Solestic Advisory key principles article

Key Principles in Accounting

Here, we provide an overview of the five main principles in preparing company accounts.

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?

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According to the accrual principle, you should:

Recognise income when it’s earned, regardless of when you receive it.
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.

The matching principle

Your organisation buys production equipment in one quarter and uses it for the next 24 quarters. When does the expenditure take place for its accounts?

The matching principle aims to align revenues and expenses. This means you should recognise your costs in the same periods as those from which you’re earning revenues – and vice versa.

So, your organisation should spread the cost of the equipment equally over the 24 quarters.

The historical cost principle

Your organisation’s head office building has increased slightly in value due to increased property values. Should it reflect this in the accounts?

Accounting is concerned with past events, so it requires consistency and comparability. To achieve this, financial statements typically adopt the historical cost principle.

This principle requires organisations to record their transactions at their historical cost. Historical 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, the increase isn’t reflected in the financial statements, except where allowed or required by accounting standards.

However, any permanent impairment in the value of an asset is recognised in the accounts.

The conservatism principle

Your organisation is preparing for the high legal costs of future lawsuits arising from a significant environmental incident. Should these potential costs be recognised in the accounts?

In theory, accounting transactions could be recorded in 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 and settlement costs, and only realise expected gains, such as profits from a new customer contract, when they occur.

Your organisation should make an explicit provision in its accounts for the anticipated legal costs and penalties associated with the environmental incident.

The principle of substance over form

Although you’ll still be legally responsible for their accuracy, you can hand over complete management of your accounts to your accountant. This means they’ll be able to do everything on your behalf, from completing your tax return and managing PAYE to filing your reports with Companies House. You could even nominate them to handle your communication with HMRC. Have you no more wasted hours listening to dreary hold music? Yes, please.

You might need an investment

Your organisation uses a piece of machinery 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 importance of transactions and events in financial statements rather than just their legal document.

If the lease is brief, say for a few months, your financial statement should show the total 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.