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Accounting is guided by principles, standards, concepts, and assumptions. This section describes several of these key fundamentals of accounting. Ethics — A Key Concept
The goal of accounting is to provide useful information for decisions. For information to be useful, it must be trusted. This demands ethics in accounting. EthicsCodes of conduct by which actions are judged as right or wrong, fair or unfair, honest or dishonest. are beliefs that distinguish right from wrong. They are accepted standards of good and bad behavior. Identifying the ethical path is sometimes difficult. The preferred path is a course of action that avoids casting doubt on one's decisions. For example, accounting users are less likely to trust an auditor's report if the auditor's pay depends on the success of the client's business. To avoid such concerns, ethics rules are often set. For example, auditors are banned from direct investment in their client and cannot accept pay that depends on figures in the client's reports. Exhibit 1.6 gives guidelines for making ethical decisions. Point: Sarbanes-Oxley Act requires each issuer of securities to disclose whether it has adopted a code of ethics for its senior financial officers and the contents of that code.
Providers of accounting information often face ethical choices as they prepare financial reports. These choices can affect the price a buyer pays and the wages paid to workers. They can even affect the success of products and services. Misleading information can lead to a wrongful closing of a division that harms workers, customers, and suppliers. There is an old saying: Good ethics are good business. Some people extend ethics to social responsibility, which refers to a concern for the impact of actions on society. An organization's social responsibility can include donations to hospitals, colleges, community programs, and law enforcement. It also can include programs to reduce pollution, increase product safety, improve worker conditions, and support continuing education. These programs are not limited to large companies. For example, many small businesses offer discounts to students and senior citizens. Still others help sponsor events such as the Special Olympics and summer reading programs. Point: The American Institute of Certified Public Accountants' Code of Professional Conduct is available at www.AICPA.org.
Generally Accepted Accounting PrinciplesFinancial accounting practice is governed by concepts and rules known as generally accepted accounting principles (GAAP)Rules that specify acceptable accounting practices.. To use and interpret financial statements effectively, we need to understand these principles, which can change over time in response to the demands of users. GAAP aims to make information in financial statements relevant, reliable, and comparable. Relevant information affects the decisions of its users. Reliable information is trusted by users. Comparable information is helpful in contrasting organizations.
Setting Accounting Principles Two main groups establish generally accepted accounting principles in the United States. The Financial Accounting Standards Board (FASB)Independent group of full-time members responsible for setting accounting rules. is the private group that sets both broad and specific principles. The Securities and Exchange Commission (SEC)Federal agency Congress has charged to set reporting rules for organizations that sell ownership shares to the public. is the government group that establishes reporting requirements for companies that issue stock to the public. In today's global economy, there is increased demand by external users for comparability in accounting reports. This often arises when companies wish to raise money from lenders and investors in different countries. To that end, the International Accounting Standards Board (IASB)Group that identifies preferred accounting practices and encourages global acceptance; issues International Financial Reporting Standards (IFRS). issues International Financial Reporting Standards (IFRS) that identify preferred accounting practices. The IASB hopes to create more harmony among accounting practices of different countries. If standards are harmonized, one company can potentially use a single set of financial statements in all financial markets. Many countries' standard setters support the IASB, and differences between U.S. GAAP and IASB's practices are fading. Yet, the IASB does not have authority to impose its standards on companies. Point: State ethics codes require CPAs who audit financial statements to disclose areas where those statements fail to comply with GAAP. If CPAs fail to report noncompliance, they can lose their licenses and be subject to criminal and civil actions and fines.
Principles and Assumptions of Accounting Accounting principles (and assumptions) are of two types. General principles are the basic assumptions, concepts, and guidelines for preparing financial statements. Specific principles are detailed rules used in reporting business transactions and events. General principles stem from long-used accounting practices. Specific principles arise more often from the rulings of authoritative groups. We need to understand both general and specific principles to effectively use accounting information. Several general principles are described in this section that are relied on in later chapters. General principles (in red) and assumptions (in yellow) are portrayed as building blocks of GAAP in Exhibit 1.7. The specific principles are described as we encounter them in the book.
