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Guiding Principles of Accounting-1.pdf

Guiding Principles of Accounting-1.pdf - 158 ACCOU NTI NG...

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Unformatted text preview: 158 ACCOU NTI NG DeMYSTiFieD Guiding Principles of Accounting These are the basic accounting principles, concepts, and assumptions that we will cover in this chapter: 0 Business entity 0 Continuing concern 0 Censervatism 0 Objectivity 0 Time period 0 Revenue recognition 0 Cost 0 Consistency 0 Materiality 0 Full disclosure 0 Matching Business Entity A business—whether it is a sole proprietorship, a partnership, or a corpora- tion—is a separate and distinct entity. The records of the business are not to mingle with those of other entities, including the owner of the entity. For exam- ple, if the owner of a partnership buys a house for his family, it does not go on the books of the partnership. Continuing Concern A business is assumed to live on and on unless expressly stated otherwise. This is known as the continuing;- or going—concern concept, and the financial records are maintained on the assumption that the business will continue forever. When an auditor has doubt that the business will live much longer, he or she will report in the auditor’s opinion that the business is a “going concern” and detail why the business is likely to fail or cease business. Chapter 11 GUIDING PRINCIPLES OF ACCOUNTING AND ADJUSTING ENTRIES I59 Conservatism This is also known as the prudence principle. Dear Prudence, won’t you come out to play. Until the Enron fiasco, I mistakenly believed that all accountants were trained to be conservative. [I know that we were definitely trained to dress conservatively. When I graduated from college, white shirts, blue suits, and those little red ties that looked like whipped cream flowers were all the rage for female accountants.) I was trained to record transactions only if they definitely had happened or were going to happen. And I was trained to record, when in doubt, the most conservative number—the worst-case scenario, if you will. If there was a choice between a high revenue number and a low revenue number, you were to go with the low revenue number. In that way, if things turned out for the better, you could adjust upward and make everyone happy. If things went bad, you’d have already faced it. Conservatism asks that you don’t overstate revenues or understate expenses. It also asks that what you record be fair and reasonable. Or another way to look at it is that it asks you not to anticipate any profit unless realized but to provide for all probable losses. ObJECIIVII'y All transactions entered into the accounting records of a business should be based on evidence—not opinion. Instead of guessing how much a vendor is going to request as payment, you wait until you get the invoice and enter the bill amount. You don’t just pull numbers out of the sky. If you are forced to do this for some reas0n, you disclose your method for guessing in the notes to the financial statements. This is one of the reasons that accountants don’t bother putting a value on a brand name, such as the Coca-Cola brand. It is impossible to figure out with any great accuracy how much that would be worth. The brand is worth millions, maybe billions, but until someone pays actual cash for it, you would just be guessing at its worth. Guessing makes us accountants uncomfortable, so we try to avoid it I Who Comes Up with All This Stuff Anyway? Congress created the Securities and Exchange Commission (SEC) in 1934 as a reaction to the stock market crash that led to the Great Depression. Before 1934, corporations were unregulated, and insider trading and other funny business practices were common and legal. 150 ACCOUNTING DeMYSTiFieD The Securities Exchange Act of 1934 both created the SEC and directed corpo- rations to present registration statements for new issuances of stock and to make a ”full and fair"disclosure of financial information. Congress gave the SEC the power to regulate the accounting profession.The SEC handed this job off to the profession, which promptly formed a self-regulating body. This body has had many names but is now called the American Institute of Certified PubiicAccountants (AICPA). The AICPA then turned around and created several rule-making boards. The first board is the Financial Accounting Standards Board (FASB).The FASB was formed in 1973, has seven full—time members, and has issued 140 pronounce— ments that make up the bulk of generally accepted accounting principles (GAAP). The FASB's mission is to ”establish and improve standards of financial accounting and reporting for the guidance and education of the public.” In 1984, the AICPA created the GASB, which is similar to the FASB except that it issues GAAP for gov— ernmental entities. After the Enron debacle, the federal government again intervened and criti— cized the accounting and auditing profession for doing a poorjob with financial statements.The federal government created another standard setter, the Public Company Accounting Oversight Board (PCAOB) in 2002.You may have heard of the Sarbanes-Oxley Act, or”Sarbox"? Sarbox refers to the law that created the PCAOB and a litany of audit and ac— counting requirements. One of them is the letter that executives must sign in the back of the financial statements that promises that the statements are free of material error and that internal controls are in place and