There are six main accounting principles or concepts that determine the way that the accounts are prepared. The first four are incorporated into SSAP 2 (which looks at account- ing policies) and the last two are reflected in many other accounting standards:
● matching/accruals
● prudence
● consistency
● going concern
● substance over form
● materiality.
It is important to understand these principles if you want to understand the accounts.
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The matching/accruals principle
This matches costs to revenues and brings them into the profit and loss account in the period to which they relate. This means that the profit and loss account does not necessarily reflect the cash that has come in and gone out of the business. The sales are the sales that have been legally made in the period and the costs are those that relate to these sales.
2 The accounting principles
Most accounts are prepared using historical cost, with the profit and loss account based on the value of the revenues and the costs that relate to the sales that have been made in the period, and the assets shown on the balance sheet at the lower of cost or net realisable value. Many UK companies do not use strict historical cost, as they revalue properties. As most accounts are not adjusted for inflation, an analyst should adjust historical-cost prof- its to get some idea of the real underlying profit growth in the company.
Current-cost accounting is an alternative approach that uses year-end costs, and attempts to take account of the inflation that the business has experienced during the year. The reported profits are reduced by the effect of inflation, and asset values are increased. This approach tends only to be used in the regulatory accounts of utilities, and is not allowed for tax purposes.
SUMMARY
The fact that we have to consider the costs that relate to the sales in the period means that we make judgements about what those costs are. We shall consider these judgements later in Chapter 13. They are important as they give companies the opportunity to engage in cre- ative accounting.
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The prudence principle
This is the most important principle. All others are subordinate to it. Prudence means you must take into the profit and loss account any probable losses, but you cannot take poten- tial gains. Revenues and profit cannot be anticipated, but companies must make provisions for items such as possible bad debts. Companies also cannot include any increases in their asset values in the profit and loss account, as they have yet to be realised.
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The consistency principle
Items should be accounted for in a consistent manner within a period and from one period to the next. This ensures the comparability of accounts.
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The going-concern principle
This assumes that the business will continue in existence for the foreseeable future. There- fore, the accounts are based on the assumption that there is neither the intention, nor the need, to reduce the scale of the company’s operations or go into liquidation.
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Substance over form
This tries to ensure that accounts reflect the commercial reality rather than the strict letter of the law. If a company has all the risks and reward associated with owning something, it should be included in the accounts, regardless of the legal position. The way that long-term leases (finance leases) are treated in the accounts is a good example of this. Finance leasing is just another form of borrowing, which can be particularly attractive to companies with tax losses. The company leasing the assets has all the benefits and risks that are associated with owning the assets. So although the leasing company legally owns the assets, they are shown in the company’s accounts as fixed assets and depreciated in the usual way. The amount owed to the leasing company, over the life of the lease, is included in creditors.
FRS 5 (Reporting the Substance of Transactions) is based on the principle of substance over form as it requires that the accounts should reflect commercial reality rather than the strict legal form.
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Materiality
Accounts do not include items that are considered to be immaterial, but it is not possible to give a precise definition of what is and what is not material. In some situations an error of less than 5 per cent would be considered satisfactory, but in another situation any error would be unacceptable. For example, in a business with a multimillion pound turnover, a
£10 000 error in the materials cost is unlikely to be considered material, but a £10 000 error in the chairman’s salary, which is subject to specific disclosure requirements, would be regarded as material.
Accountants regard an item as material if there is a statutory requirement to disclose it
accurately, or knowing about that item would influence your view about the company.
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Recent developments
In November 1995 the ASB published The Statement of Principles for Financial Reporting. This suggested that other principles should be included in the accounts. Two controversial addi- tions have been suggested:
Financial adaptability
The company should be able to respond to changed circumstances and have both the flexi- bility and ability to manage change.
Comparability
Users of financial statements should be able to compare companies; both over time, and within a sector. This could have important implications for company accounts, as to make accounts truly comparable it would be necessary to:
● adjust for inflation to make the numbers comparable over time;
● have the same accounting policies, both over time and within a sector;
● finance the assets in the same way, or adjust the numbers to reflect the differences in financing.
INTERNATIONAL DIFFERENCES
Whilst all countries have the same set of broad accounting principles there are many differ- ences both in emphasis and interpretation. Accounting formats and practices vary widely across the world. These differences are inevitable and are likely to continue for the foresee- able future as the accounting practices and formats are shaped by a number of factors which include:
The legal system
Legal systems can be broadly categorised into two major groups: the Roman legal system and a system of common law. The two systems have generated different levels of government intervention. Roman law usually involves extensive governmental prescription, whereas common law survives on limited government intervention. It is inevitable that these differ- ent legal frameworks will lead to the development of different accounting systems.
