Strict legal frameworks govern accounting practices, yet many grey areas remain.
Being aware of these and having a working knowledge of general accounting principles will help you support your colleagues in finance. It will also help you to understand and manage around the many areas of legal work in-house where legal and accounting principles touch on the same business issue but deal with it differently.
Key principles in accounting
The statute and regulations that govern the preparation of financial statements extend to many hundreds of pages.
However, when accountants prepare financial statements, they generally adhere to these five principles.
1. The accrual principle
Your organisation ships goods to a customer in one accounting period but receives payment for them in the following accounting period. When should it record the sale in its accounts?
According to the accrual principle, you should:
- Recognise income when it’s earned, regardless of when you receive it; and
- Recognise expenses when you incur them, regardless of when you pay them.
Recognition of transactions in financial statements is tied to when the relevant business activities take place, not the date when money changes hands. So, in the example above, the sale would be recorded in your organisation’s accounts in the accounting period for the date it shipped the goods to the customer.
2. The matching principle
Your organisation buys production equipment in one quarter and uses it for the next 24 quarters. When does the expenditure actually take place for the purpose of its accounts?
The matching principle aims to align revenues and expenses. This means you should recognise your expenses in the same periods as those in which you’re earning revenues from them – and vice versa.
So, your organisation should spread the cost of the equipment equally over the 24 quarters.
3. The historic cost principle
Your organisation’s head office building increases slightly in value as a consequence of general increases in property values. Should it reflect this in the accounts?
Accounting is concerned with past events, so requires consistency and comparability. To achieve this, financial statements normally adopt the historic cost principle.
This principle requires organisations to record their transactions at their historic cost. Historic cost is defined as the actual value of a resource, such as cash given up or a liability incurred to secure an asset. If that asset subsequently appreciates in value, the increase isn’t reflected in the financial statements, except where allowed or required by accounting standards.
However, any permanent impairment in value of an asset is recognised in the accounts.
The concept of historical cost is important. Market values, particularly for property, change often, so allowing organisations to report their assets and liabilities at current values would distort the fabric of accounting, impair comparability and make financial statements unreliable.
So the answer is no, your organisation should not reflect the increase in value in its head office building in its accounts.
4. The conservatism principle
Your organisation is preparing for the high legal costs of future lawsuits arising from a major environmental incident. Should these potential costs be recognised in the accounts?
Accounting transactions like this could, in theory, be recorded in one of several ways. This means that, without any controls, different accountants could make radically different choices in recording the same item.
The principle of conservatism requires accountants to choose the approach that produces the lowest net income or net assets. They should recognise anticipated costs, such as legal fees and settlement costs, immediately and only recognise anticipated gains, such as profits from a new customer contract, when they actually occur.
Your organisation should make an explicit provision in its accounts for the anticipated legal costs and penalties associated with the environmental incident.
5. The principle of substance over form
Your organisation uses a piece of machinery, which it acquired on a long-term lease, to manufacture its product. Should it recognise the machinery as an asset, even though the lessor retains legal ownership?
The principle of substance over form requires your organisation to record the economic substance of transactions and events in financial statements, rather than just their legal form.
If the lease is brief, say for a few months, your financial statement should show the whole rental fee your organisation pays as an expense, with no asset listed.
If, on the other hand, your organisation leases the equipment over several years, the transaction is economically similar to a sale with an associated loan, often because the lease covers the whole or most of the asset’s life. In this case, accounting rules treat the lease as a purchase by your organisation and a separate, but associated, debt owed to the lessor.
Fraud, accounting problems and over-optimism - don't get duped!
Many business accounting and reporting scandals and /or frauds revolve around playing with or pushing the boundaries of these accounting principles beyond where they should go either deliberately or through ignorance, sloppiness or over-optimism.
Frequently the finance function in business is segmented (between forecasting, reporting, management accounting, tax, audit, internal audit, payroll, accounts receivable and accounts payable) in a way that inadvertently compounds this problem by making joined up financial thinking harder, more error prone or haphazard.
Frequently also a sales, purchase, M&A, disposal, employment, treasury, lease, incentive plan or other legal agreement will be the tool through which these problems are accidentally or deliberately created.
So a well-intentioned lawyer can actually be the builder both of the problem and the creator of the "smoking gun" contract that documents it.
So, as finance - in any of its forms - may not spot these issues unaided (and may sometimes even be the architects of the problems) it is important for lawyers to be well versed in theses issues and to understand who owns them in the business, what the policy positions are, who to escalate and/or to whistle blow to as needed so as to avoid creating issues for the business.
Conclusion
Although the guidelines for accountants are extensive, there are five main principles that underpin accounting practices and the preparation of financial statements. These are the accrual principle, the matching principle, the historic cost principle, the conservatism principle and the principle of substance over form. Together they cover revenue recognition, fluctuating value of assets, provision for exceptional costs and how to account for leased equipment over short and long-term agreements.
Lawyers should have a good understanding of these principles as they impact on many business decisions that need to be documented in legal form and the lawyer should be helping to spot and avoid the creation of problems rather than ignorantly drafting those problems into contracts.
To read the next article titled 'The financial reporting framework' click here.