What are Accounting Principles?

what-are-accounting-principlesAccounting principles govern the accounting choices of management.

It is important to know that the accounting process is governed by accounting principles that sometimes are very binding and sometimes provide some flexibility. Well known principles include International Financial Reporting Standards (IFRS) and U.S. GAAP (Generally Accepted Accounting Principles).

Sometimes economic assets are not allowed to be recognized as accounting assets by accounting principles. In other words: some assets may not be on the balance sheet. This generally is the case when it is difficult to determine the value of the asset.

Accounting Principle Examples

Research expenditures are never allowed to be recognized as an asset, since it is considered too uncertain whether the research will yield future benefits.

Oil companies are free to decide whether or not they recognize expenditures for unsuccesful drillings as assets.

Finance leases are considered an asset, whereas (short term) operational leases are not.

Self developed (as opposed to purchased) brand names, human capital and research are not allowed to be capitalized for example in the United States and under IFRS (International Financial Reporting Standards).

In ‘The Top 100 most valuable global brands 2009’ the Google brand name is listed as the world’s most valuable brand with an estimated value of $100 billion. U.S. accounting principles (U.S. GAAP) does not allow self-developed brand names to be included on the company’s balance sheet. (When a company purchases a brand name from another party, the value of the brand name is considered less uncertain, and can therefore be capitalized.) The relative size of Google’s brand name relative to their other assets is rather big, as total assets included on the balance sheet at the end of 2008 amount to ‘only’ $31.8 billion.

Asset Valuation

When assets are recognized (i.e. accounting principles allow/require the asset to be shown on the balance sheet) the basis for valuation needs to be determined. The two most common bases are historic cost and fair value.

With historic cost, the amount originally paid for the asset is the basis for valuation. If the market value of an asset drops below the book value of an asset, the company needs to lower (‘write down’, or ‘impair’) the value of the asset to the lower market value. (The rule that prescribes this is called the ‘lower-of-cost-or-market rule’.)

The definition of fair value is the amount for which an asset or liability could be exchanged between knowledgeable, willing parties in an arm’s length transaction. Hence, when fair value is the basis for valuation, it is possible that assets are valued above cost, whereas this is not possible with historic cost as the basis.

Asset Valuation Example

Consider the situation where a firm has purchased goods for 1,000 cash. In the situation that the value of these goods drop to 800, the goods need to be written down to 800 under historic cost as well as fair value.

However, if the value were to increase, for example to 1,100, the valuation will differ. Under historic cost, the ‘cap’ is cost, thus the value cannot exceed 1,000. Hence, under historic cost the goods will be included for 1,000. Under fair value however, such a cap does not exist. Therefore the goods will be included for 1,100 when using fair value.