16. Accounting assumptions and principles (3.5.2.)

Accounting principles are built on a foundation of a number of basic concepts. One of them is known as the consistency principle. Companies can choose their accounting policies – their way of doing their accounts. But in choosing accounting policies they have to be consistent – which means using the same methods every year, unless there is a good reason to change a policy. The policies have to be disclosed to the shareholders in the “Statement of Accounting Policies” included in Annual Report.

The historical cost principle states that companies record the original purchase price of assets and not their (estimated) current selling price or replacement cost. The current price is not important if the business is going concern – a successful company that will continue to do business – as its assets are not going to be sold, or do not currently need to be replaced. Some countries with regular high inflation use replacement cost accounting, which values all assets at their current replacement cost – the amount that would have to be paid to replace them now.

Other accounting principles are as follows. The full-disclosure principle states that financial reporting must include all significant information. The principle of materiality says that very small and unimportant amounts do not need to be shown. The principle of conversation (prudence) is that where different accounting methods are possible, you choose the one that is least likely to overstate or over-estimate assets or income. The objectivity principle says that accounts should be based on facts and not on personal opinions or feelings. The revenue recognition principle is that revenue is recognized in the accounting period in which is earned. This means the revenue is recorded when a service is provided or goods delivered, not they are paid for. The matching principle states that each cost or expense related to revenue earned must be recorded in the same accounting period as the revenue it helped to earn.

17. Financial accounting (3.3)

Financial accounting information is intended both for managers and for the use of parties external to the organization, including shareholders (and trustees in nonprofit organizations), bankers and other creditors, government agencies, and the general public. Investors in an enterprise need information about the financial status and future prospects of an organization. Bankers and suppliers grant loans and extend credit to organizations based on their financial soundness. Even customers and employees concerned about the condition of an organization make use of accounting information. The external users of accounting information and the types of questions for which they seek answers can be classifies as:

1. Stockholders, prospective stockholders in a corporation, and their advisers – financial analysts and investment counselors. Should an ownership interest be acquired in this firm? Or, if one is now held, should it be increased, decreased, or retained at its present level? Has the firm earned satisfactory profits?

2. Creditors and lenders. Should a loan be granted to the firm? Will the firm be able to pay its debts as they become due?

3. Employees and their unions. Does the firm have an ability to pay increased wages? Is the firm financially able to provide permanent employment?

4. Customers. Is this firm offering desirable goods and services at reasonable prices? Will the firm survive to honor its product warranties?

5. Governmental units. Is a public utility earning a fair rate of return on its capital investments? Can a firm install costly pollution control equipment and remain profitable?

Besides keeping track of accounting information the accountant is also called upon to prepare various reports. There are three basic reports that the business organization uses on a regular basis: income statement, statement of capital and balance sheet.

Financial statements provide information on a firm’s financial condition (or position), on changes in this position, and on results of operations (profitability). All businesses maintain records based on an accounting period of 12 months that follows either the calendar year or any other complete 12-month period known as fiscal year. Many companies publish these statements in annual report. This report also contains the auditor’s opinion as to the fairness of the financial statements. In addition the accountant may be called upon to prepare financial statements, known as interim reports, for a period of time less than a complete accounting period.

Financial accounting information generally relates to the firm as a whole, since outsiders can make decisions only on matters pertaining to the firm in its entirety, such as whether to extend credit to it. Such information, usually historical, is a report upon what has happened. Because interfirm comparisons are often made, the information supplied must conform to certain standards. In the USA there are Generally Accepted Accounting Principles (US GAAP). In most of the rest of the world there are International Financial Reporting Standards (IFRS). There is basic similarity of GAAP throughout the world though in some respect they may differ from country to country.