Basic Accounting Concepts and Assumptions PDF

t os Financial Accounting V.G. Narayanan and Dennis Campbell, Co-Series Editors rP Basic yo op Accounting...

t os Financial Accounting V.G. Narayanan and Dennis Campbell, Co-Series Editors rP Basic yo op Accounting Concepts and tC Assumptions No DAVID F. HAWKINS HARVARD BUSINESS SCHOOL Do 5060 | Published: June 8, 2017 1  t Table of Contents os 1 Introduction...................................................................................................................................................................... 3 2 Essential Reading........................................................................................................................................................ 4 2.1 Basic Accounting Concepts..................................................................................................................... 4 rP 2.1.1 Business Entity...................................................................................................................................... 5 2.1.2 Going Concern....................................................................................................................................... 5 2.1.3 Monetary Unit......................................................................................................................................... 6 2.1.4 Historical Cost........................................................................................................................................ 7 yo 2.1.5 Accounting Period............................................................................................................................. 8 2.1.6 Consistency........................................................................................................................................... 10 2.1.7 Matching................................................................................................................................................... 11 2.1.8 Dual Aspect........................................................................................................................................... 12 op 2.1.9 Reliability of Evidence................................................................................................................ 14 2.1.10 Disclosure............................................................................................................................................. 15 2.1.11 Materiality............................................................................................................................................ 16 tC 2.1.12 Conservatism.................................................................................................................................... 16 2.2 Financial Analysis........................................................................................................................................... 18 2.3 Summary................................................................................................................................................................. 20 3 Supplemental Reading......................................................................................................................................... 21 No 3.1 Qualitative Characteristics of Useful Financial Information................................... 21 4 Key Terms........................................................................................................................................................................ 23 5 Endnotes........................................................................................................................................................................... 24 6 Index..................................................................................................................................................................................... 25 Do David F. Hawkins, Lovett-Learned Professor of Business Administration, Harvard Business School, developed this Core Reading. Copyright © 2017 Harvard Business School Publishing Corporation. All rights reserved. 5060 | Core Reading: BASIC ACCOUNTING CONCEPTS 2  t 1 INTRODUCTION os T o understand any complex field that involves a diversity of practices and approaches, it’s important first to understand the rP field’s fundamental ideas, its basic premises. In financial accounting, some basic concepts and assumptions constitute a framework that informs the work of everyone involved. These concepts and assumptions guide the organizations that set accounting standards, yo such as the Financial Accounting Standards Board (FASB) in the United States and the International Accounting Standards Board (IASB); they give preparers of financial statements a shared foundation for the reporting of data; and they help users fully op appreciate the information that financial statements convey. These basic accounting concepts and assumptions are not the same as accounting standards or principles. For example, a manager of a US company who wants to know tC how to account for inventory cannot turn to the basic concepts to create or justify some version of inventory accounting. Instead, he or she must refer to Accounting Standards Codification Topic 330, “Inventory,” in the FASB’s generally accepted accounting principles, known as US GAAP. Accounting principles provide guidance on accounting policy decisions for a specific transaction or event; the basic concepts are the broader framework that defines both the value and the limitations of financial No statements. Where did these concepts and assumptions originate? Some have developed over years of practice. Some have been identified by the FASB in its Statements of Financial Accounting Concepts (SFAC). The IASB has issued an almost identical set of publications called Conceptual Framework for Financial Reporting (CFFR). This reading covers the key concepts and assumptions observed in practice, regardless of Do their source. Although accounting’s basic concepts and assumptions have remained largely unchanged for decades, if not centuries, they can change over time. For example, recently the use of the fair value measurement concept has replaced the historical cost concept in many accounting applications. 