Accounting Principles & Window Dressing

Accounting Principles

This section contains a survey of the underlying principles involved in accounting. It is possible to succeed with many accounting exercises without referring to these principles; however, these principles are natural and common-sense rules which book-keepers, accountants and business people are required to follow in their detailed practice.

The principle of going concern. This is the assumption that the business is not about to fail, and that all of the assets of the company can be valued on that assumption.

As soon as a business buys a new asset, that asset's market value goes down. This happens, for example, with the purchase of new cars. As soon as the car leaves the car-dealer's showroom its resale value drops considerably. However, in the accounts the actual value, and not the resale value of all assets is recorded. So the figure for the total fixed assets values everything at the price it was paid for. The loss of value due to wear and tear is recorded as depreciation, but the resale value of these assets, in the event of liquidation, might be very different.

The principle of consistency of method. As this implies, the same methods must be used to calculate such things as stocks and depreciation from year to year. New methods can be employed, but if so, these must be indicated in the accounts. If consistency of method is not applied there is scope for intentional or unintentional fraud.

The principle of verification requires that all statements in the accounts must be capable of confirmation by independent persons. This also means that the totals of the revenues and expenditures must be capable of being matched with the figures in the books, ledgers and journals of the business.

The principle of prudence requires that accounts always record the least favourable position. That means, that if stock has become damaged, it is recorded at a reduced value, and not its purchase or normal sale value. Accounts act as a source of information to business people, proprietors, investors and so forth. Prudence requires that you are realistic about your assets and profits, and that you do not shy away from hard facts.

The principle of matching requires that revenue must be matched with expenditure and vice-versa. Accounts divide the activity of the business into accounting periods, which may be days, months, quarters or years. The balance sheet in effect takes a snap shot of the business at the end of each accounting period. The principle of matching requires that the snap shot should not include items that do not belong to that period. Thus a prepayment for an item that will be manufactured in the next accounting period does not belong to this accounting period, and should not be included in this accounting period.

The principle of realization states that firstly an increase in sales revenue occurs at the moment that a sale is made. That is, as soon as you have sold the good, and entered into a contract with the customer to supply that good at a price (which is the customer's obligation), a sale is recorded in the ledger, whether or not the good has been paid for. Similarly, as soon as a stock item has been purchased a debit is recorded in the purchase ledger and an expenditure has occurred, even if the company does not actually pay for the good for several months.

Questions

1. Why can the principle of going concern lead to an over-valuation of a company, especially in the event of a liquidation?

When the assets of a company are valued as a going concern they are valued at the price you paid for them, less any depreciation that is taken into account. However, when a company is forced out of business then usually what happens is that its assets cannot be sold for the amount they are recorded at in the accounts. For example, suppose a school buys six tables at $50 each and depreciates them at 25% every year. They pay $300 at the start for them, and at the end of the second year record a figure of $225 in their books for their value, which takes into account their depreciation. But if the school was forced out of business then it would be very unlikely to get even a fraction of the $225 for the tables. So the principle of going concern can lead to an overvaluation.

2. Why do Companies have to annotate the accounts they submit to the Tax authorities detailing the methods they used in compiling them?

This is to prevent fraud. The value of the profits recorded by the Company depend on the way in which those profits are calculated. The company can, by changing its methods of, for example, stock evaluation, either inflate or deflate the figures for the profits. Hence, every change to the methods of accounting should be recorded.

3. How does the principle of verification help to prevent fraud?

This means that the tax inspectors should be able to check every entry in the accounts against a physical record of a financial transaction. If a company makes a purchase it needs to keep the receipt. The receipt is logged in a ledger, and from the ledger the final accounts are prepared. The Inland Revenue are able to check (verify) the transaction against the receipt. The need to meet this requirement prevents fraud as a deterrent, since it is easy to cheat, but also cheating can be discovered and punished.

