Trying to understand financial statements without understanding the 3 most important principles that underlie all accounting is like trying to eat healthy without understanding what foods do in your body. There are three bedrock principles that govern accounting. The first is the “Matching Principle”, the second is “Conservatism” and the third is “Consistency”.
The matching principle says, “Record your revenues on the dates they are earned (but not received) and record your expenses on the dates they are incurred (not paid).” This is the accrual basis of accounting. This is distinctly different than recording revenues when you receive the money and the expenses when you pay them, which is known as the cash basis of accounting.
The conservatism principle aims to make the books conservative so that those who rely on them such as banks and investors are basing their decisions on the most conservative view of the business’ performance. Otherwise, the results could be overly optimistic or aggressive and mislead those users.
To make the financials conservative, where doubt exists as to whether events have rendered damage to an asset (such as a customer not paying their invoices) or created a potential liability (such as might arise from pending litigation), accountants estimate such potential losses.
For example, when the receivable from a customer ages due to non-payment, it casts doubt as to whether the customer will ever pay. When that doubt creeps in, it is appropriate to record an Allowance For Doubtful Accounts, which increases an expense called bad debt expense and decreases the accounts receivable asset. That makes the accounts receivable asset more conservative on the balance sheet.
If an electric utility company sparks a wildfire due to negligence in maintaining its equipment and people die, and it is highly likely that it will be sued and pay out claims, it would be conservative for them to record the expense and corresponding liability now rather than after a court renders a judgement in the future. If such claims never materialize and there is no eventual liability, the liability they recorded today could be reversed in the future with a corresponding increase to income at that future time.
Users of financial statements rely on applying these two principles on a consistent basis so that financial statements are comparable year to year for a company and, also comparable when comparing one company to another. This concept of “Consistency” is paramount. Imagine if a company changed its accounting practices year-to-year. Their financial statements would be misleading and unreliable. And lenders, investors and management would be powerless to discern trends that are so vital when understanding the health of a company.
I hope things make more sense now that you know how the matching principle, conservatism and consistency influence your books and accountants’ work.
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This is Robert Band, your business finance expert, helping business owners make their financial problems go away. Remember, one tip could be worth millions and profits today become fortunes tomorrow so don’t let them fall through the cracks.