5060 | Core Reading: BASIC ACCOUNTING CONCEPTS 3  t The basic accounting concepts and assumptions described in this reading apply to os general purpose financial statements. According to the FASB, “The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders, and other creditors in making decisions about providing resources to the entity. Those decisions involve buying, selling, or holding equity and debt investments and making or rP settling loans and other forms of credit. General purpose financial reports are not designed to show the value of a reporting entity; but they provide information to help existing and potential investors, lenders, and other creditors to estimate the value of the reporting entity.” 1 General purpose financial statements prepared using either US GAAP or Interna- yo tional Financial Reporting Standards (IFRS) are for the most part based on a similar set of concepts and assumptions. Students wishing to gain a deeper or more formal understanding of the FASB and IASB Concepts Statements should consult the sources listed toward the end of this reading. op 2 ESSENTIAL READING tC 2.1 Basic Accounting Concepts In this reading, we cover 12 basic accounting concepts and assumptions that anyone in a field in which financial statements play a role—general management as well as No finance and accounting—needs to understand. 1 Business Entity 7 Matching 2 Going Concern 8 Dual Aspect 3 Monetary Unit 9 Reliability of Evidence 4 Historical Cost 10 Disclosure Do 5 Accounting Period 11 Materiality 6 Consistency 12 Conservatism 5060 | Core Reading: BASIC ACCOUNTING CONCEPTS 4  t 2.1.1 Business Entity os This concept defines the accountant’s area of interest: a business entity that is separate and distinct from its owners. The concept thus sets limits on the possible objectives and contents of financial reports. The accountant’s role is to prepare financial statements for the business entity—the affairs of the owners are irrelevant to rP those statements. The business entity concept applies equally to incorporated, unincorporated, small, and big businesses. In the case of incorporated, widely held, and publicly owned companies, such as General Motors, it is not difficult to separate the affairs of the business from those of its owners. yo In the case of small businesses, in which the owners exert day-to-day control and personal and business assets are often intermingled, the boundaries of the business entity may be more difficult to define, for financial—as well as managerial— accounting purposes. In those cases, the accountant must try to tease apart the owners’ and the entity’s assets and liabilities. op 2.1.2 Going Concern Unless evidence suggests otherwise, those preparing and auditing general purpose financial statements for a business entity assume that the entity will continue tC operations into the foreseeable future. The going concern assumption reflects management’s and investors’ normal expectation about the life of a business. To avoid misleading readers of financial statements, the financial statements of business entities with limited lives must clearly indicate the terminal date and type of liquidation involved. Otherwise, the reader will assume that the accounts are based on the presumption that the enterprise has an indefinitely long life. No The going concern assumption reflects the emphasis in accounting on the continuing nature of business activity. For example, the accountant expects that in the normal course of business the company will receive the full value of most of its accounts receivable. Accordingly, these items are recorded at their face value, less some deduction for anticipated bad debts, rather than at current liquidation value. Similarly, expenditures for finished goods inventories are recorded as assets, since the Do accountant assumes the inventories will be disposed of in the normal course of operations. The going concern assumption does not imply, however, that the future will be the same as the past. 5060 | Core Reading: BASIC ACCOUNTING CONCEPTS 5  t 2.1.3 Monetary Unit os Accounting is a measurement process dealing only with events that can be measured in monetary terms. The monetary unit concept reflects the fact that money is the common denominator used in business to measure the exchange value of goods, services, and capital. Obviously, financial statements should indicate the currency on rP which they are based. For example, Exhibit 1 shows the 2015 consolidated statement of financial position (balance sheet) for The Daimler Group, the manufacturer of Mercedes-Benz cars and trucks. The report notes that the amounts are in euros. EXHIBIT 1 Consolidated Balance Sheet for The Daimler Group yo B.34 Consolidated statement of financial position Dec. 31, 20X5 Dec. 31, 20X4 X5/X4 In millions of euros % change Assets op Intangible assets 10,069 9,367 +7 Property, plant and equipment 24,322 23,182 +5 Equipment on operating leases and 112,456 94,729 +19 receivables from financial services Equity-method investments 3,633 2,294 +58 Inventories 23,760 20,864 +14 tC Trade receivables 9,054 8,634 +5 Cash and cash equivalents 9,936 9,667 +3 Marketable debt securities 8,273 6,634 +25 Other financial assets 7,454 5,987 +25 Other assets 8,209 8,277 –1 Total assets 217,166 189,635 +15 No Equity and liabilities Equity 54,624 22,584 +23 Provisions 26,145 28,393 –8 Financing liabilities 101,142 86,689 +17 Trade payables 10,548 10,178 +4 Do Other financial liabilities 12,360 10,706 +15 Other liabilities 12,347 9,085 +36 Total equity and liabilities 217,166 189,635 +15 Source: Daimler Annual Report 2015. 5060 | Core Reading: BASIC ACCOUNTING CONCEPTS 6  t The monetary unit concept highlights one of the limitations of accounting—its os inability to record or communicate factors such as the state of the company president’s health, the attitude of the labor force, or the relative advantage of comp- etitive products. Consequently, the most important aspects of a business may not be reflected in the financial statements. rP Another limitation of the monetary unit concept as applied in US GAAP is that it fails to distinguish between the purchasing power of monetary units in different periods. This can become a significant problem in trying to interpret financial statements during periods of high inflation. For example, expenses may include dollars spent recently to acquire goods and services as well as dollars spent in earlier periods when the dollar purchased more goods and services. IFRS allows the yo monetary unit to be stated in inflation-adjusted units of purchasing power. 