Valuation Principles

1. Going Concern Principle

The going concern assumption establishes that an entity will continue to operate in the foreseeable future, meeting its financial obligations as they fall due. The basis of this assumption lies in the idea that the company does not have the intention or the need to liquidate its assets or significantly reduce the scale of its operations.

If a company cannot sustain the going concern assumption, the valuation of its assets must be carried out at its liquidation value, which is generally lower than the value they would have if used to generate future income.

The going concern principle has several important implications for financial reporting. It allows the classification of assets and liabilities into current (short-term) and non-current (long-term) categories, based on the expectation that the company will continue its operations beyond the next year. Furthermore, this principle justifies the systematic depreciation and amortization of assets over their estimated useful life, as these assets are expected to be used to generate income over several periods. Under this assumption, assets are initially recorded at their historical cost, which is the price paid at the time of acquisition, rather than at their current market value or an estimated liquidation value.

This principle also influences the decision of how certain disbursements are treated. If an expense is expected to provide benefits to the company for more than one period, it can be capitalized as an asset and then recognized as an expense (through depreciation or amortization) over time. However, if the company is not expected to continue operating, the distinction between a capital expenditure (which creates an asset) and an operating expense (which is recognized immediately) becomes less relevant, as the future benefit of the asset will not materialize.

2. Accrual Principle

The accrual principle, also known as the matching principle, is a fundamental concept in accounting that requires revenues to be recognized in the period in which they are earned and expenses in the period in which they are incurred, regardless of when the cash is received or paid.

This principle is essential for providing a more accurate and complete picture of a company's financial performance during a specific accounting period. Accrual accounting is based on two key principles: the revenue recognition principle, which dictates when revenue should be recorded, and the matching principle, which states that expenses should be recognized in the same period as the revenues they are related to.1

The accrual principle allows for a better matching between the efforts made by a company (represented by expenses) and the results obtained (represented by revenues) during a given period, which in turn provides a more realistic and accurate view of the company's profitability. In the context of investment, this principle is crucial as investment is made with the expectation of a future return.

2.1 Revenue Recognition:

Under the accrual principle, revenues are recognized in the accounting period in which the performance obligations are satisfied, that is, when a company has delivered the goods or provided the services to its customers. This recognition may occur at a different time than when the company receives cash. For example, if a company sells products on credit in a given month, it will recognize the revenue in that month, even if it does not receive payment until the following month. This treatment contrasts with cash accounting, which only recognizes revenue when cash is received, without considering when it was actually earned.

2.2 Expense Recognition:

Similarly, the accrual principle states that expenses should be recognized in the accounting period in which they are incurred, regardless of when2 the cash payment is made. Furthermore, the matching principle requires that expenses be recognized in the same period as the revenues to which they are directly related. This includes accrued expenses, which are those expenses that a company has incurred during an accounting period but has not yet paid at the end of that period.

3. Uniformity Principle

The uniformity principle, also known as the consistency principle, states that once an entity has adopted a specific accounting principle or method, it must use that same principle or method consistently in future accounting periods to record and report similar transactions. This fundamental principle ensures that a company's financial statements are comparable over time. If a company decides to change an accounting method, it must have a valid justification for the change and must disclose the nature of the change, the reasons for making it, and its effect on the financial statements.

Examples of Application of the Uniformity Principle:

The uniformity principle is applied in various areas of accounting. A common example is the consistent use of a specific method for inventory valuation, such as the First-In, First-Out (FIFO) method or the Last-In, First-Out (LIFO) method, over several accounting periods. Another example is the uniform application of a particular depreciation method.

4. Prudence Principle

The prudence principle, also known as the conservatism principle, is a fundamental concept in accounting that requires the exercise of caution and moderation when making judgments and estimates under conditions of uncertainty. This principle dictates that a company's revenues and assets should not be overstated, while liabilities and expenses should not be understated. In essence, the prudence principle advocates anticipating potential losses and recognizing them early in the financial statements, while gains should only be recognized when their realization is virtually certain.

