There are some basic accounting principles that are generally accepted by the accounting profession as being essential for recording and reporting financial information. These are as follows:
Accounting Entity Principle
Financial reports are produced for the business, independent of the owners – the business and its owners are separate entities. This is particularly important for owner-managed businesses where the personal finance of the owner must be separated from the business finances. The problem caused by the entity principle is that complex organizational structures are not always clearly identifiable as an ‘entity’. The treatment by Enron of joint-venture vehicles that were not part of the “Enron group” for financial reporting purposes enabled ‘off-Balance Sheet’ financing that was a cause of that company’s collapse.
Accounting Period Principle
Financial information is produced for a financial year. The period is arbitrary and has no relationship with business cycles. Businesses typically end their financial year at the end of a calendar or national fiscal year. The business cycle is more important than the financial year, which after all is nothing more than the time taken for the Earth to revolve around the Sun. If we consider the early history of accounting, “merchant ships” did not produce monthly accounting reports. They reported to the ship’s owners at the end of the business cycle, when the goods they had traded were all sold and profits could be calculated meaningfully.
Closely related is the matching (or accruals) principle, in which income is recognized when it is earned and expenses when they are incurred, rather than on a cash basis. The accruals method of accounting provides a more meaningful picture of the financial performance of a business from year to year. However, the preparation of accounting reports requires certain assumptions to be made about the recognition of income and expenses. One of the criticisms made of many companies is that they attempt to ‘smooth’ their reported performance to satisfy the expectations of stock market analysts in order to maintain shareholder value. This practice has become known as “earnings management“. This has been particularly difficult in the telecommunication industry, where income that should have been spread over several years has been taken up earlier, or where expenditure has been treated as an asset in order to improve reported profits.
Monetary Measurement Principle
Despite the importance of market, human, technological and environmental factors, accounting records transactions and reports information in financial terms. This provides a limited though important perspective on business performance. The criticism of accounting numbers is that they are lagging indicators of performance. An emphasis on financial numbers tends to overlook important issues of customer satisfaction, product/service quality, innovation and employee morale, which have a major impact on business performance.
Historic Cost Principle
Accounting reports record transactions at their original cost less depreciation, not at market (realizable) value or at current (replacement) cost. The historic cost may be unrelated to market or replacement value. Under this principle, the Balance Sheet does not attempt to represent the value of the business and the owner’s capital is merely a calculated figure rather than a valuation of the business. The Balance Sheet excludes assets that have not been purchased by businesses but have been built up over time, such as customer goodwill, brand names etc. The market-to-book ratio (MBR) is the market value of the business divided by the original capital invested. Major service-based companies such as Microsoft, which have enormous goodwill and intellectual property but a low asset base, have high MBRs because the stock market takes account of information that is not reflected in accounting reports.
Going Concern Principle
The financial statements are prepared on the basis that the business will continue in operation. Many businesses have failed soon after their financial reports have been prepared on a going concern basis, making the asset values in the Balance Sheet impossible to realize. As asset values after the liquidation of a business are unlikely to equal historic cost, the continued operation of a business is an important assumption.
Accounting is a prudent practice, in which the sometimes over-optimistic opinions of non-financial managers are discounted. A conservative approach tends to recognize the downside of events rather than the upside. However, as mentioned above, the pressure on listed companies from analysts to meet stock market expectations of profitability has resulted from time to time in ‘creative’ accounting practices, such as those that led to problems at Enron and WorldCom.
The accounting standards and principles that have been applied in the financial statements are described in the financial reports. It is interesting to know that in the UK, there is a substantial body of principles governing what information is to be disclosed in financial reports, although in the US the disclosure requirements are rule based rather than principle based. As a result, it has been argued that it is easier to find ways to get around rules that are set in explicit terms than principles that are more general. The interpretation of the disclosure rules is important in auditing and led to criminal charges against accounting firm Arthur Andersen in the United States.
The application of accounting standards and principles should be consistent from one year to the next. Where those principles vary, the effect on profits is separately reported under the disclosure principle. However, some businesses have tended to change their rules, even with disclosure, in order to improve their reported performance, explaining the change as a once-only event. These principles are applied in the collection, recording and reporting of financial information. It therefore follows that information used by managers for decision-making is subject to the same principles, and therefore to the same limitations. One of the most important pieces of financial information for line managers is cost, which forms the basis for most of the sub-topic I am going to discusse. The calculation of cost is determined in large part by accounting principles and the requirements of financial reporting. The cost that is calculated under these assumptions may have limited decision usefulness.
Cost Terms and Concepts
Cost can be defined as “a resource sacrificed or foregone to achieve a specific objective”
(Horngren et al., 1999, p. 31).
Accountants define costs in monetary terms, and while we will focus on monetary costs, readers should recognize that there are not only non-financial measures of performance but also human, social and environmental costs. For example: making employees redundant causes family problems (a human cost) and transfers to society the obligation to pay social security benefits (a social cost). Pollution causes long-term environmental costs that are also transferred to society. These are as important as (and perhaps more important than) financial costs, but they are not recorded by accounting systems. The exclusion of human, social and environmental costs is a significant limitation of accounting.
For planning, decision-making and control purposes, cost is typically defined in relation to a cost object, which is anything for which a measurement of costs is required. While the cost object is often an output – a product or service – it may also be a resource (an input to the production process), a process of converting resources into outputs or an area of responsibility (a department or cost centre) within the organization. Examples of inputs are materials, labour, rent, marketing expenses etc. Examples of processes are purchasing, customer order processing, order fulfillment, dispatch etc.
Businesses typically report in relation to line items (the resource inputs) and responsibility centre (departments or cost centre). This means that decisions requiring cost information on business processes and product/service outputs are difficult, because most accounting systems do not provide adequate information about those cost objects.
In a project-based business, published financial reports do not provide cost and revenue information about each project, but instead report information about salaries, rental, office costs etc.
Businesses may adopt a system of management accounting to provide this information for management purposes, but rarely will this second system reconcile with the external financial reports because the management information system may not follow the same accounting principles described earlier in this chapter.
The requirement to produce financial reports based on line items, rather than cost objects, is a second limitation of accounting as a tool of decision-making.
The notion of cost is also problematic because we need to decide how cost is to be defined. If, as Horngren et al. defined it cost is a resource sacrificed or forgone, then one of the questions we must ask is whether that definition implies a cash cost or an opportunity cost. A cash cost is the amount of cash expended (a valuable resource), whereas an opportunity cost is the lost opportunity of not doing something, which may be the loss of time or the loss of a customer, equally valuable resources.
If it is the cash cost, is it the historical (past) cost or the future cost with which we should be concerned?
Is the cost of an employee:
- The historical, cash cost of salaries and benefits, training, recruitment etc.
- The future cash cost of salaries and benefits to be paid? Or ……
- The lost opportunity cost of what we could have done with the money had we not employed that person, e.g. the benefits that could have resulted from expenditure of the same money on advertising, computer equipment, external consulting services etc.?
Wilson and Chua (1988) quoted the economist Jevons, writing in 1871, that past costs were irrelevant to decisions about the future because they are “gone and lost forever“. This is a difficult question, and the problematic nature of calculating costs may have been the source of the comment by Clark (1923) that there were “different costs for different purposes’.
This, then, is our third limitation of accounting: what do we mean by cost and how do we calculate it?