2.1.4 Historical Cost For accounting purposes, business transactions are measured initially in terms of op their actual (historical) cost, a value that is usually easily documented by reliable sources such as contracts, invoices, and other readily available sources. This basic accounting concept applies not only to the initial recording but also in many cases to the subsequent reporting of transactions. While agreeing with the need to record historical cost initially, the FASB and IASB have concluded that financial statements tC would be “more useful” if, under certain conditions, such as in the case of readily marketable securities, actual or estimates of current value were substituted for historical costs. As a result, financial statements are said to conform to the “mixed attributes” accounting model. That is, some balances, such as property, plant, and equipment, No are reported under US GAAP on a historical cost basis while others, such as marketable securities held for trading purposes, are reported on some measure of current value. It is important that financial statement users learn when and which accounts are stated at their historical cost or at current value. In the case of monetary assets, accounting is more likely to report them periodically at some measure of their current value. For example, under certain cond- itions, marketable securities can be reported at their market value on the balance Do sheet date. The market value of many assets may change over time. Typically, in the case of nonmonetary assets, US GAAP does not recognize such changes. As a result, the 5060 | Core Reading: BASIC ACCOUNTING CONCEPTS 7  t value of nonmonetary assets shown on financial statements seldom reflects the assets’ os current market value. In practice, there have been a number of modifications to the historical cost concept. For example, under special conditions, inventory may be reported at market values if those are lower than historical costs. Assets acquired for stock are recorded rP at the estimated market value of the stock exchanged. Mutual funds and pension funds whose assets consist almost entirely of securities report the market value of their investments, taking the unrealized gain or loss into income at the end of each reporting period. Similarly, donated assets may be carried at their appraised value at the time of acquisition, and IFRS allows depreciable assets to be reported at their fair value using what is called the revaluation model as long as fair value can be measured yo reliably. Measuring “cost” can pose some problems. For example, issues can arise as to which cost elements should be included in the cost of assets created by the company rather than bought from outsiders. If an asset is acquired through a swap, then the value to be placed on the asset given up or received may be unclear. op 2.1.5 Accounting Period For decision-making purposes, managers and investors need periodic “test readings” of the progress of the business. Accounting recognizes this, breaking the flow of tC business activity into a series of reporting periods or fiscal years that are usually 12 months in length. Most companies also issue quarterly financial statements to stockholders. For management use, financial statements covering a month or week may be prepared. Regardless of the length of the period, the financial statements must indicate the period covered. Exhibit 2 shows the consolidated statements of income No from an annual report (10-K) for The Gap, Inc., a US clothing retailer. The amounts are expressed in millions and report the net income of the company in accounting periods of 12 months (the fiscal years). The Gap, Inc.’s fiscal year is a 52-week or 53- week period ending on the Saturday closest to January 31. The fiscal years ended January 31, 2015 (fiscal 2014), and February 1, 2014 (fiscal 2013), consisted of 52 weeks. The fiscal year ended February 2, 2013 (fiscal 2012), consisted of 53 weeks. Do 5060 | Core Reading: BASIC ACCOUNTING CONCEPTS 8  t EXHIBIT 2 Consolidated Statements of Income for The Gap, Inc. os Fiscal Year ($ and shares in millions, except per share amounts) 2014 2013 2012 Net sales $16,435 $16,148 $15,651 Cost of goods sold and occupancy expenses $10,146 $9,855 $9,480 rP Gross profit $6,289 $6,293 $6,171 Operating expenses $4,206 $4,144 $4,229 Operating income $2,083 $2,149 $1,942 Interest expense 75 61 87 yo Interest income (5) (5) (6) Income before income taxes $2,013 $2,093 $1,861 Income taxes 751 813 726 Net income $1,262 $1,280 $1,135 Source: The Gap, Inc., Annual Report 2014. op Although it is the practice to report earnings in 12-month segments, breaking business activity into a series of discrete segments creates a number of accounting problems. For example, given the uncertainties surrounding the life of an asset and its scrap value, how should the cost of a long-lived asset be allocated across periods? tC How should the income and costs associated with long-term contracts covering several accounting periods be treated? Such questions must be resolved in light of the particular circumstances and relevant GAAP (or IFRS). There is no easy, general solution. The accountant and business manager must rely on their experience, knowledge, and judgment to arrive at the appropriate answer. No The definition of the accounting period will depend on the nature of the business. For most US companies, the annual accounting period runs from January 1 to December 31. Some companies use a different annual period, usually because their yearly business cycle does not conform to the calendar year. For example, the annual statements of US department stores are more revealing if their fiscal period begins on February 1 and ends January 31. By January 31, inventories are low, and most product returns have been made. Exhibit 3 shows several large public corporations Do and their fiscal year ends. 5060 | Core Reading: BASIC ACCOUNTING CONCEPTS 9  t EXHIBIT 3 Fiscal Year Ends of Selected Public Companies os Company Fiscal Year End Best Buy Co., Inc. January 31 Bed Bath & Beyond, Inc. March 1 Sony Corp. March 31 Wiley April 30 rP Darden Restaurants, Inc. May 25 General Mills, Inc. May 31 Sysco Corp. June 27 Winn-Dixie Stores, Inc. June 29 Estée Lauder Companies, Inc. June 30 Costco Wholesale Corp. August 31 yo Apple, Inc. September 24 Walt Disney Co. September 27 Hewlett-Packard Co. October 31 