Accounting purpose and use
Financial statements, Matching, and estimating.
Purpose of accounting
One of the main reasons for accounting is profit measurement or performance evaluation of a company. Accounting entails the recording of entries that represent transactions undertaken by the company. It is from these entries that financial statements are prepared. By looking at the financial statements of a business, one can range the company’s performance. This information is used by both the company and third parties like investors and suppliers.
Accounting also provides information that acts as a basis on which many decisions are made—some of the decisions made based on accounting include.
-How to use internal resources to make sales.
-Whether to fund a firm.
Accrual financial statements; cash?
Under Accrual basis of accounting, revenues are recorded on the income statement when they are earned rather than when the payments are received. Under this basis, expenses are reported on the income statement when the Cost has no future benefit that can be measured. If an expense is recorded and payment is not yet made, a liability account will be opened to record the entry.
Under an Accrual basis, payment of cash or receiving of cash is not the focus of reporting both revenues and expenses. Entries are only made when revenue is earned on an expense incurred.
The accrual basis of accounting provides a more accurate and elaborate perspective of the business assets and liabilities at the end of the accounting period.
An alternative to the accrual basis of accounting is the cash basis. Under this basis, revenues are only recorded on the income statement only when payment (cash) is paid. Expenses are also recorded only when payment (cash) is paid. The main problem with using a cash basis is that it gives a false impression of reduced liabilities.
Accrual statements; Matching
Accrual statements tell the story of a business model through ways such as the:
The revenue model is a structure that outlines the earning strategy of the business. It explains the products, revenue sources, revenue generation techniques, and also the targeted markets.
There are various types of revenue models, each with a different aspect; some examples include markup and arbitrage. It also explains what assets and operations are necessary for the business.
Is there sufficient cash to operate the business? Through an Accrual basis, the business owners can accurately evaluate their liabilities and assets and determine if the business is sustainable.
Matching (alignment of revenue with its Cost) is on the income statement.
Balance sheet balances due to the financing of assets. Assets are used to make sales, not matching.
The statement of cash flows is used to monitor sources and uses.
Accounting conceptual framework (FASB)
FASB-Financial accounting standards board is an independent organization in charge of establishing accounting and financial reporting standards for companies and nonprofit organizations in the USA.
According to FASB, financial information should have the following features.
Relevant-Financial information should be predictive, confirmatory, and timely, ie. It should be up to date.
Reliability: According to Generally Accepted Accounting Principles (GAAP), Financial information should be complete and neutral and without being biased.
Consistent –GAAP outlines that a company’s financial data should be consistent; that is, they should stick to a particular method rather than changing from time to time.
Comparable with other firms financial statements
Elements
Assets: An asset is an item that has economic value or future benefits.
Liability-Liabilities are whatever the company owes to outsiders.
Equity-Refers to the amount of money that would be returned to a company’s shareholders in case all of its assets are liquidated.
Revenues- This is the total amount of income generated by the sale of goods or services.
Expenses- This is the Cost of operation that a company incurs to generate revenue.
Gains –This is an increase in the value of an asset.
Losses-this is a decrease in net income that is outside the normal operations of a business.
Investment by owners-This is the capital put into the business by its starters. The value amount is found under equity.
Distributions to owners-This are the distribution of retained earnings of a business to owners.
Comprehensive income is the variation in the company’s net assets from non-owner sources during a specific period.
Assumptions and Constraints of Accounting Principles.
Assumptions
Going concern-This assumes the business will continue to operate for the foreseeable future.
Periodicity-Financial results reported by a business should cover a uniform and consistent period.
Constant monetary-Inflation can be ignored.
Economic entity-The transactions of the business and those of its owners should not be intermingled.
Constraints
Materiality – would it matter to a reasonable investor? Choice of method
Conservatism – low estimates of revenue/gains, high estimates of costs/losses
Cost-Benefit Tradeoff – if the method is not worth the information, don’t
Industry Practices – if other similar firms do it one way, be comparable
- Principles:
Revenue Recognition – at the time of the sales (not when collected) TRIGGERSà
Expense Matching – alignment of specific sales with their costs for profit measurement
Historical Cost of assets for depreciation (i.e., matching)
Full Disclosure – of all relevant information (e.g., notes to the financials)
Estimations
Matching helps measure performance
Revenue recognition triggers it (at the time of sale)
Cost measurement issues (cost-benefit Tradeoff, accuracy?)
Judgment
Method (e.g., depreciation)
Inputs (accuracy?)
Manipulation
Performance payor appearance
Cost of capital (investments)
Cash helps “check” accrual (in addition to being necessary to operate)
Profits should turn into cash at a regular rate (operating CF)
Cash has other sources and uses (investment, financing CFS)