Document: Fundamental Principles of Accounting
As control needs arose, accounting created instruments to register all events affecting an entity's equity. As accounting history unfolded, doubts arose regarding the best criterion to register certain transactions. In light of this, the first accountants made some choices later adopted by their peers, which became universally accepted rules. These basic rules they adopted we today call Accounting Principles. They form the theoretical framework that supports all accounting.
Thus, the Fundamental Principles of Accounting are the rules upon which the entire theoretical structure for bookkeeping and accounting analysis is built.
Given the complexity of the topic, a detailed study of each principle is beyond the scope of this document. We will briefly cover how accountants must follow the principles in a practical manner.
We can classify the fundamental principles in three categories:
POSTULATES
PRINCIPLES
CONVENTIONS
1. POSTULATES.
Postulates are the basic vital elements that entirely structure modern accounting. They are the sine qua non conditions for accounting development.
These are the postulates:
1.1. ENTITY.
This postulate states that the accounting of an entity (company, person, philanthropic institution) cannot be confused with the accounting of the members who own it. In other words, the bookkeeping of a company must be fully dissociated from the bookkeeping of its owners.
1.2. CONTINUITY.
This postulate states that the company must be evaluated and, consequently, undergo bookkeeping, in the assumption that the institution will never become extinct. Company Assets are evaluated in accordance with this presupposition. Thus, if a company is being closed, that is, in the process of ending its business activities, its Asset evaluation criteria are different. This postulate also exists to calculate periodic results.
2. PRINCIPLES.
Accounting is essentially a practical science. Throughout the years, various criteria were developed and several options implemented, in attempts to normalize and arrive at the best way to control a company's equity. Thus, the principles are the externalization of criteria accepted by most accountants.
2.1. COMMON MONETARY DENOMINATOR.
This principle says that accounting must operate on a single Currency and that all items must be evaluated with this currency. Thus, a debt originally incurred in USD will be controlled in USD, although in business bookkeeping it is stated in BRL. For example: a donated artwork that becomes a company asset is evaluated by accounting in BRL.
2.2. ACCRUAL ACCOUNTING
This principle is applied in the bookkeeping of revenues and expenses. This is actually a joint expression of the following principles that normalize the result:
a) Revenue Realization Principle.
b) Principle of Matching Expenses with Revenue.
Bearing in mind that its comprehension is of vital importance to perfectly interpret accounting statements, we will explain it in greater detail, with practical examples.
We can say that, for any expense or revenue, there are two moments in which you can book the events involving such equity elements, as follows:
I. the economic moment (of its occurrence or generation).
II. the financial moment (when it came into effect, through payment or receipt).
To exemplify, let us imagine the salary expense of December/x1, paid in January/x2.
When should we book salary as an expense (which reduces Net Equity)?
a) at the time of its generation, of its economic moment; that is, in the month of December/x1; or
b) at the time of its payment, of its financial moment; that is, in the month of January/x2.
When they had to Opt for one of two moments, accountants decided that expenses (and revenues) must be booked when they occur; that is, at the economic moment of their generation, not when they are paid (or received, in the case of revenues). This decision became the principle of accrual accounting, which says:
"Expenses and revenues must be booked as they are, at the time of their occurrence, regardless of their payment or receipt".
2.2.1 CONCEPT OF FISCAL YEAR.
In accounting, we understand that the Fiscal Year is a period of one year in which the result is calculated. The accounting period of one year does not necessarily coincide with the calendar year, but the accounting period must have 12 months. The company determines the start and the end of the period.
We must emphasize that business and tax legislation requires at least a Balance Sheet at the end of each accounting period, followed by the Income Statement of the last period.
Thus, expenses and revenues must be booked in the year they were generated, even if paid or received in a later year or years, or even before, as the case may be.
2.2.2 EXTENDED CONCEPT OF ACCRUAL ACCOUNTING - MONTHLY ACCRUALS
In spite of the requirement to prepare Accounting Statement only at the end of each year (of each fiscal period), the need for accounting data for equity control purposes motivates good companies to prepare such statements at least once a month. Thus, every month an Income Statement of the last month is made, and the Balance Sheet at the end of each month.
Hence, the accrual accounting concept is subdivided in 12 periods, and the occurrence concept is applied to each month. Of course, if a company does not need monthly results, it may also consider quarterly results as sufficient. However, today we believe the monthly calculation period is the ideal minimum to be pursued.
Let us take another example, this time of revenue, and of application of the monthly accrual concept.
We have sales made in March/x1 to be received in June/x1. The sales revenue must be booked in the month of invoice issue and respective outflow of goods, which is March/x1, even if the trade note is received a few months later, in this case in June/x1.
The adoption of accrual accounting was imposed by the need for accounting to control rights and obligations. Thus, the values receivable in fixed assets mean sales of Goods or Services in installments. The values payable in Liabilities represent purchases of Goods or Services or expenses in installments.
2.3. REVENUE REALIZATION.
This principle states that when we must consider revenue as realized, or executed. Many theoreticians alleged that we should regard the revenue of a product at the moment we finished producing it. Yet the consensus of accountants does not accept this theory. We must consider the sale revenue of a product only when the product is delivered to the customer, already with an agreed Price. You can determine the moment of revenue realization by checking some basic conditions:
- objective market evaluation for the Price of the product:
- execution of all production efforts;
- condition of evaluating expenses related to the product being sold;
Some variations exist in the traditional concept of revenue realization, but you may find them included in the general rule. This happens with the bookkeeping of long-term contracts, in which the revenue value is booked as the product is manufactured; that is, in accordance with the stage of production. An example of this type of bookkeeping is shipbuilding. The fact that the shipbuilder has a formal contract and starts construction only when this contract is signed means that an objective Price exists for this production. Also the efforts of each stage of Production are exerted and nothing is lost, so that even another shipyard may finish construction. Likewise, we know the cost of each stage of Production.