Deere & Co. October 31 Levi Strauss & Co. November 30 Archer Daniels Midland Co. December 31 op 2.1.6 Consistency The consistency concept states that once an entity has decided on one accounting method, it should use the same method for all subsequent events of the same tC character unless it has a sound reason to change methods. Clearly, comparing inter- period results would be difficult if a company changed its depreciation policy each year, for example. Consistency must not trump flexibility, however. Changes in accounting policies are appropriate when justified by changing circumstances. Accountants place considerable emphasis on consistency because it improves the No reliability of the information reported to external parties. When expressing an audit opinion, the auditor notes whether the statements were prepared “on a basis consistent with that of the preceding year.” If accounting policy changes were made, the auditor notes these in the audit opinion and insists that the nature and impact of these changes are fully disclosed. Consistency does not necessarily require uniformity of accounting practices among Do affiliated business units or even within a unit or company. One unit may value inventory on the LIFO (Last In, First Out) basis, whereas another may use the FIFO (First In, First Out) basis. Similarly, a single unit might use both methods to value different parts of its inventory. In either case, the inventory accounting policy should be disclosed and consistently followed. 5060 | Core Reading: BASIC ACCOUNTING CONCEPTS 10  t Consistency also does not imply uniformity in the treatment of particular items os among independent companies. Indeed, one characteristic of US accounting practice is the diversity of accounting methods in use, all of which meet the criterion of generally accepted accounting principles. 2.1.7 Matching rP The income or profit reported on a financial statement is the net result of the matching of related costs and revenues of a period. This process can be described as matching “effort and accomplishments”—costs measure effort, and revenues measure the related accomplishments. But the process can become complicated, because costs yo often cannot be easily matched with specific current or anticipated revenues. Not all expenses exhibit a cause-and-effect relationship, and in those cases, the matching principle is a bit more difficult to execute. Matching costs and revenues may require deferring recognition of expenses and revenues to future periods. For example, cash may be spent today to obtain subscriptions to a magazine that will op provide subscribers with copies for the next five years. In this case, the accountant will not recognize the cash outlay as an expense until the magazines are due and the expected revenues are earned. At that time, the costs and revenues would be matched. In the meantime, however, the unexpired cost would be reported as an asset (i.e., capitalized), since it will produce future benefits in the form of subscription revenue tC as the magazines are delivered. Whether or not costs should be deferred and, if deferred, over what time period, are difficult questions to resolve in practice. The matching process is usually achieved through application of the accrual method of accounting rather than the cash method. The cash method of accounting records cash receipts and disbursements and focuses on changes in the cash account. No The accrual method seeks to measure changes in the owners’ equity during the accounting period. Revenues are realized from noncapital transactions that result in an increase in the owners’ equity. In contrast, expenses are expired costs that are associated with the period, or with revenues during the period that decrease owners’ equity. The difference between revenues and expenses is the net income for the period. These changes in the owners’ equity may not result in changes in the cash account. For example, a $100 sale on credit will increase accounts receivable and the Do owners’ equity. The accrual method recognizes the fact that the service has been performed and a valuable asset created. Under the cash method, no record of revenue would be made until the customer’s $100 cash was received. Similarly, no record of the related cost would be made until it was paid in cash. 5060 | Core Reading: BASIC ACCOUNTING CONCEPTS 11  t 2.1.8 Dual Aspect os Every transaction affects at least two items in the basic accounting equation and preserves the equation’s equality. This is the dual aspect concept.a The fundamental accounting equation is: Assets = Liabilities + Stockholders’ equity rP Assets represent probable future, measurable economic benefits that the reporting entity has acquired through a transaction. Assets include such items as cash, inventories, and buildings. An asset can represent an expected future economic benefit in several ways: yo 1 The asset may be used to acquire other assets. Cash is the principal example of an asset that derives its value from its purchasing power. 2 The asset represents a claim on another entity for money—for example, accounts receivable, which are amounts owed to the reporting company for credit sales. op 3 The asset can be converted to cash or a money claim. Finished goods inventories that will be sold in the normal course of business are an example. 4 The asset has potential benefits, rights, or services, allowing the entity to earn something from its use. Such assets include items like raw materials. tC Liabilities are probable future sacrifices of measurable economic benefits arising from the entity’s obligations to convey assets to or perform services for a person, firm, or another organization. These obligations require future settlement and represent claims of a nonownership nature on the entity’s assets. Accounts payable to trade creditors, bonds payable, and taxes payable are examples of liabilities. No Liabilities also include deferred credits. These do not represent clear-cut claims on the entity. They result from the need to recognize some expenses currently in order to get a “proper” matching of costs and revenues. To offset the expense item, a reserve balance is reported as a liability. Examples of deferred credits are reserves set up for tax payments that may or may not be paid in the future but that accounting standards require to be recognized as an expense currently. Do Stockholders’ or owners’ equity represents the ownership interest in the entity. It is the excess of the entity’s total assets over its total liabilities. As Exhibit 4 shows, equity a The dual aspect concept is the basis for double-entry bookkeeping. 