Countries adopting Roman law have a strong legal framework, with accounting rules 2 The accounting principles
The accounting principles ensure that the accounts reflect an accountants’ view of reality:
● Profitable businesses can go into liquidation – cash transactions are not necessarily reflected in the current period’s profit and loss account.
● Companies are required to make judgements in arriving at the costs that relate to the sales.
● The book value of a company is unlikely to be realised if there is a liquidation.
● The accounts are not totally accurate; they are subject to approximations and may not reflect the legal position.
SUMMARY
enshrined in law, accounting plans, or commercial codes. Whereas countries adopting case law have the principles and an overview in law, but the details are found in a separate set of accounting rules. Highly litigious societies, like the USA, have highly detailed rules that strive to be clear and unambiguous.
Corporate ownership
In some countries the ownership of most companies is still in the hands of the board of directors, whereas in others ownership is separated from the management of the company.
Where the ownership is separated, there is an increased demand for financial reports and external audit.
Thus, both the quality and the quantity of accounting information will inevitably vary from one country to another with disclosure increasing as the ownership of the company becomes separated from its management.
The taxation system
The taxation rules will influence many day to day financial decisions such as provisioning and the valuation of assets. Some tax systems require the figures in the financial accounts to be the same as those shown in the tax accounts. This means that the accounting numbers will be largely determined by the tax rules. Whereas other countries are bedevilled with the problems of accounting for deferred tax, as the tax rules are substantially different from the accounting rules. In these countries, two sets of accounts will be prepared. The ones report- ing performance to the shareholders, and those complying with the tax rules.
Political and historical factors
These have played a large part in a country’s accounting practices. For example:
● Commonwealth countries have a legacy of UK accounting practices, prior to the 1981 Companies Act.
● French accounting has been strongly influenced by the German Occupation, with the Plan Comptablelargely reflecting the ideas proposed by Professor Eugen Schmalenbach and adapted by the Vichy government in 1942. This has been subsequently modified but still clearly reflects the original proposals.
● Japanese accounting is a hybrid that has been influenced by both German and American practices.
● Entry into the European Union (EU) has affected the accounting practices of all the mem- ber countries, and will continue to do so for the foreseeable future.
These factors interact to provide us with a wide variety of accounting practices. Despite the attempts at standardisation embodied in the Fourth Directive, the formats of accounts within the EU are still different. The accounting practices are even more varied. This presents analysts with difficulties when making international comparisons – it becomes essential to know the detail of each country’s accounting regulations. This book will discuss the main differences in accounting practices in Canada, France, Germany, the Netherlands, Japan and USA. This will help you to understand the accounts that are prepared in any country.
Despite the pressures for the standardisation of accounting practices and presentation, there are still numerous differences. Although the differences will diminish over time, they are unlikely to disappear in the foreseeable future, as they arise from differences in the legal and taxation systems and from political and historical factors.
SUMMARY
Accounting principles These are the underlying principles that affect the way that the accounts are prepared. There are six main principles: matching, prudence, consistency, going concern, sub- stance over form, and materiality.
Accounting Standards Board (ASB) The UK accounting standard-setting body.
Accounting Standards Committee (ASC) The old UK accounting standard-setting body, replaced in 1990 by the ASB.
Cost of sales adjustment An adjustment made in current-cost accounts to reflect the additional costs that would have been incurred had costs been based on year-end costs.
Current-cost accounting A basis for accounting when values are based on year-end costs.
Depreciation adjustment An adjustment made in current-cost accounts to reflect the additional depreciation charge that would have been made if depreciation had been based on the cost of buying fixed assets at the year end.
Financial Reporting Council (FRC) This is the body that has determined the general policies for the UK accounting standard-setting regime since 1990.
Financial Reporting Exposure Draft (FRED) A draft UK accounting rule.
Financial Reporting Review Panel The enforcement arm of the UK standard-setting regime.
Financial Reporting Standard (FRS) A UK accounting rule issued after 1990.
Gearing adjustment The reduction made to the other current-cost adjustments to reflect the bene- fit of partially financing the business with borrowings.
Historical-cost accounting A basis for accounting where values are based on the historical costs paid.
This is the commonest basis for preparing accounts.
International Accounting Standard (IAS) An international accounting rule.
International Accounting Standards Committee (IASC) The international accounting standards-setting body.
Monetary working-capital adjustment An adjustment made in current-cost accounts to reflect the additional investment in trade credit.
Statement of Recommended Practice (SORP) A non-mandatory UK guideline for accounting practice in specific industries.
Urgent Issues Task Force (UITF) Part of the ASB that develops a consensus interpretation of contro- versial areas of the existing UK accounting rules.
2 Accounting practice
JARGON