Accounting Principles General principles consist of at least four basic principles, four assumptions, and certain constraints. The cost principleAccounting principle that prescribes financial statement information to be based on actual costs incurred in business transactions. means that accounting information is based on actual cost. Cost is measured on a cash or equal-to-cash basis. This means if cash is given for a service, its cost is measured as the amount of cash paid. If something besides cash is exchanged (such as a car traded for a truck), cost is measured as the cash value of what is given up or received. The cost principle emphasizes reliability and verifiability, and information based on cost is considered objective. Objectivity means that information is supported by independent, unbiased evidence; it demands more than a person's opinion. To illustrate, suppose a company pays $5,000 for equipment. The cost principle requires that this purchase be recorded at a cost of $5,000. It makes no difference if the owner thinks this equipment is worth $7,000. Point: The cost principle is also called the historical cost principle. Revenue (sales) is the amount received from selling products and services. The revenue recognition principleThe principle prescribing that revenue is recognized when earned. provides guidance on when a company must recognize revenue. To recognize means to record it. If revenue is recognized too early, a company would look more profitable than it is. If revenue is recognized too late, a company would look less profitable than it is. Three concepts are important to revenue recognition. (1) Revenue is recognized when earned. The earnings process is normally complete when services are performed or a seller transfers ownership of products to the buyer. (2) Proceeds from selling products and services need not be in cash. A common noncash proceed received by a seller is a customer's promise to pay at a future date, called credit sales. (3) Revenue is measured by the cash received plus the cash value of any other items received. Example: When a bookstore sells a textbook on credit is its earnings process complete? Answer: A bookstore can record sales for these books minus an amount expected for returns. The matching principlePrescribes expenses to be reported in the same period as the revenues that were earned as a result of the expenses. prescribes that a company must record its expenses incurred to generate the revenue reported. The full disclosure principlePrinciple that prescribes financial statements (including notes) to report all relevant information about an entity’s operations and financial condition. requires a company to report the details behind financial statements that would impact users' decisions. Those disclosures are often in footnotes to the statements.
Accounting Assumptions The going-concern assumptionPrinciple that prescribes financial statements to reflect the assumption that the business will continue operating. means that accounting information reflects a presumption that the business will continue operating instead of being closed or sold. This implies, for example, that property is reported at cost instead of, say, liquidation values that assume closure. The monetary unit assumptionPrinciple that assumes transactions and events can be expressed in money units. means that we can express transactions and events in monetary, or money, units. Money is the common denominator in business. Examples of monetary units are the dollar in the United States, Canada, Australia, and Singapore; and the peso in Mexico, the Philippines, and Chile. The monetary unit a company uses in its accounting reports usually depends on the country where it operates, but many companies today are expressing reports in more than one monetary unit. The time period assumptionAssumption that an organization’s activities can be divided into specific time periods such as months, quarters, or years. presumes that the life of a company can be divided into time periods, such as months and years, and that useful reports can be prepared for those periods. Point: For currency conversion: cnnfn.com/markets/currencies Point: abuse of the entity assumption was a main culprit in the collapse of Enron. The business entity assumptionPrinciple that requires a business to be accounted for separately from its owner(s) and from any other entity. means that a business is accounted for separately from other business entities, including its owner. The reason for this assumption is that separate information about each business is necessary for good decisions. A business entity can take one of three legal forms: proprietorship, partnership, or corporation.
Decision Ethics boxes are role-playing exercises that stress ethics in accounting and business.
Sarbanes–Oxley (SOX)Congress passed the Sarbanes-Oxley ActCreated the Public Company Accounting Oversight Board, regulates analyst conflicts, imposes corporate governance requirements, enhances accounting and control disclosures, impacts insider transactions and executive loans, establishes new types of criminal conduct, and expands penalties for violations of federal securities laws., also called SOX, to help curb financial abuses at companies that issue their stock to the public. SOX requires that these public companies apply both accounting oversight and stringent internal controls. The desired results include more transparency, accountability, and truthfulness in reporting transactions. Point: An audit examines whether financial statements are prepared using GAAP. It does not attest to the absolute accuracy of the statements. Compliance with SOX requires documentation and verification of internal controls and increased emphasis on internal control effectiveness. Failure to comply can yield financial penalties, stock market delisting, and criminal prosecution of executives. Management must issue a report stating that internal controls are effective. CEOs and CFOs who knowingly sign off on bogus accounting reports risk millions of dollars in fines and years in prison. AuditorsAnalysis and report of an organization’s accounting system, its records, and its reports using various tests. also must verify the effectiveness of internal controls. Point: BusinessWeek reports that external audit costs run about $35,000 for startups, up from $15,000 pre-SOX. A listing of some of the more publicized accounting scandals in recent years follows.
To reduce the risk of accounting fraud, companies set up governance systems. A company's governance system includes its owners, managers, employees, board of directors, and other important stakeholders, who work together to reduce the risk of accounting fraud and increase confidence in accounting reports. The impact of SOX regulations for accounting and business is discussed throughout this book. Ethics and investor confidence are key to company success. Lack of confidence in accounting numbers impacts company value as evidenced by huge stock price declines for Enron, WorldCom, Tyco, and ImClone after accounting misconduct was uncovered.
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