5060 | Core Reading: BASIC ACCOUNTING CONCEPTS 12  t comes about from capital contribution from the stockholders (owners) and from the os net income that is retained after dividends are paid to the stockholders (retained earnings). EXHIBIT 4 Sources of Equity rP yo op tC Source: David W. Young, “Notes on Understanding Financial Statements,” HBP No. TCG 328. No Accounting systems are designed to record events in terms of their influence on at least two of the following categories: assets, liabilities, and owners’ equity. Thus, every accounting event has a dual aspect. For example, assume Jane Smith invested $5,000 in a new business; the accounting entry would recognize the $5,000 asset of the business and Jane Smith’s claim on this asset: Asset, $5,000 = Stockholders’ equity, $5,000 Do Now, if the company borrowed $1,000 from the bank, assets (cash) would increase by $1,000 and liabilities (bank loan payable) would also increase. Here are how things would stand after the bank loan. Notice how the assets are still equal to the liabilities and the stockholders’ equity: 5060 | Core Reading: BASIC ACCOUNTING CONCEPTS 13  t Assets = Liabilities + Equity os Cash + $6,000 Bank loan payable + $1,000 Stockholders’ equity + $5,000 Total + $6,000 Total + $6,000 rP Next, assume the business used $2,000 of its cash to acquire some inventory. The asset “cash” is reduced by $2,000, and the asset “inventory” is increased by a similar sum. Thus, the double-entry system requires two entries for each event. Other systems are possible, but the double-entry system is the most widely used. yo Assets = Liabilities + Equity Cash + $4,000 Bank loan payable + $1,000 Stockholders’ equity + $5,000 Inventory + $2,000 Total + $6,000 Total + $6,000 op 2.1.9 Reliability of Evidence tC Accountants recording events rely as much as possible on objective, verifiable documentary evidence instead of on the subjective and potentially biased judgments of a person. Acceptable evidence includes source documentation (both paper and digital) of such items as: Sales invoices No Purchase (supplier) invoices Checks written and received Payment vouchers Bank statements Receiving reports Do Time cards and payroll journals Credit memos 5060 | Core Reading: BASIC ACCOUNTING CONCEPTS 14  t The audit is the mechanism that allows users of financial statements to place trust os in those reports. Auditors look for distinct audit trails and supporting documenta- tion and test internal controls, which help ensure that business transactions are reliably recorded and supported by evidence. The desire to base decisions on objective evidence is one of the principal rP arguments in support of the historical cost concept, although, as noted earlier, some proponents of alternative approaches believe these approaches can be objective. In practice, accountants cannot always rely on objective, verifiable evidence. Many major decisions, such as the allocation of costs between periods, must be based on reasonable estimates after considering all relevant facts. In addition, in many yo instances, because of the volume of transaction processing it is not feasible for an auditor to verify the recording of every event. As a result, auditors base their opinions in large part on a sampling of transactions and on assessments of the company’s internal controls—the procedures management adopts to safeguard assets, ensure the reliability and accuracy of data, and encourage adherence to company policies. op As a result of the Sarbanes-Oxley Act, the management of US-based public companies must provide an assessment of internal control over financial reporting (ICFR) within their annual report. The independent auditors are required to “attest” to and report on that assessment. To do that, the auditor must gather evidence to test that management’s assertion that its ICFR is effective and correct. tC 2.1.10 Disclosure Accounting reports should disclose enough information that they will not mislead careful readers who are reasonably well informed in financial matters. This is the disclosure concept. Special disclosure is made of unusual items, changes in No expectations, significant contractual relations, and new activities. The disclosure can be included in the body of a financial statement, in the auditor’s opinion, or in the notes to the statement. Exhibit 5 shows the equity section of Ford Motor Company’s balance sheet as of December 31, 2014 (amounts in millions). Notice that the common stock and the class B stock have parenthetical data showing the number of shares issued and authorized as of the balance sheet date. In addition, there are references to notes for such components as capital stock, accumulated other Do comprehensive income /(loss), and treasury stock. 5060 | Core Reading: BASIC ACCOUNTING CONCEPTS 15  t EXHIBIT 5 Equity Section of Ford Motor Company’s Balance Sheet as of December 31, 2014 os Equity (amounts in millions) Capital stock (note 23) Common stock, par value $.01 per share rP (3,938 million shares issued of 6 billion authorized) 39 Class B stock, par value $.01 per share (71 million shares issued of 530 million authorized) 1 Capital in excess of par value of stock 21,089 Retained earnings 24,556 Accumulated other comprehensive income/(loss) (note 17) (20,032) yo Treasury stock (note 23) (848) Total equity attributed to Ford Motor Company 24,805 Equity attributable to noncontrolling interests 27 Total equity 24,832 op Total liabilities and equity $208,527 Source: Ford Motor Company 10-K for the fiscal year ended December 31, 2014. 2.1.11 Materiality tC Accounting standards apply only to material items. Inconsequential items can be dealt with expediently. This is the materiality concept. In applying this concept, care must be taken to ensure that the cumulative effect of a series of immaterial items does not materially alter the total statements. No Whether or not an item is immaterial is a matter of judgment. One common test of materiality is whether the decision of a reasonably well informed reader of financial statements would be altered if the item were treated differently. If the decision would change, then the item is material. 