4.1 Application in the Valuation of Assets and Liabilities:

The prudence principle has a direct application in how both assets and liabilities are valued in the financial statements. In general, assets are reported at the lower of their historical cost and their current market value. This practice avoids overstating the value of assets on the balance sheet.

Furthermore, under this principle, companies must recognize provisions for potential losses, such as bad debts, as soon as they are considered probable, even if the actual loss has not yet materialized.

Regarding revenues, the prudence principle requires that they only be recognized in the financial statements when their realization is virtually certain, rather than merely probable or projected.

5. Non-Compensation Principle

The non-compensation principle, an essential component of Generally Accepted Accounting Principles (GAAP), states that all aspects of an organization's financial performance, whether positive or negative, must be reported in full in the financial statements, without the possibility of offsetting debts with assets or income with expenses. This fundamental principle is designed to ensure maximum transparency in financial reporting, providing users of financial statements with a complete and undistorted view of an entity's true financial situation. The underlying idea is that offsetting could conceal important information and lead to a misinterpretation of a company's performance and financial position.

On the balance sheet, assets and liabilities must be shown separately, without allowing one to be offset against the other, unless very specific criteria are met.

Similarly, in the income statement, revenues and expenses must be reported separately, without allowing a substantial source of income to be merged with a significant expense to present a more favorable picture of financial performance. This detailed presentation allows for the evaluation of its operating performance, including the profitability of its sales and the efficiency in managing its costs.

5.1 Exceptions to the Non-Compensation Principle:

While the non-compensation principle is an important general rule, there are certain specific exceptions that are permitted under accounting standards. The offsetting of assets and liabilities, or of income and expenses, is only allowed when there is a legally enforceable right of set-off and the intention to settle the items on a net basis or to realize the asset and settle the liability simultaneously. This exception commonly applies to certain financial instruments, such as derivatives, futures, or shares, which are often subject to legally binding master netting agreements between the parties (commissions, spread, etc.).

6. Materiality Principle

The materiality principle states that only information that is significant enough to influence the economic decisions of users of financial statements should be included in those statements. In other words, information is considered material if its omission or misstatement could reasonably be expected to influence the decisions that the primary users of general purpose financial statements make on the basis of those statements. Materiality is not based solely on the size or magnitude of an item (quantitative factors), but also considers its nature and the context in which it occurs (qualitative factors).

This principle introduces an important element of professional judgment in accounting, recognizing that not all information is equally relevant to users of financial statements. It allows companies to focus on presenting information that truly matters to stakeholders in their economic decisions. For investors, the materiality principle is fundamental as it helps them focus on the financial data that has a significant impact on a company's valuation and investment decisions, avoiding the overload of non-essential information.

6.1 Application of the Materiality Principle

The materiality principle is applied at various stages of the accounting and financial reporting process. Companies must determine what information is material enough to warrant disclosure in the financial statements, either in the main body of the statements or in the accompanying notes. In doing so, they must decide whether an omission or misstatement in the information could be significant enough to affect the decisions made by reasonable users of the financial statements. Furthermore, the concept of materiality also influences the scope of audit procedures, as auditors will focus on areas where there is a higher risk of material misstatements that could significantly affect the financial statements.

The application of the materiality principle requires significant professional judgment and can vary considerably between different companies, depending on factors such as their size, nature, industry, and specific circumstances. What is considered material for a small company may not be for a large corporation, and vice versa. Therefore, investors should be aware that materiality is, to some extent, subjective and that different people may have different interpretations of what is considered important in the context of a company's financial statements.

6.2 Criteria for Determining Materiality

There is no single, strict rule for determining whether an item of information is material; instead, the assessment is largely based on the professional judgment of accountants and auditors. In making this determination, several factors should be considered, including the absolute size of the amount in question, its relative size compared to other relevant items in the financial statements (such as revenue or net profit), the nature of the item (for example, whether it relates to fraud or a breach of contract), the industry in which the company operates, the quality of its internal controls, and its overall financial performance. The assessment of materiality should take into account both quantitative (the amount) and qualitative (the nature and impact of the error or omission) factors.