working.l talked about that briefly in Chapter 7. And as I mentioned in Chapter 4, the United States is doing its best to put aside its narcissistic tendencies and go international.The International Financial Report— ing Standards (IFRS) likely will be implemented by publicly traded U.S. corpora- tions by 2013. So, if you are wondering whose rules to follow in case of an accounting ques- tion, here is the list of the rule makers, with the most influential being at the top: 0 Securities and Exchange Commission (SEC) 0 American Institute of Certified Public Accountants (AICPA) - Financial Accounting Standards Board (FASB) - Governmental Accounting Standards Board (GASB) - Public Company Accounting Oversite Board (PCAOB) Time Period Have you ever heard of a fiscal year? This accounting principle says that all accounting periods should be of similar length. Many fiscal years will begin on January 1 and end on December 31, but a business can choose any time period. Chapterl'l GUIDING PRINCIPLES OF ACCOUNTING AND ADJUSTING ENTRIES 161 Many companies choose a fiscal year that ends when sales are at their peak so that the cash balance and other balances will look as attractive as possible. For instance, a school textbook'publisher I worked with made the majority of its sales in August, when the school districts purchased their books, so its fiscal year end was in September. Some companies choose a fiscal year to end during a time that is not so busy for the accountants so that the accountants will have time to prepare the finan- cial statements. Whatever you choose, you have to stick with it because of the consistency concept [discussed later]. Revenue Recognition Revenue should be recorded when the transaction actually occurs. Generally, revenue is recognized when the customer is billed or cash is received. Sometimes, deciding when to recognize revenue is more complicated, such as when a service firm, say, a consultant, is working on a long-term project. Remember that conservatism asks that we not overstate revenues. One of the major sticking points of changing from US. GAAP to IFRS regards revenue recognition. US. GAAP are written to be industry-specific, and IFRS rely on a set of more simple principles. As of this writing, the jury is still out on what the FASB and AICPA will do to guide the creators of financial statements. In other words, if you have a question on this, it can get very technical. You may have to wade through the FASB’s accounting pronouncements. I COSt We don't work with market value much in accounting.Whatever was paid to pur- chase a fixed asset remains that asset’s value until it is sold or disposed of. This makes things easier for accountants—but not necessarily more accurate. For ex- ample, if your business purchased a warehouse in 1982 for $180,000, then the book value would remain at $180,000 less depreciation until you sold it or it burned down. Even if the warehouse is worth $500,000 in 201 1, its value remains at $180,000. This is one of the biggest drawbacks of the accounting model. If assets are valued at historical value, this might understate or sometimes overstate the value of the assets. But given our principle of objectivity, you can see the theo- retical and practical dilemma.What evidence would we have of the market value of the warehouse? In 2006, the profession decided that marketable securities (e.g., stocks, bonds, and derivatives) should be valued not at historical cost but rather at fair value. Fair value is described in IFRS as "the amount for which an asset could be exchanged 152 ACCOUNTING DeMYSTiFieD between knowledgeable, willing parties in an arm's-length transaction.” Is that vague enough for you? CPAs have to get 40 hours of education each year to keep their |icense,and CPAs can opt to attend two—day courses on this very topic. I’ve even been invited to attend fair-value conferences taught by experts in the field. Obvi— ously,fair-value determination gets very granular and requires the application of plenty of professional judgment. It is so much easier to go with historical cost! Although most financial statements still are based on historical cost, you should know that if you are selling your business, the purchaser won’t care what you paid, but he will care what it is worth.You will have to come up with a market value for all your assets. And whatever the buyer pays you over book value (historic value on your books) for your business becomes my least favorite concept in accounting— goodwill. Don’t make me talk about it; it is a very silly concept, and to make it even sillier,goodwil| must be amortized.The books have to balance, after all! Consistency Changing your mind about how a transaction is treated from period to period is frowned on in accounting. Once you make up your mind about something, you should stick with it. Otherwise, the financial statements won’t be compa- rable, and users of the financial information won’t know what’s going on from year to year. If you do change your mind, you must disclose the change in the financial statements. The principle of consistency also means that the same accounting treatment is applied to similar events from period to period. Once you choose a fiscal year and a method for valuing inventory, for instance, you are stuck with those choices. Are you getting a sense of what sort of personalities would be attracted to the accounting profession? Folks who don’t mind doing the same thing every time, who want to record things only once, and who take the most conservative or pessimistic view are well suited to financial accounting. (1 am going to get a lot of letters on this one.) .