2.1.12 Conservatism Do The conservatism concept is controversial. It is rejected by the FASB but observed in practice by managers and others who believe conservative accounting is both prudent and responsible. 5060 | Core Reading: BASIC ACCOUNTING CONCEPTS 16  t The conservatism concept prescribes a degree of skepticism in assessing the os prospects that incomplete transactions will be concluded successfully. In practice, this means that in deciding between permissible accounting choices, some added weight should be given to whichever choice leads to the lowest asset or highest liability figures. Conservatism also means that more-stringent requirements should be im- posed for recognizing revenues and gains as components of earning than for rP recognizing expenses and losses. The application of conservatism requires considerable judgment. If not carefully applied, the conservatism concept can lead to abuses that result in unnecessary or dishonest understatements. Moreover, by understating income in one period, income in another period may be overstated. yo The FASB rejects conservatism as a legitimate accounting concept. In the opinion of the FASB, the concept leads to deliberate misstatements and as such has no place in accounting. The FASB believes that statement issuers should provide unbiased data so that statement users can evaluate the risk of, say, investing in the reporting company. If conservatism is applied, the FASB believes issuers allow their evaluations op of risk to substitute for the user’s independent evaluation, which might have been different if unbiased data had been available. Finally, the FASB argues that the concept of conservatism is capricious in practice. There are no uniform approaches to its application. However, conservatism has long been an approach and continues to be used in practice as an antidote to over-optimistic appraisals, judgments, and tC estimates made by management and a philosophy deeply entrenched in the minds of accountants. No Do 5060 | Core Reading: BASIC ACCOUNTING CONCEPTS 17  t os SFAC 8 states the following: Financial reports represent economic phenomena in words and numbers. To be useful, financial information not only must represent relevant phenomena, but it also must faithfully represent rP the phenomena that it purports to represent. To be a perfectly faithful representation, a depiction would have three characteristics. It would be complete, neutral, and free from error. Of course, perfection is seldom, if ever, achievable. The Board’s objective is to maximize those qualities to the extent possible. On the topic of neutrality, it states: yo A neutral depiction is without bias in the selection or presentation of financial information. A neutral depiction is not slanted, weighted, emphasized, deemphasized, or otherwise manipulated to increase the probability that financial information will be received favorably or unfavorably by users. Neutral information op does not mean information with no purpose or no influence on behavior. On the contrary, relevant financial information is, by definition, capable of making a difference in users’ decisions. tC 2.2 Financial Analysis No Those who use financial statements might be tempted to dismiss the subject matter covered in this reading as being primarily of interest to accountants and accounting standard setters. That would be a mistake. Not only should those who set the standards and those who apply them be aware of basic accounting concepts, but also any financial statement user should understand the assumptions that underlie the financials. Do Financial statements, as noted earlier, are presented on the assumption that the reader understands the basics of accounting and finance. Therefore, knowledge of basic accounting concepts is required to be a literate reader of financial statements. 5060 | Core Reading: BASIC ACCOUNTING CONCEPTS 18  t The basic accounting concepts determine the character and scope of data used for os financial statement analysis. Because no one set of measurement concepts governs accounting, financial statements include amounts that are arrived at by a variety of valuation procedures, based on cash, economic, financial, and accrual concepts of measurement. A statement user who does not appreciate an account’s valuation basis can easily misinterpret financial statements. rP One of the purposes of financial analysis is to determine whether the basic accounting concepts reflected in a particular company’s financial statements are reasonable representations of the company’s circumstances. Knowledge of the basic concepts is necessary to make an appropriate determination. For example, the “going concern” assumption suggests that even if a company issues audited financial yo statements with no indication that the auditors or management question the company’s continued existence, analysts should not assume that the issuer will in fact be in existence in the near future. An important use of financial analysis is to identify approaching financial difficulties and possible bankruptcy on the basis of data contained in a company’s most recent financial statements, which may have been based on the assumption that the entity was a going concern. op Statement users must be able to distinguish between the financial consequences that are included in financial statements and those that are not. A knowledge of basic accounting concepts is helpful in this regard. For example, financial statement analysis is usually undertaken for a specific decision, such as buying a security, tC determining a bond rating, or valuing a company. The basic accounting concepts reflected in the accounting data may result in financial statement data that are irrelevant for those decisions. For example, the market value of the properties of a company being considered for acquisition is important economic data for determining the acquisition price. Market price data related to properties will not be found in US GAAP–based financial statements. Yet there is something in the No statements that could be misinterpreted as data relevant to property valuation— namely, the net book value (original cost less accumulated depreciation) of the company’s properties. A statement user who is ignorant of the historical cost concept may unwittingly use those accounting values instead of the more relevant economic values. One who is aware of accounting concepts is less likely to fall into the trap of thinking the accounting data is something other than what it is intended to represent. Do 5060 | Core Reading: BASIC ACCOUNTING CONCEPTS 19  t 2.3 Summary os The basic accounting concepts and assumptions covered in this chapter may be summarized as follows: rP 1 Business Entity: Financial statements are prepared for a business entity that is separate and distinct from its owners. 