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Under the prudence concept, you should not overestimate the amount of revenues that you
record, nor underestimate the expenses. You should also be conservative in recording the
amount of assets, and not underestimate liabilities.
Another way of looking at prudence is to only record a revenue transaction or an asset when
it is certain, and to record an expense transaction or liability when it is probable. Another
aspect of the prudence concept is that you would tend to delay recognition of a revenue
transaction or an asset until you are certain of it, whereas you would tend to record expenses
and liabilities at once, as long as they are probable. In short, the tendency under the prudence
concept is to either not recognize profits or to at least delay their recognition until the
underlying transactions are more certain.
The prudence concept does not quite go so far as to force you to record the absolute least
favorable position (perhaps that would be entitled the pessimism concept!). Instead, what you
are striving for is to record transactions that reflect a realistic assessment of the probability of
occurrence. Thus, if you were to create a continuum with optimism on one end and
pessimism on the other, the prudence concept would place you somewhat further in the
direction of the pessimistic side of the continuum.
You would normally exercise prudence in setting up, for example, an allowance for doubtful
accounts or a reserve for obsolete inventory. In both cases, a specific item that will cause an
expense has not yet been identified, but a prudent person would record a reserve in
anticipation of a reasonable amount of these expenses arising.
Generally Accepted Accounting Principles incorporates the prudence concept in many of its
standards, which (for example) require you to write down fixed assets when their fair values
fall below their book values, but which do not allow you to write up fixed assets when the
reverse occurs. International Financial Reporting Standards do allow for the upward
revaluation of fixed assets, and so do not adhere so rigorously to the prudence concept.
The prudence concept is only a general guideline. Ultimately, you must use your best
judgment in determining how and when to record an accounting transaction.
Negative trends. Can include declining sales, increasing costs, recurring losses,
adverse financial ratios, and so forth.
Legal. Legal proceedings against the company, which may include pending liabilities
and penalties related to environmental or other laws.
Business structure. The company has lost a major customer or key supplier.
Financing. The company has defaulted on a loan or is unable to locate new financing.
The auditor's going concern qualification can be mitigated by management if it has a plan to
counteract the problem. If such a plan exists, the auditor must assess its likelihood of
implementation and obtain evidential matter about the most significant elements of the plan.
For example, if the CEO has declared that he will extend a loan to the company to cover a
projected cash shortfall, evidential matter might be considered a promissory note in which the
CEO is obligated to provide a stated amount of funds to the company.
The going concern qualification is of great concern to lenders, since it is a major indicator of
the inability of a company to pay back its debts. Some lenders specify in their loan
documents that a going concern qualification will trigger the acceleration of all remaining
loan payments. A lender is typically only interested in lending to a business that has received
an unqualified opinion from its auditors regarding its financial statements.
An auditor who is considering issuing a going concern qualification will discuss the issue
with management in advance, so that management can create a recovery plan that may be
sufficient to keep the auditor from issuing the qualification. Thus, the going concern
qualification is a major issue, but you will have a chance to find a way around the problem
and potentially keep the auditor from issuing it.
The justification for the accrual concept is that earning of revenue and consumption of a
resource (expenses) can be accurately related to particular or specific accounting period. This
would enable the measurement of Income of matching expenses and revenue. The drawbacks
include:i. The apportion of expenses to different time periods is a time consuming process and
ii. Financial statements become more complex for the layman who may find it difficult to
understand the difference between the actual receipt of cash and the right to receive the cash
and also the actual payments and the obligation to pay.In other words the inclusion of
prepayments and inclusions in the Balance Sheet may not be understood easily
Example - Size
A default by a customer who owes only $1000 to a company having net assets of worth $10
million is immaterial to the financial statements of the company.
However, if the amount of default was, say, $2 million, the information would have been
material to the financial statements omission of which could cause users to make incorrect
business decisions.
Example - Nature
If a company is planning to curtail its operations in a geographic segment which has
traditionally been a major source of revenue for the company in the past, then this
information should be disclosed in the financial statements as it is by its nature material to
understanding the entity's scope of operations in the future.
Materiality is also linked closely to other accounting concepts and principles:
Relevance: Material information influences the economic decisions of the users and is
therefore relevant to their needs.
Record sales when you invoice the customer, rather than when the customer pays you.
Record an expense when you incur it, rather than when you pay for it.
Record the estimated amount of bad debt when you invoice a customer, rather than
when it becomes apparent that the customer will not pay you.
Record depreciation for a fixed asset over its useful life, rather than charging it to
expense in the period purchased.
Record a commission in the period when the salesperson earns it, rather than the
period in which he is paid it.
