You may know accountants follow generally accepted accounting principles (GAAP), but you may not know how the GAAP evolved. The Financial Accounting Standards Board (FASB) periodically reviews the principles that govern the objectives of financial reporting, recognition and measurement and the elements of financial statements.
Here is a quick summary.
Going concern: Your company is presumed to have value beyond the liquidation price of its assets because it should operate into the foreseeable future, at least as long as the useful lives of its assets. Therefore, your depreciated asset figures on the balance sheet do not indicate the true value of what they contribute to your profitability.
Monetary unit: Items on your statements are defined using a stable unit of measurement, so that value interpretation is consistent. For example, if you operate in the United States, values would be shown as U.S. dollars. The assumption is that the unit value does not change over time, though inflation distorts this concept.
Accounting period: The results and state of your operations will be reported regularly over defined periods, such as annually or quarterly. Using commonly defined periods allows you to comply with reporting requirements and consistently analyze trends or seasonality.
Economic entity: Each company is a single unit and should use one set of books. Economic entity is not the same as legal entity. For example, there is no legal difference between the personal financial affairs of the owner of a proprietorship and the company itself, but each would be reported separately, using the economic entity principle. For corporations, the two often are the same—the corporation legally functions as an individual entity. Consolidated financial statements are used to summarize the economic activity of multiple subsidiaries or economic entities, though each has its own set of books.
Matching of revenue and expenses: During a given period, expenses are presumably incurred to generate revenues, and both are matched according to time. For example, direct labor and material expenses are matched to the sales revenue or billings for associated projects. Management salaries or utilities are considered period expenses and are matched to the time when they occur. Of course, this kind of matching does not apply to cash flow, where payments of expenses usually precede receipt of the receivables.
Conservation: Accountants say it is less harmful to understate net income than overstate it, minimizing the negative impact of potential measurement errors. With two equally likely sales receipts estimates, you should use the lower one. For expense projections, use the higher one. The principle relates to occasional errors and is not intended for deliberate or consistent understatement of net income or asset values.
These principles do not define your accounting method, which is based on producing information that is useful in making management decisions. Characteristics of useful information include the following:
Understandability: Since the competence of users varies, the criteria include assumptions of a “reasonable understanding of business and economic activities” and willingness to study the information “with reasonable diligence.” Data should not be excluded because some users might not understand it.
Relevance: If information does not improve the decision maker’s ability to predict the future or correct past expectations, it is not relevant. Relevant information can reduce uncertainty, but it must be timely to be effective. Also, the same information that is relevant to one category of user (such as bankers) may not be relevant to another (such as stockholders).
Reliability: This is the assurance that the information is reasonably free of errors and bias and represents what it claims to represent. It must be independently verifiable and complete, so you can be confident in using it to make decisions.
Comparability and consistency: Comparability allows analysis of similarities and differences between companies. Consistency allows for comparisons over time because accounting methods do not change. In fact, one of the main reasons for establishing accounting standards is the use of uniform procedures and practices to make reporting consistent and comparable. However, enough flexibility must exist, allowing companies to adapt to circumstances.
Materiality: If an item is not large enough to influence user decisions, it should not be reported. For some companies, rounding to the nearest dollar amount is an appropriate level of materiality. For very large companies, any amount less than $100 might be considered immaterial.
Cost effectiveness: The benefits of providing a chosen level of accounting information must outweigh the costs expended. Evaluating the benefits may be difficult, but absolute perfection is too expensive to be the standard.
Being familiar with these principles and concepts may not make your company profitable, but you will have a better understanding of how your financial reporting is constructed. Now, use the information to make better business decisions. EC
NORBERG-JOHNSON is a former subcontractor and past president of two national construction associations. She may be reached at email@example.com.