2 Going Concern: Unless evidence suggests otherwise, it is assumed that the entity will continue operations into the foreseeable future. 3 Monetary Unit: Accounting is a measurement process that deals only with yo events that can be measured in monetary terms. 4 Historical Cost: Nonmonetary and monetary assets are ordinarily initially recorded at their acquisition price. This price, rather than current fair value, is the basis for subsequent accounting for nonmonetary assets. Most monetary assets are accounted for at fair value following their acquisition. IFRS permits op some nonmonetary assets to be accounted for at fair value following acquisition. 5 Accounting Period: Accounting measures activities for a specific interval of time, called the accounting period. 6 Consistency: Similar transactions are reported in a consistent fashion. tC 7 Matching: Accounting profit is the net result of matching related costs and revenues. 8 Dual Aspect: Every transaction affects at least two items in the basic accounting equation. No 9 Reliability of Evidence: Accountants recording events rely as much as possible on objective, verifiable documentary evidence. 10 Disclosure: Accounting reports should disclose enough information that they will not mislead careful readers reasonably well informed in financial matters. 11 Materiality: Accounting standards apply only to significant items. Do 12 Conservatism: A degree of professional skepticism should be adopted when assessing the prospects that incomplete transactions will be concluded successfully. Although conservatism has been rejected by the FASB and IASB as an “official” accounting concept, it is often observed by managers and others who believe that conservative accounting is both prudent and responsible. 5060 | Core Reading: BASIC ACCOUNTING CONCEPTS 20  t Except in rare instances, these basic accounting concepts and assumptions are not os tools for determining the accounting for specific financial transactions and events. That is the role of US GAAP and IFRS. The basic accounting concepts and assumptions are the framework upon which financial reporting in general is based. rP 3 SUPPLEMENTAL READING 3.1 Qualitative Characteristics of Useful Financial Information b yo The FASB and IASB have jointly issued Statement of Financial Accounting Concepts No. 8 (SFAC No. 8). It sets forth their views on the qualitative characteristics of financial information that is most useful to existing and potential investors, lenders, and other creditors for making decisions about the reporting entity. op While SFAC No. 8 confirms a number of the basic accounting concepts and assumptions discussed in this reading, it was not the boards’ intention to present SFAC No. 8 as a statement of basic accounting concepts and assumptions. Rather, the purpose is to provide general guidance to the two boards on the nature of useful tC financial information as they carry out their standard-setting roles. Financial information that falls short of SFAC No. 8’s useful information charac- teristics should be regarded with caution by financial statement users. Knowing SFAC No. 8’s content helps financial report users make this assessment. No The boards concluded in SFAC No. 8 that financial information is useful when it is both relevant to the users’ need for the information and it faithfully represents what it purports to represent. In the boards’ opinion, the usefulness of financial information is enhanced if it is material, comparable, verifiable, timely, and understandable. SFAC No. 8 defines these requirements as follows: Relevance: Financial information is relevant if it would make a difference in Do the decisions of users because of its predictive or confirmatory value, or both. b The IASB refers to its version of SFAC No. 8 as The Conceptual Framework for Financial Reporting, Chapter 3, “The qualitative characteristics of useful financial information.” 5060 | Core Reading: BASIC ACCOUNTING CONCEPTS 21  t Faithful representation: To be useful, financial information must faithfully os represent the phenomena it purports to represent. A perfectly faithful representation would be complete, neutral, and free from error. While this may be difficult to adopt in practice, the objective is to optimize those qualities to the extent possible. rP Materiality: Information that is immaterial is not useful. Immaterial information is information that would not influence the decisions of financial statement users. Comparability: Current or past financial information about a reporting entity is more useful if it can be compared with similar information about other yo entities or the same entity in a different period. Verifiability: Verifiability means that knowledgeable and independent individuals would reach a consensus that a particular representation is measurably faithful. op Timeliness: The financial statement information should be available to financial statement users in time to influence their decisions. Understandability: According to SFAC No. 8, the boards believe classifying, characterizing, and presenting information clearly and concisely makes it understandable. tC In SFAC No. 8 the boards recognize that preparing financial reports is costly. Preparer costs are a constraint that the boards are fully aware of as they deliberate new standards. In the end, the boards hope their decisions on new standards will strike the right balance between costs and benefits. No Do 5060 | Core Reading: BASIC ACCOUNTING CONCEPTS 22  t 4 KEY TERMS os audit trail Paper or digital trail that gives a step-by-step documented history of a transaction. It enables an auditor to trace the financial data from the financial statements to the general ledger to the source document (invoice, receipt, voucher, check, etc.). The presence of a reliable audit trail is an indicator of good internal rP controls. Conceptual Framework for Financial Reporting (CFFR) A framework that describes the objective of, and the concepts for, general purpose financial reporting; assists in the development of future IFRS standards; and assists management and accountants