32 ACCOUNTING FOR MANAGERS
year at the end of a calendar or national fiscal year. The business cycle is more
important than the financial year, which after all is nothing more than the time
taken for the Earth to revolve around the Sun. If we consider the early history
of accounting, merchant ships did not produce monthly accounting reports. They
reported to the ships’ owners at the end of the business cycle, when the goods they
had traded were all sold and profits could be calculated meaningfully.
Matching principle
Closely related is the matching (or accruals) principle, in which income is rec-
ognized when it is earned and expenses when they are incurred, rather than on
a cash basis. The accruals method of accounting provides a more meaningful
picture of the financial performance of a business from year to year. However,
the preparation of accounting reports requires certain assumptions to be made
about the recognition of income and expenses. One of the criticisms made of
many companies is that they attempt to ‘smooth’ their reported performance to
satisfy the expectations of stock market analysts in order to maintain shareholder
value. This practice has become known as ‘earnings management’. This has been
particularly difficult in the telecoms industry, where income that should have been
spread over several years has been taken up earlier, or where expenditure has been
treated as an asset in order to improve reported profits. When this last practice
was disclosed, it was a significant cause of the difficulties faced by WorldCom.
Monetary measurement
Despite the importance of market, human, technological and environmental fac-
tors, accounting records transactions and reports information in financial terms.
This provides a limited though important perspective on business performance.
The criticism of accounting numbers is that they arelaggingindicators of per-
formance. In Chapter 4 we consider non-financial measures of performance that
are more likely to presentleadingindicators of performance. An emphasis on
financial numbers tends to overlook important issues of customer satisfaction,
product/service quality, innovation and employee morale, which have a major
impact on business performance.
Historic cost
Accounting reports record transactions at their original cost less depreciation
(which is explained in Chapter 6), not at market (realizable) value or at current
(replacement) cost. The historic cost may be unrelated to market or replacement
value. Under this principle, the Balance Sheet does not attempt to represent the
value of the business and the owner’s capital is merely a calculated figure rather
than a valuation of the business. The Balance Sheet excludes assets that have not
been purchased by businesses but have been built up over time, such as customer
goodwill, brand names etc. Themarket-to-book ratio (MBR)is the market value of the
business divided by the original capital invested. Major service-based companies