded when they have actually been realised. However, all potential losses/costs should always be recorded, even if there is only a probable chance that these losses or costs will actually occur. So you assume a ‘worst-case scenario’.
This precautionary principle was introduced to not give auditors the opportunity to select a particular biased choice when reporting potential losses, such as a lawsuit. For example, the auditor should always assume the worst potential news, even if the company often prefers not to have it. In this way, net profit would only be undervalued, rather than overvalued. This ensures that there is more chance of positive news regarding net profit than negative news.
Why do we want more chance of positive news? Obviously, It’s nicer, but it also has a studied effect (Skinner, 1994). The share price reacts more strongly to bad news than to good news. Therefore, it is important that all potential bad news is already known, in order to avoid an extreme shock to the share price and its costs.
Summary
In summary, the 6 most important accounting principles or principles consist of: the consistency principle, the matching principle, the Going Concern principle, the materiality principle, the historical cost principle, and the prudence principle. These principles ensure that everyone reports financially in the same way. The principles work together and can even be subdivided into related principles/techniques within accountancy.
IFRS and GAAP (Generally Accepted Accounting Principles) are based on these principles. The method of financial reporting will be centralized, making it clear to everyone how accountants work.
Source research reaction positive/negative news on companies: b1665777.0001.001.pdf (umich.edu)