Accounting, like most any other field of study, is anchored in a set of broad assumptions, concepts, and principles from which all rules are derived. It is almost impossible to develop an expertise in accounting without being cognizant of those fundamental precepts. Once you comprehend the essence of that set of broad accounting assumptions, concepts, and principles, only then will you be on the path to becoming a black belt in the mastery of all things accounting.
Let’s first answer the question: what are the objectives of financial reporting?
The Financial Accounting Standards Board’s (FASB) first Statement of Financial Accounting Concepts (SFAC 1) state that financial reporting should provide (1) information useful in investment and credit decisions, (2) information useful in assessing cash flow prospects (amount, timing, and uncertainty), and (3) information about enterprise resources (Assets), claims to those resources (Liabilities), and changes therein (profit or loss).
Second, let’s explore some of the underlying assumptions of accounting which form the basis for Generally Accepted Accounting Principles (GAAP):
Entity Unit Assumption – as the name indicated, the business is separate and distinct from its owner(s), which in effect means that the entity accounts and finances are totally segregated from those of its owner(s). Thus, the business is treated as a separate person.
Time period assumption - meaning that business profit or loses are measured on a recurring basis, for example one year, six months, 3 months.
Going Concern Assumption – meaning that the business is going to be operated for a non predefined period, in other words, there is no ending date to the life of the business.
Monetary Assumption – assume the dollar is stable over time.No adjustments are made for inflation or deflation.
Third, let’s examine the key principles of accounting:
Historical cost principle requires companies to account for most assets and most liabilities at cost rather than fair market value. This principle provides information that is reliable (removing opportunity to provide subjective and potentially biased market values), but not always relevant. Consequently, there is a trend to use fair values. Most debts and securities are now reported at market values.
Revenue recognition principle requires companies to record revenue when it is (1) realized or realizable and (2) earned, but not when cash is received. Accrual basis accounting is a byproduct of this principle.
Matching principle requires expenses be matched with revenues as long as it is reasonable to do so. Expenses are recognized not when the work is performed, or when a product is produced, but when the work or the product actually makes its contribution to revenue. Only if no connection with revenue can be established, cost may be charged as expenses to the current period (e.g. office salaries and other administrative expenses). This principle allows greater evaluation of actual profitability and performance (shows how much was spent to earn revenue). Depreciation and Cost of Goods Sold are good examples of practical applications of this principle.
Full Disclosure principle requires that amount and kinds of information disclosed should be decided based on trade-off analysis as a larger amount of information costs more to prepare and use. Information disclosed should be enough to make a judgment while keeping costs reasonable. Information is presented in the main body of financial statements, in the notes or as supplementary information
Last, let’s explore some of the constraints inherent to accounting:
Objectivity – the company financial statements provided by the accountants should be based on objective evidence.
Materiality – the significance of an item should be considered when it is reported. An item is considered significant when it would affect the decision of a reasonable individual.
Consistency – the company uses the same accounting principles and methods from period to period.
Conservatism - when choosing between two solutions, the one that will be least likely to overstate assets and income should be picked
Anybody interested in developing competent knowledge in the field of accounting should take the necessary time to obtain a very good understanding of these assumptions, concepts, and principles from which all accounting rules are derived. Some of the information contained in this blog post is based on articles published by Wikipedia. If you have any questions about accounting, try querying Wikipedia. You may be surprised by the treasure trove of information cataloged by this Open Source encyclopedia. Feel free to submit a comment below if you have any questions or if you wish to make a contribution to the discussion.