Accounting rules and guidelines
also known as GAAP
(Generally Accepted Accounting Principles)
The accounting system is one of the tools (one of the Management Information Sytems, MIS) to manage the firm.
There are many other MIS which are necessary to managers: MIS on production, on selling activity, on human resources, on competition (market shares, prices, cost structures, etc.), information on technology (product and production), etc.
The accounting system, however, can be viewed as the most important one: a firm could be run for a little while without the other MIS, but not without the accounting system.
In order for the accounting system to produce useful information, some rules and guidelines must be followed. They are classified into three large categories:
- Boundary rules
- Measurement rules
- Ethical rules
1. Boundary rules
1.1 Entity rule: distinguish clearly what concerns the firm and its operations, and what does not. Do not mix up transactions which engage the firm as a moral person (its ownership over things, its responsibilities, etc.) and transactions, for instance, of the owners or other agents. The vacations of the boss should not paid for by the firm (be it directly or through an expense sheet submitted later). They should not be treated as an expenditure of the firm, because they are not an exchange between the firm and the rest of the world to operate the firm. On the other hand, do not overlook transactions concerning the firm. See the example of the rent overlooked by the owner of "Les Editions Entente".
1.2 Periodicity rule: prepare the final documents on a regular basis, usually at the end of every year. Stick to the same period. The period is usually 12 month long, because most firms have activities with a seasonal pattern, and if we used, say, periods of 9 months, two successive periods would not be comparable.
1.3 Going concern: record all transactions with the assumption that the firm will exist forever, and there always will be more transactions in the future. There are economic activities which are not firms, and which are not going concerns; they are projects with a beginning and an end. Building a bridge is such a project which is not a going concern.
1.4 Quantitative rule: record only quantifiable information in the accounting system. For instance, a sale of $100 to a new client, which opens nice perspectives of development, will be treated in the same way as a sale of $100 to a small unimportant client. The strategic value of the new client is a useful piece of information, but is not of an accounting nature. Similarly, skills of workers are not recorded in the accounting system.
2. Measurement rules
2.1 Monetary measurement: everything is recorded in monetary units, and the same monetary unit. In the example of the toy manufacturer, before going into the accounting techniques, we saw that at the end of month three the assets of the firm were 7000 €, plus an IOU for 20 000 €, plus 1000 toys ready, plus some other assets. "1000 toys" is not an accounting piece of information; their value must be measured in euros. There are accounting techniques to evaluate stocks. We shall study them in coming lectures. Multinational firms must present a balance sheet in one currency, not several. Currency movements are a big problem for multinational firms. Sometimes a growth of 10% achieved by an overseas subsidiary can be wiped out by a depreciation of the local currency in which it deals. Often we read in annual reports sentences like this: "The loss last year was 7%, half of which is due to currency variations". There are some ways to try and protect oneself against currency movements. It is called hedging. It belongs to the field of options and futures. It does not come without cost (or risk) similar to taking an insurance policy.
2.2 Historic costs: assets are recorded in the accounts at their value when they were purchased. Usually this record will not be changed in the books, even if the market value of the asset has changed. The typical example is the case of a firm which bought land many years ago, recorded it at its value at the time of purchase, and now the land is worth much more. We do not make a change in the books to take into account this appreciation. This rule has a drawback: it makes the balance sheet not representative of the reality of actual values. This is true of financial assets too: even though their value varies a lot, they are usually not changed in the books. As a result, balance sheets often contain "potential capital gains" - or losses. (The IFRS rules, under some circumstances, allow you to increase historic values, and "mark to market" some of your assets.) Even though the historic cost rule says "do not change values", if we know that some asset has lost a lot of its value, in that case another rule (the prudence rule, see below) says "record the potential loss now".
2.3 Realisation rule: it is an important rule which concerns the date of a transaction, and therefore to which accounting period it belongs. It states: the date of a transaction is the date of change of ownership of the goods sold, or bought. Usually the date of change of ownership is the shipment date, more precisely the exact time of delivery to the buyer's warehouse. But there are exceptions, for instance when the change of ownership contractually takes place only when the goods are actually paid for. It has an important legal consequence: in the case of bankruptcy, what does not belong to the firm in banruptcy, even if it is on its premises, will not be included in the liquidation procedures, and will return to its owner.
2.4 Matching rule: again, an important rule. In preparing the Income Statement for the period [t1, t2] record only sales and expenditures which correspond to that period. If, the 1st of December, we pay for three month of forthcoming rent, and the accounting period is the calendar year, only a third of this expenditure should be counted into the current period. We already saw this in the lesson on prepayments.
2.5 Dual aspect: it simply says that a transaction involves two accounts, one will be debited, and another one will be credited. It is the technical translation of the fact that a transaction is made of two movements of value, most usually one leaving the firm, and one entering the firm.
2.6 Materiality rule: we create different accounts to distinguish expenditures or assets or liabilities of different nature, but we don't create new accounts for insignificant things, we treat them as a lump quantity. For instance, we may have an account called "Stationery", but we will not have separate accounts for pens of different colors. In the same spirit, in our personal mailer we don't create a new folder for every new incoming e-mail, otherwise we would have as many folders as e-mails, and the whole classification process would become meaningless.
3. Ethical rules
3.1 Prudence rule: surprisingly enough there are transactions where we have the choice of how to record them (this is the case, for instance, of passing provisions). The rule says: when you have a choice between several recording methods, choose the one that minimizes the profit. That way we are prudent. By the way, it is one of the reasons of the historic costs rule. It is easy to be overly optimistic with one's accounts and show a profit that is misleading. And then, after a while, we run into trouble - usually lack of cash, and also we must then make big write-offs.
3.2 Consistency rule: when we have adopted one accounting way to treat such and such transaction, we should stick to the same way in the subsequent periods. It is important, because one of the functions of the accounting system is to show the evolution of the firm from one year to the next. If we change the accounting procedures, we end up with figures which are not comparable. This rule applies, in particular, to depreciation calculations; if we selected a linear depreciation over 5 year for our new cars, we must stick to the same depreciation calculations for future cars we acquire.
3.3 Objectivity rule: let's not introduce personal bias in keeping our accounts. If we have a set of procedures to make provision for bad clients, we should not say "this one, even though it falls in the category that is provisioned at 25%, we will not provision, because it is a friend..." or "because we feel he will recover..." Be objective.
3.4 Relevance rule: put only relevant information in the accounting documents and their accompanying appendices.
These rules and guidelines are all fairly natural. They are designed to make the accounting documents as useful as possible.