Record wages in the period earned, rather than in the period paid.
When properly implemented, the accrual principle allows you to aggregate all revenue and
expense information for an accounting period, without the distortions and delays caused by
the cash flows arising from that accounting period.
Recording transactions under the accrual principle may require the use of an accrual journal
entry. An example of such an entry for a sale on credit is:
Debit
Accounts receivable
Credit
8,000
Sales
8,000
In this entry, revenue is recorded before payment from the customer arrives, along with an
accounts receivable asset in the same amount. In the following month, the customer pays the
company, and the company records the following entry:
Debit
Cash
Accounts Receivable
Credit
8,000
8,000
The cash balance increases as a result of the customer payment, which also eliminates the
accounts receivable asset. If you do not use the accrual principle, then you are using the cash
method of accounting, where you record revenue when cash is received and expenses when
they are paid. There are also modified versions of the cash method of accounting that allow
for the limited use of accruals.
have at that time. You should not use the principle to consistently record the lowest possible
earnings for a company.
The consistency principle states that, once you adopt an accounting principle or method, you
should continue to follow it consistently in future accounting periods. You should only
change an accounting principle or method if the new version in some way improves reported
financial results. if you make such a change, you should fully document its effects, and
include this documentation in the notes accompanying the financial statements.
Auditors are especially concerned that their clients follow the consistency principle, so that
the results reported from period to period are comparable. An auditor may refuse to provide
an opinion on a client's financial statements if there are clear and unwarranted violations of
the principle.
The consistency principle is most frequently ignored when the managers of a business are
trying to report more revenue or profits than would be allowed through a strict interpretation
of the accounting standards. A telling indicator of such a situation is when the underlying
company operational activity levels do not change, but profits suddenly increase.
The cost principle is less applicable to long-term assets and liabilities. Though depreciation,
amortization, and impairment charges are used to bring them into approximate alignment
with their fair values over time, the cost principle leaves little room to revalue these items
upward. If a balance sheet is heavily weighted towards long-term assets, as is the case in a
capital-intensive industry, then there is a greater risk that the balance sheet will not accurately
reflect the actual values of the assets recorded on it.
The cost principle implies that you should not revalue an asset, even if its value has clearly
appreciated over time. This is not entirely the case under Generally Accepted Accounting
Principles, which allows some adjustments to fair value. The cost principle is even less
applicable under International Financial Reporting Standards, which not only permits
revaluation to fair value, but also allows you to reverse an impairment charge if an asset
subsequently appreciates in value.
The revenue recognition principle states that, under the accrual basis of accounting, you
should only record revenue when an entity has substantially completed a revenue generation
process; thus, you record revenue when it has been earned. For example, a snow plowing
service completes the plowing of a company's parking lot for its standard fee of $100. It can
recognize the revenue immediately upon completion of the plowing, even if it does not
expect payment from the customer for several weeks.
Also under the accrual basis of accounting, if an entity receives payment in advance from a
customer, then the entity records this payment as a liability, not as revenue. Only after it has
completed all work under the arrangement with the customer can it recognize the payment as
revenue.
Under the cash basis of accounting, you should record revenue when a cash payment has
been received. For example, using the same scenario as just noted, the snow plowing service
will not recognize revenue until it has received payment from its customer, even though this
may be a number of weeks after the plowing service completed all work.
The economic entity principle states that the activities of a business entity will be kept
separate from the activities of its owner(s) and any other business entities. This means that
you must maintain separate accounting records for each entity, and not intermix with them
the assets and liabilities of its owners or business partners. Also, you must associate every
business transaction with an entity.
A business entity can take a variety of forms, such as a sole proprietorship, partnership,
corporation, or government agency.
It is customary to consider a commonly-owned group of business entities to be a single entity
for the purposes of creating consolidated financial statements for the group.
The economic entity principle is a particular concern when businesses are just being started,
for that is when the owners are most likely to commingle their funds with those of the
business. A typical outcome is that an accountant must be brought in after a business begins
to grow, in order to sort through earlier transactions and remove those that should be more
appropriately linked to the owners.
The going concern principle is the assumption that an entity will remain in business for the
foreseeable future. Conversely, this means the entity will not be forced to halt operations and
liquidate its assets in the near term. By making this assumption, the accountant is justified in
deferring the recognition of some expenses until a later period, when the entity will
presumably still be in business and using its assets.
An entity is assumed to be a going concern in the absence of significant information to the
contrary. An example of such contrary information is an entitys inability to meet its
obligations as they come due without substantial asset sales or debt restructurings. If such
were not the case, an entity would essentially be acquiring assets with the intention of closing
its operations and reselling the assets to another party.
