1.3 Accounting Principles

There are five basic accounting principles that are used to record economic transactions: (1) Accrual basis ; (2) Historical cost; (3) Realization; (4) Matching; and (5) Full disclosure.

1.3.1 Accrual Basis

The accrual basis of accounting recognizes revenue when realized and expenses when incurred. It refers to all revenues and costs which incurred in the current period, whether or not the payment is received or paid, treated as the income and expenses of the current period. On the contrary, those that do not belong to this period of income and expenses, even if the amount is received or paid in this period, shouldn’t be treated as income or expenses of the current period.

Under the accrual basis, the criteria for the recognition of revenues are as follows: The process to earn revenue is completed and the authority to receive payment is obtained，but not the money has been collected. Similarly, under the accrual basis, the criteria for the recognition of expenses are the related benefits have been enjoyed and the obligation of payment has been assumed, and rather not the payments have been paid. For example, employees’ wages should be recognized as expenses in the period when employees provide service to the company, but not to recognize until the wages are paid. Therefore, accrual basis is a standard taking whether have obtained the authority of receiving payment or assumed the payment obligation as the criterion to recognize revenues and expenses. It could reflect the operating performance of enterprises in different periods more reasonably.

The accrual basis requires numerous adjustments at the end of an accounting period. For example, if revenue has been collected in advance, such as rent received in advance, at the end of the accounting period,the accountant should judge which part can be recorded as revenue, which part relates to the future periods and must, therefore, be deferred to those period and be considered a liability.

Above all, we can dig out that the use of the accrual basis complicates the accounting process. Then why do we use it? That’s because the measurement result of an entity’s financial condition and operating performance based on accrual basis is more representative than that based on cash basis . Meanwhile, if without accrual basis, it would be unnecessary to make the time period assumption.

Cash basis accounting is to deal with economic transactions, and to recognize revenues and expenses according to whether actually receipt or payment of money has incurred. Based on cash basis, if payment is actually paid during one period, regardless of whether it bring benefits to the company in the current period,it should be recognized as cost or expense. If cash is actually received during one period, regardless of whether it’s earned during this period, it should be treated as revenue.

In practice, immaterial items are frequently handled on cash basis, and some specific standards also allow the application of cash basis. In China, accrual basis is required to use.

The accrual basis indicates a profitable business by $150 000, whereas the cash basis indicates a loss of $20 000. Accordingly, the cash basis fails to truly reflect the business activities and would mislead financial information users.

1.3.2 Historical Cost

Measurement attribute is the basis of determining the amount of accounting elements . According to the Accounting Standards for Business Enterprises in China，there are typically five measurement attributes , which are historical cost , current cost , current market value , net realizable value , and present value .

Historical cost means to record accounting elements based on the cost when economic business occurs.According to this requirement, assets, costs, and expenses should be recorded in accordance with the actual cash or cash equivalents paid to acquire assets, or with the fair value of assets paid to acquire another asset;and liabilities are measured according to the actual expenditure when obtain and repay it.

Compared to other measurement attributes, historical cost is objective and determinable, so it is widely used in practice. Nevertheless, when it becomes apparent that the historical cost cannot be recovered, a deviation from historical cost is accepted. This deviation is justified by the conservatism concept. A deviation from historical cost is also found in practice where specific standards stipulate other measurement attributes such as current cost, current market value, net realizable value, and present value.

We have mentioned the concept of conservatism in the above. According to the concept of conservatism,when accountants are faced with a choice of different measurements of a situation, they must choose the measurement with the least favorable effect on net income and financial position in the current period.

Significantly, an accountant cannot use the conservatism concept to justify arbitrarily low figures. To apply the concept of conservatism to any given situation, there must be alternative measurements and each measurement is reasonable and allowed by rules. For example, the accountant cannot write inventory down to an arbitrarily low figure to make earning management, because it cannot be justified under the concept of conservatism. Only making choice at the lower of historical cost or market value can be acceptable under the concept of conservatism.

1.3.3 Realization

Revenue (sales) is the amount received from selling products or providing services. But accountants always face a problem of when to recognize revenue. If revenue is recognized too early, the financial statement of the company will look more profitable than it is. If revenue is recognized too late, a company will look less profitable than it is. Whether to recognize early or later will always mislead information users. The realization principle just provides a guidance on when to recognize revenue, and then help to solve the problem above.

Three concepts are important to revenue recognition. (1) Revenue is recognized when earned. The earnings process is generally completed when services are performed, or the ownership of products is transferred to buyers. (2) Proceeds from selling products and services need not be in cash. For example,when a customer purchases merchandises and promises to pay at a future date, this sale is called sale on credit . (3) Revenue is measured by the cash received plus the cash value of any other items received. The recognition of revenue at the completion of the production process is acceptable when the price of the item is known and there is a ready market.

1.3.4 Matching

The matching principle, also called expense recognition principle, prescribes that a company records the expenses it incurred to generate the revenue reported. Its basic purpose is to determine revenues first and then match the appropriate costs with these revenues. For example, when a company sells inventory and recognizes revenue, the cost of inventory should be matched directly with revenue. There are still some costs which have no direct connection with revenue. To allocate these costs against revenues, there are some systematic policies which can be adopted. For example, the research and development costs will be recognized in the period when these costs occur. It is not in conformity with the matching principle, but with the concept of conservatism.The principle of matching and realization are essential to modern accounting.

1.3.5 Full Disclosure

According to the full disclosure principle, accounting reports must disclose all transactions and events that may influence the judgment of an informed reader. This principle prescribes that a company discloses the details after financial statements that would affect users’ decisions.

There are several ways of disclosure, including parenthetical explanations , supporting schedules , cross-references , and notes. Usually, to explain a specific situation, additional disclosures must be made by a note, such as long-term leases, provisions of a bond issue or pension plans .

Because of the complexity of a business and the increased expectations of the public, to disclose fully is becoming more and more difficult. Accountants are frequently involved in lawsuits because of failing to make an appropriate disclosure. When making decisions about what information should be reported, accountants need to follow special accounting standards so that the information disclosed could be of sufficient importance to influence the judgment and decision of an informed user. As it is a decision that needs judgment, it is not surprising that some people disagree with the adequacy of the disclosure. cnLcLwqf6SLChts0c+mcXyhuB4EiddEskLXI/fsQ6jAZxpWkdDVIG8sAszeYgeOz