Finance basics for lawyers: the key principles in accounting

Although strict legal frameworks govern accounting practices, there are many grey areas. Being aware of these, and having a working knowledge of general accounting principles, will help you support your finance colleagues. It will also help you to understand and manage the many areas of legal work where legal and accounting principles touch on the same business issue but deal with it differently.

The guidelines for accountants are extensive but there are five main principles that underpin accounting practices and the preparation of financial statements:

Together they cover revenue recognition, fluctuating value of assets, provision for exceptional costs and how to account for leased equipment over short and long-term agreements. Lawyers should have a good understanding of these principles as they affect many business decisions that need to be documented in legal form. They should also be helping to spot and avoid problems, rather than drafting them into contracts.

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? According to the accrual principle, you should recognise income when it's earned, regardless of when you receive it, and expenses when you incur them, regardless of when you pay them.

The recognition of transactions in financial statements is tied to when the relevant business activities take place, not the date when money changes hands. 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.

Your organisation buys production equipment in one quarter and uses it for the next 24 quarters. When does the expenditure take place for the purpose of its accounts? The matching principle aims to align revenues and expenses. This means you should recognise your expenses in the same periods as those in which you are earning revenues from them and vice-versa. Your organisation should spread the cost of the equipment equally over the 24 quarters.

Your organisation's head office building increases slightly in value due to a general increase in property values. Should the organisation reflect this in the accounts? Accounting is concerned with past events and requires both consistency and comparability. To achieve this, financial statements normally adopt the historic cost principle.

This principle requires organisations to record their transactions at their historic cost. Historic 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 in value, the increase isn't reflected in the financial statements, except where allowed or required by accounting standards. However, any permanent impairment in value of an asset is recognised in the accounts.

The concept of historical cost is important. Market values, particularly for property, change often and allowing organisations to report their assets and liabilities at current values would distort the fabric of accounting, impair comparability and make financial statements unreliable. Your organisation should therefore not reflect the increase in value of its head office building in its accounts.

Your organisation is preparing for the high legal costs of future lawsuits arising from a major environmental incident. Should these potential costs be recognised in the accounts? Accounting transactions like this could, in theory, be recorded in one of several ways. This means that, without any controls, different accountants could make radically different choices in recording the same item.

The conservatism principle (also known as the prudence concept) requires accountants to choose the approach that produces the lowest net income or net assets. They should recognise anticipated costs (such as legal fees and settlement costs) immediately and only recognise anticipated 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.

Your organisation uses a piece of machinery that it 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 substance of transactions and events in financial statements, rather than just their legal form.

If the lease is only for a few months, your financial statement should show the whole rental fee your organisation pays as an expense, with no asset listed. However, if 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.

Many accounting and reporting scandals or frauds involve the business pushing the boundaries of these accounting principles, either deliberately or through ignorance or over-optimism. Frequently a business's finance function is segmented in a way that inadvertently compounds this problem by making joined-up financial thinking more difficult. For example, there are often separate departments for:

Often a purchase, sales, M&A, disposal, employment, treasury, lease, incentive plan or other legal agreement will be the means by which these problems are accidentally or deliberately created. As Finance (in all its forms) may not spot these issues unaided (and may sometimes even be the architects of the problems) it is important for lawyers to be well-versed in them. To avoid creating problems for the business, lawyers need to understand who owns the issues in the business, what the policy positions are and who to escalate them to.