- Internal Controls Aren't Vitamins internal controls are policies and procedures that help you to get things accom- plished.Thinking of this from a personal perspective, consider this question: How do you make sure that you get to work on time every day? Chapter11 GUIDING PRINCIPLES OF ACCOUNTING AND ADIUSTING ENTRIES 163 l have controls in place to make sure I am not late to teach my classes. One of my recurring nightmares when I am stressed out is that | show up for class three or four hours late. I then have to face hostile participants who are ready to go to lunch.To make sure that this nightmare does not become a reality, I pick out and press my clothes the night before. I write down an estimate of how long it will take me to get ready in the morning and to travel to the site. I factor in how long it will take me to set up the room. (Some of my classes require more setup than others.) I also pack my supplies,such as my laptop, my pens, my toys, etc., and put them by the front door.l set two alarm clocks, one battery-operated and the other electric; in this way, even if one doesn’t work, I have another. lfl am at home, | tell my husband what time I need to be up; if he wakes up and I'm not up yet, he can get me up. If I am on the road,l call for a wake-up call from the hotel.And I could keep going with this—My controls reduce my anxiety. Organizations also have anxieties.They worry about whether their products or services will be delivered to the customer in good condition and on time. They worry about whether their financial statements will be accurate. They worry about whether their employees will get sent a payroll check each week. In order to get where they want to go and do what they need to do, they have to put controls in place. Controls are little procedures that ensure that goals are met. The Sarbanes-Oxley Act (also known as"Sarbox") requires auditors to evaluate the internal controls that contribute to the creation of accurate financial state- ments.The hope is that these controls will keep shyster accountants from lying about financial results in the financial statements. Materiality Here we accountants cut ourselves a little slack; we get a little rebellious. [Get out the Harleyl) If you hear an accountant say that something is not material this means that it has no significant impact on the financial statements. This allows us to sometimes bypass GAAP rules, especially when the cost of comply- ing with GAAP is prohibitive. Auditors love to use the phrase not material in conducting their audits. Audi- tors can’t examine every single transaction, so the purchase of a stapler in a multibillion-dollar corporation usually will not come under scrutiny. Even if the stapler were accounted for improperly, who would really care? It isn’t material. Next time your significant other gives you a hard time about buying an expen- sive pair of shoes, tell him or her that the purchase was not material and to focus on the big picture. 16"! ACCOUNTING DeMYSTiFieD .- Still Struggling? Materiality If you work with auditors frequently, you will hear them say "not material" over and over and over. Auditors are responsible for designing their audits of financial statements to determine whether they are materially misstated. In other words, they are looking for big, misleading mistakes in the financials. Not the small stuff. If they were looking for absolute accuracy in the financial statements, they’d be camped out at the client's offices forever! So, when l audited a $23 billion teacher’s pension fund, I designed my audit to catch errors bigger than $500,000. Anything less than that was "immaterial. ”Yes. You read that right. Later, when I audited a small not—for—profit business, my materiality level was $350. Materiality, good looks, and smarts are relative.When auditors do find a material error,they ask the client to make journal entries to the books to correct the mistake. T105534 201505510151111191191 Full Disclosure This reminds accountants that all disclosures in the financial statements are considered complete unless stated otherwise. Information that may affect a user’s understanding of the financial statements must be disclosed. A knowl- edgeable user should be able to make an informed judgment about the financial condition of the business given the information provided. Matching This principle says that the expenses incurred in generating revenue should be matched with the revenues they generate. Here is an example: Let’s say that you use a software program to design custom birdbaths for your customers. The software may have been purchased several years before, but you are using it now to generate income. In accounting, we like to match the software expense to the revenue it helped generate. It is only fair. Why should the first year be the only year burdened with the cost of the software? The matching principle is one of the main reasons we bother with depreciating things. A depreciation expense is recorded every year that an asset is used. In this way, the cost of purchasing the software is not recorded in a way that artificially reduces profit in the year of purchase and then artificially inflates revenues in future years. Matching evens out the resulting profit [revenues less expenses). ...
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