4. What does the principle of verification mean in terms of stock valuation?

It means that items bought in one year for the purpose of increasing stock must be recorded as increases in stock, and vice-versa for decreases of stocks. So changes in the levels of stocks must be recorded.

5. Explain how the principle of matching leads to the Balance Sheet representing a “snap shot” of the business at the end of each accounting period?

A Balance Sheet is like a photograph (snap shot) of the financial health (or otherwise) of a business. The principle of matching means that only payments that relate to one year's activities can be recorded as belonging to that year. If you buy raw materials that will be used in the next year's production, these raw materials should be recorded as stocks in the balance sheet and cannot be deducted as costs in the profit and loss account. This means that for every financial period — year, month, day or hour — the balance sheet is an exact picture of what took place and where the company is at.

6. In what ways is the principle of realization based on the law of contract? The law of contract deems that a sale is made as soon as the contract is agreed. Once you have agreed the contract with a customer, the customer is legally obliged to pay your bill, and you are legally required to supply the goods or services.

Window dressing

The principles of accounting all work to create accounts that are an accurate reflection of the financial position of the company. Profits are neither exaggerated nor underestimated; the balance sheet clearly distinguishes between the different kinds of assets.

In contrast to this, there are techniques in accounting that can be used to present the financial position of the company in a favourable light. This is called window dressing. One example of a window dressing principle in accounting is goodwill.

Goodwill

Goodwill is an indication of the value of the company that arises over and above what the value of its fixed and liquid assets might be. It represents the value attaching to the successful running of the company. For example, an established company will have a list of satisfied and continuing clients. The value of the company lies as much in this list of clients as in the physical assets.

Companies increase their value by creating brand names and labels. The value of the brand name is also represented as goodwill.

Another example of goodwill is a doctor's list of patients. When one doctor takes over another doctor's practice, what he pays for is the value of the list of patients (clients) that the doctor selling his practice has built up.

On the other hand, sometimes it is appropriate to write off goodwill. What this means is that goodwill is regarded as being fully depreciated. So it is entered as an asset, and then subtracted immediately as an item to be depreciated. The effect of this is to record that a payment has been made for the goodwill, but it has also be decided not to record this as part of the value of the company's assets.

Goodwill is an example of an intangible asset. It is not a physical asset. It is, however, an asset, and one company might pay a good deal of money for a well-developed brand name, so intangible assets can be bought and sold just like tangible ones.

Question

Is goodwill nothing more than window dressing?

Although goodwill can be used as window dressing in accounts, it is certainly arguable that it represents a real asset of the company as the above examples illustrate. When a doctor sells his practice to another doctor he is selling very little more than goodwill — a list of clients. However, if this was all mere window dressing, no one would pay for a list of names, but people do. If one company was to buy a chain of cinemas, say, for example, the Odeon chain, then they would certainly obtain a lot of physical assets for their money. But more importantly they would be purchasing the reputation of the company as a provider of entertainment, and this would make the purchase of the company much more expensive than merely buying physical cinemas and the like. So goodwill may be an intangible asset but it is not necessarily an unreal asset. It is valuable and can and will be paid for. This links to the concept of branding, which is one of the key concepts in marketing.

Artificial methods of boosting liquidity

The liquidity of a company is an indicator of the company's ability to pay bills and the efficiency of its production processes. Liquidity is the subject of another chapter, and it is assumed the student understands liquidity here.

However, companies with poor liquidity may be tempted to make their liquidity appear better than it really is just prior to the publication of accounts. Students should be aware of this.

One way to achieve this is to sell assets just before the accounting period comes to an end. Since the assets are needed for the functioning of the company, it may be that they company will lease back the assets immediately after sale. For example, a company might sell several mini-buses, thus boosting the cash in their current account and increasing liquidity. Since it needs those buses to run its business it will lease them back. This creates a longer term regular liability — the rent on the buses — and so reduces the liquidity of the company in the longer run. However, by this means and others the company may prevent shareholders from spotting dangerous threats to the liquidity of the company.