in developing consistent accounting policies when no IFRS standard yo applies to a particular transaction. Financial Accounting Standards Board (FASB) The private-sector organization in the United States that establishes financial accounting and reporting standards. op fiscal year The 12-month period over which a company reports its financial results. Many companies align their fiscal year with the calendar year, but they may choose to report over any 12-month period. internal control over financial reporting (ICFR) Policies, procedures, and tC activities that help ensure that financial statements are presented in accordance with generally accepted accounting principles and faithfully represent the financial condition and results of operations of a reporting entity. International Accounting Standards Board (IASB) The accounting standard- setting body outside the United States. No International Financial Reporting Standards (IFRS) The rules and standards developed by the IASB. monetary assets Cash, accounts receivable, or a note receivable in which the amount is a fixed, stated quantity. Holding these assets during periods of inflation will result in a loss of purchasing power. Do neutrality A requirement that information contained in the financial statements be free from bias. nonmonetary assets Assets that appear on the balance sheet but are not cash or cannot be readily converted into cash. Generally, nonmonetary assets include fixed 5060 | Core Reading: BASIC ACCOUNTING CONCEPTS 23  t assets, such as property, plant, and equipment, as well as intangible items, such as goodwill. os purchasing power The value of money expressed in terms of the amount of goods or services that can be purchased with it. All else being equal, inflation decreases purchasing power. rP retained earnings An owners’ equity account that reflects the amount of resources a business generates by running its operations and keeps for internal purposes. revaluation model Under IFRS, an entity can report its property, plant, and equipment at fair value (less subsequent accumulated depreciation) as long as fair yo value can be reasonably measured. Sarbanes-Oxley Act A US law that was passed by Congress as a reaction to a number of high-profile corporate and accounting scandals in the early 2000s. It set new or enhanced oversight standards for US public company boards, management, and accounting firms. op Statements of Financial Accounting Concepts (SFAC) A document issued by the FASB covering broad financial reporting concepts, providing a general overview of accounting concepts, definitions, and ideas. US GAAP The set of accounting standards issued by the FASB and followed by most tC US companies. 5 ENDNOTES No 1 Financial Accounting Standards Board. “Statement of Financial Accounting Concepts No. 8.” http://www.fasb.org/jsp/FASB/Document_C/DocumentPage?cid=1176157498129&acceptedDisclaimer=tr ue, accessed July 20, 2016. Do 5060 | Core Reading: BASIC ACCOUNTING CONCEPTS 24  t 6 INDEX os accounting period, consolidated equity, in dual aspect concept, 12 statements of income example of, 8, equity, sources of, 13 9 accounting period, definition of, 20 rP fair value measurement, 3, 20 accounting period, nature of business affecting year end in, 9, 10 faithful representation, 22 accrual method of accounting, 11 Financial Accounting Standards Board (FASB), 3, 23 assets, in dual aspect concept, 12 financial analysis, 18 audit trail, 15, 23 financial information, requirements for usefulness of, 21 yo basic accounting concepts, list of, 4 financial information, SFAC 8 on business entity, 5, 20 characteristics of, 18, 21 financial reporting, business entity cash method of accounting, 11 and limits of, 5 comparability, 22 financial reporting, internal control over, 15 Conceptual Framework for Financial op Reporting (CFFR), 3, 23 financial reporting, objective of, 4 conservatism, 16, 20 fiscal year, consolidated statements of income example of, 8, 9 consistency, 10, 20 fiscal year, definition of, 23 consolidated balance sheet example, 6 fiscal year, examples of year end for, 9, consolidated statements of income 10 tC example, 8, 9 Ford Motor Company, equity section current value measurements, 7 of balance sheet of, 16, 17 Daimler Group, consolidated balance Gap, consolidated statements of sheet for, 6 income for, 8, 9 deferred credits, as liabilities, 12 going concern, 5, 20 No depreciable assets, revaluation model for, 8 historical cost, current value versus, 7 disclosure, definition of, 20 historical cost, description of, 7, 20 disclosure, Ford balance sheet example of, 16, 17 historical cost, fair value versus, 3, 20 donated assets, valuation of, 8 historical cost, modifications over time to, 8 dual aspect, accounting event example for, 13 Do dual aspect, assets in, 12 inflation, purchasing power adjustments for, 7 dual aspect, definition of, 12, 20 internal control over financial dual aspect, liabilities in, 12 reporting, 15, 23 dual aspect, stockholders’ or owners’ International Accounting Standards equity in, 12 Board (IASB), 3, 23 5060 | Core Reading: BASIC ACCOUNTING CONCEPTS 25  t International Financial Reporting Sarbanes-Oxley Act, 15, 24 Standards (IFRS), 4, 23 SFAC 8, on financial information os inventory accounting, 3, 8 characteristics, 18 SFAC 8, on useful information liabilities, in dual aspect concept, 12 requirements, 21 Statements of Financial Accounting Concepts (SFAC), 3, 24 rP marketable securities, market value reporting of, 7 stockholders’ equity, in dual aspect concept, 12 matching, 11, 20 materiality, common test of, 16 timeliness, 22 materiality, descriptions of, 16, 20, 22 mixed attributes accounting model, 7 understandability, 22 yo monetary assets, current value reporting of, 7 useful financial information, SFAC 8 requirements for, 21 monetary assets, definition of, 23 useful financial information, useful monetary unit, balance sheet example qualitative characteristics of, 21 for, 6 US GAAP, 3, 24 monetary unit, description of, 6, 20 monetary unit, limitations of, 7 op verifiability, 22 neutrality, 18, 23 nonmonetary assets, 8, 23 owners’ equity, in dual aspect concept, tC 12 purchasing power, 7, 24 relevance, 21 reliability of evidence, acceptable No evidence in, 14 reliability of evidence, audit trails for, 15 reliability of evidence, definition of, 20 retained earnings, 13, 24 revaluation model, 8, 24 Do 5060 | Core Reading: BASIC ACCOUNTING CONCEPTS 26