Another example of variation in revenue bookkeeping is the case of long-term maturation livestock farming. Revenue may be booked proportionately as the herd fattens. Usually, revenue is calculated based on the age of the herd. At each elapsed year, we enter the revenue of the year that has just ended, which is the fattening of the year.
2.4. MATCHING EXPENSES WITH REVENUE.
This principle says the revenues realized in a period must be matched, in the same period, with the expenses that generated them. That is, to calculate a period's results, the revenues must be taken into account, subtracted of the expenses incurred for their achievement.
2.5. COST PRINCIPLE.
This principle says Asset acquisitions must be booked by their historical value, by their purchase or acquisition value. Today this principle endures in Brazil because we accept the adjusted historical cost as part of this principle. This principle has a restriction: when, in an acquisition, the cost value is higher than the sale or market value, then we should evaluate the asset by the market. Thus, in practice, we speak of this principle as "lower of cost or market".
2.5.1. EXAMPLE: GOODS IN STOCK.
This concept is very important to understand the account of Goods in Stock. Goods in Stock are Assets the company acquires for the basic purpose of selling them later for a profit. The Transaction is what gives a business its substance.
The principle of Cost Basis states that Assets acquired must be registered by the purchase Price (acquisition price), which is its cost Price. Thus, when we purchase goods for BRL 100.00 to sell them later, we must enter their acquisition value in accounting, even knowing that we will sell them later for, say, approximately BRL 250.00.
This means that, in spite of being aware that the sale value is BRL 250.00, while not yet sold, we must keep their value in the Goods account at Cost Price.
When the sale takes place and the goods are no longer in stock, we also post them in the Goods in Stock account at the Cost Price, entering the counterpart as expense. The sale value will be entered in a Revenue account. The difference between Sales Revenue values, minus the Expense of the Cost of Goods that left stock (Cost of Goods Sold), is the Gross Profit of the Sale of Goods.
3. CONVENTIONS.
Conventions are held as restrictions to accounting principles. They are also regarded as practical rules that must be followed, as guides that make the accountant's work easier. They are not regarded as generators of definitions for accounting criteria.
3.1. OBJECTIVITY.
The accountant must be objective. When bookkeeping an event, they need to embrace objective elements to take the fullest possible advantage of subjectivity in the accounting entry. The value must have an accounting document that confirms the entry. The object must be measurable and the accountant must not stamp their personal brand on the evaluation of the object.
3.2. CONSERVATISM.
From a very old view of accountants that shaped our image, this convention says that, when in doubt, the accountant must choose the most conservative bookkeeping method. A practical rule of conservatism: when in doubt, enter all expenses whenever possible. If you already have the revenue , when in doubt, do not enter it.
3.3. MATERIALITY.
This convention is basically related to the cost/benefit analysis of information. The accountant must always strive for the numeric accuracy of entries, for as long as the cost of said accuracy is not harmful to the company. Large and relevant values must be analyzed with far greater accuracy than small values, which may be handled in a simpler, summarized way.
3.4. CONSISTENCY OR UNIFORMITY.
This convention is so important that it could be considered a principle. It states that, once the accountant adopts a given evaluation criterion for an asset or liability, they must consistently adopt this criterion throughout the years. They must apply this criterion uniformly through time. They may change the criterion adopted, as long as they highlight the change in an explanatory note and refrain from noticeably repeating the change.
3.5. COMMENTS.
The fundamental principles of accounting belong to the basic framework of Accounting Theory. These principles are accepted to this day. However, there is nothing to stop these principles from changing as time goes by. Accounting is an extremely practical methodology and the need for information from multiple users of accounting data may change with the passage of time. Thus, some principles may be revised, as others may be created or extinguished. Accountants are engaged in an ongoing discussion about themselves, whether they are up-to-date and have not become a hindrance to modern information needs.
3.6. DISCLOSURE.
Currently, one of the requirements of accounting is the full comprehension of accounting statements. When we disclose the equity and profits of the latest period in accounting statements, one item or another may not be clear only by the disclosure of its number. The need arises for an additional explanation. We must provide this explanation, albeit in another way.
Basically, the substance of the disclosure process is an accounting record called explanatory notes. This record must highlight all items that require additional information to be comprehended. A common practice is that of describing the evaluation criteria adopted for the main Assets and Liabilities, as well as the main changes to adopted criteria.
The explanatory notes must contain other information needed for report comprehension, whether to add detail to report numbers or quality to numeric data.
Besides the explanatory notes, the company must employ another report to promote disclosure. This report is usually called Director's Report. It must contain all relevant events that have influenced the numbers presented, as well as the environmental conditions in which the company operated in the latest period. The report must also disclose any existing relevant and concrete facts that will decidedly affect the result of the year in progress or of upcoming years.
BIBLIOGRAPHIC REFERENCE.
PADOVEZE, Clóvis Luís. Basic Accounting Manual. Editora Atlas S.A. 3rd Edition. São Paulo. 1996.
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