If the accountant believes that an entity may no longer be a going concern, then this brings up
the issue of whether its assets are impaired, which may call for the write-down of their
carrying amount to their liquidation value. Thus, the value of an entity that is assumed to be a
going concern is higher than its breakup value, since a going concern can potentially continue
to earn profits.
The going concern concept is not clearly defined anywhere in generally accepted accounting
principles, and so is subject to a considerable amount of interpretation regarding when an
entity should report it. However, generally accepted auditing standards (GAAS) do instruct
an auditor regarding the consideration of an entitys ability to continue as a going concern.
The auditor evaluates an entitys ability to continue as a going concern for a period not
greater than one year following the date of the financial statements being audited. The auditor
considers such items as negative trends in operating results, loan defaults, denial of trade
credit from suppliers, uneconomical long-term commitments, and legal proceedings in
deciding if there is a substantial doubt about an entitys ability to continue as a going concern.
If so, the auditor must qualify the audit report with a statement about the problem.
The monetary unit principle states that you only record transactions that can be expressed in
terms of currency. Thus, you cannot record such non-quantifiable items as employee skill
levels or the quality of customer service.
The monetary unit principle also assumes that the value of the unit of currency in which you
record transactions remains stable over time. However, given the amount of persistent
currency inflation in most economies, this assumption is not correct - for example, a dollar
invested to buy an asset 20 years ago is worth considerably more than a dollar invested today,
because the purchasing power of the dollar has declined during the intervening years. The
assumption fails completely if an entity records transactions in the currency of a
hyperinflationary economy.
As an example of a clearly immaterial item, you may have prepaid $100 of rent on a post
office box that covers the next six months; under the matching principle, you should charge
the rent to expense over six months. However, the amount of the expense is so small that no
reader of the financial statements will be misled if you charge the entire $100 to expense in
the current period, rather than spreading it over the usage period.
The materiality concept varies based on the size of the entity. A massive multi-national
company may consider a $1 million transaction to be immaterial in proportion to its total
activity, but $1 million could exceed the revenues of a small local firm, and so would be very
material for that smaller company.
The materiality principle is especially important when deciding whether a transaction should
be recorded as part of the closing process, since eliminating some transactions can
significantly reduce the amount of time required to issue financial statements.
Employee bonuses. Under a bonus plan, an employee earns a $50,000 bonus based on
measurable aspects of her performance within a year. The bonus is paid in the
following year. You should record the bonus expense within the year when the
employee earned it.
Wages. The pay period for hourly employees ends on March 28, but employees
continue to earn wages through March 31, which are paid to them on April 4. The
employer should record an expense in March for those wages earned from March 29
to March 31.
Recording items under the matching principle typically requires the use of an accrual entry.
An example of such an entry for a commission payment is:
Debit
Commission expense
Credit
5,000
Accrued expenses
5,000
In this entry, the commission expense is charged before the cash payment actually occurs,
along with a liability in the same amount. In the following month, the company pays the
commission, and records the following entry:
Debit
Accrued expenses
Cash
Credit
5,000
5,000
The cash balance declines as a result of paying the commission, which also eliminates the
liability.
If you do not use the matching principle, then you are using the cash method of accounting,
where you record revenue when cash is received and expenses when they are paid.
The time period principle is the concept that a business should report the financial results of
its activities over a standard time period, which usually monthly, quarterly, or annually. Once
the duration of each reporting period is established, you use the guidelines of Generally
Accepted Accounting Principles or International Financial Reporting Standards to record
transactions within each period.
You must include in the header of any financial statement the time period covered by the
statement. For example, an income statement may cover the "Eight Months ended August
31."
The reliability principle is the concept of only recording those transactions in the accounting
system that you can verify with objective evidence. Examples of objective evidence are:
Purchase receipts
Cancelled checks
Bank statements
Promissory notes
Appraisal reports
Note that the examples shown here are of documents generated by other entities (customers,
suppliers, valuation experts, and banks). Since they are third parties, documents supplied by
them are considered to be of higher value as objective evidence than documents created
internally.
The reliability principle is particularly difficult to meet when you are recording a reserve,
such as an inventory obsolescence reserve or an allowance for doubtful accounts, since these
reserves are essentially opinion-based. In these cases, it is particularly important to justify
your actions with a detailed analysis of the reasons for the reserve. This is frequently based
on verifiable historical experience with similar transactions, and which you expect to be
repeated in the future.
From a practical perspective, you should only record those transactions that an auditor could
reasonably be expected to verify through normal audit procedures.