The Practice of Accounting
There are different committees or standards to give guidelines to accountants on how they should prepare the statements
U.S G.A.A.P (Generally Accepted Accounting Principles)
FASB - Financial Accounting Standards Board
European G.A.A.P
The most relevant principles
Historical cost principle: Requires companies to account and report based on acquisition costs rather than fair market value for most assets and liabilities
Historical principle says that we record the value of an item at the price for which we acquired it.
Eg: If I buy a brand new car for $50,000, the moment I drive that car off a lot, it's not a brand new car anymore, it's a used car and now it has just lost at least 10% of its value, it's not worth more than 45,000 now. So I buy a car and I put that on the books at $50,000.
Revenue Recognition Principle
Companies must record revenue when it is earned
The flow of cash does not have any bearing on the recognition of revenue
This is the essence of accrual basis accounting
Conversely, losses must be recognised when their occurrence becomes probable, whether or not it has actually occured
Eg: When a sale is made, I put that sale on my books, even though I gave my customer 60 day terms or 90 day terms. So I make a sale in December, but I may not be paid until January or February but the sale was made in December. This is accrued accounting.
Matching Principle
Expenses are recognised when the work or the product actually makes its contribution to revenue
Depreciation and Cost of Goods Sold are good examples of application of this principle
Expenses have to be matched with revenue
Full Disclosure Principle
Amount and kinds of information disclosed should be decided based on trade-off analysis as a larger amount of information costs more to prepare and use
Materiality principle
The significance of an item should be considered when it is reported
Consistency Principle
A company must use the same accounting principles and methods from period to period
Inventory valuation: FIFO - First in First Out; LIFO - Last in First Out; Average cost
Conservatism Principle
When choosing between two solutions, the one which has the less favourable outcome is the solution which should be choosen