17 - The Objectives of Financial Reporting & Concepts of Accrual Accounting

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spk_0 Welcome to Accounting 101, episode 17, the objectives of financial reporting and concepts

spk_0 of accrual accounting.

spk_0 Today we are going to discuss the objectives of financial reporting and the main assumptions,

spk_0 principles, concepts and constraints behind accrual accounting, which is the type of accounting

spk_0 covered in US GAP.

spk_0 US GAP or the United States generally accepted accounting principles are the standards for

spk_0 accrual accounting in the United States.

spk_0 US GAP is issued by the Financial Accounting Standards Board or FASB.

spk_0 FASB was in turn created by the American Institute of Certified Public Accountants or AICPA.

spk_0 FASB issues what are known as the Accounting Standards Updates, statements of financial accounting

spk_0 concepts and other literature that outlines US GAP.

spk_0 It gets a bit confusing with what is official US GAP and what's just guidance, but we're

spk_0 going to put that stuff aside and focus on the rules and guidelines that we need to be aware of.

spk_0 If you have absorbed the information from the prior episodes, you have the debits and credits down.

spk_0 Now you need to learn some of the basic rules that should be followed.

spk_0 And I know that this episode is a little dry, but I would not be putting this in if it were not important.

spk_0 We will first discuss FASB's principles and objectives of financial reporting and then move on

spk_0 to the general principles of accrual accounting.

spk_0 As I mentioned in earlier episodes, the accrual accounting method is the proper method of accounting

spk_0 in that it most accurately reflects the activities of a business.

spk_0 But when I say proper, you should keep in mind that proper is relative to the purposes of the financial statements.

spk_0 You may also see financial statements that are prepared on a cash basis or financial statements

spk_0 that are prepared on an income tax basis.

spk_0 Financial statements can be prepared internally by a company or externally by an accounting firm.

spk_0 The financial statements we are discussing are those prepared externally by a CPA firm.

spk_0 Accountants will conduct either an audit, review, or compilation.

spk_0 I'm not even going to get into the differences between the three right now.

spk_0 And then they will issue financial statements that are called that name,

spk_0 audited financial statements, reviewed financial statements, or compiled financial statements.

spk_0 When you see financial statements of an American company, they are most likely going to be in conformity

spk_0 with US GAP. Unless a method other than accrual is being used to present the financial statements,

spk_0 or if there is some financial reporting exception.

spk_0 In any case, you should see a notice stating whether the financial statements are in conformity

spk_0 with US GAP. Public companies in the United States, which are companies that are listed on a public

spk_0 stock exchange, are subject to further reporting regulations, because the SEC needs to ensure that

spk_0 public companies do not try to deceive shareholders. Financial reporting stress is presenting

spk_0 information as fairly and objectively as possible. That is your objective as an accountant when

spk_0 you are doing financial reporting. All of the concepts we are about to go through for financial

spk_0 reporting are related to this, and it is just FASB breaking it down into painful detail.

spk_0 The FASB concept statements go through the objectives of financial reporting for a business.

spk_0 The primary reporting objective is to provide useful information for investment and credit decisions.

spk_0 Other main reporting objectives are to provide information useful in determining cash flow

spk_0 and information about a company's resources, claims to those resources, and changes in resources.

spk_0 By resources, we really mean net assets. All of these reporting objectives can be accomplished

spk_0 if we present the information as fairly and objectively as possible. FASB lists quality of

spk_0 characteristics of financial information that make financial reporting more useful. The fundamental

spk_0 quality of characteristics are relevance and faithful representation. Relevance is information that

spk_0 is capable of making a difference in the decisions made by users. Faithful representation

spk_0 ideally means that the financial information is complete, neutral, and free for error.

spk_0 Information must be both relevant and faithfully represented to be useful for investment decisions.

spk_0 The point to take away is that if something is important to someone reading a financial statement,

spk_0 it should be disclosed in a fair way. The concept statements then go on to list enhancing

spk_0 quality of characteristics that enhance the usefulness of information that is relevant and faithfully

spk_0 represented. Those enhancing characteristics are comparability, verifiability, timeliness,

spk_0 and understandability. Comparability means that the information should be presented consistently

spk_0 so that the information can be compared with similar information about other entities

spk_0 or the same entity in a different reporting period. The concept statement mentions consistency

spk_0 along with comparability here. This means that once we adapt a method, we should continue to use

spk_0 that same method on the same type of items indefinitely. Consistency leads to comparability.

spk_0 Verifiability means that the financial information is reproducible, so a different

spk_0 preparer of the financial information could reach the same consensus. Timeliness means having

spk_0 the information available in time to make decisions. Understandability means classifying,

spk_0 characterizing, and presenting information clearly and concisely. The main constraint of financial

spk_0 reporting is cost. There is a cost imposed on a company that is reporting its financial information,

spk_0 so the cost to reporting should be justified by the benefits of having that financial information

spk_0 available to decision makers and other users of the financial statements. Another FASB concept

spk_0 focuses on when items should be recognized. It defines when revenues and expenses should be recorded

spk_0 on the general ledger. FASB states that revenue and gains are not recognized until they are

spk_0 earned and they are realized or realizable. By earned, that means that the company has performed

spk_0 its end of the bargain to the customer to earn the revenue. Realized means that you have received

spk_0 payment. Realizable means that we have an asset that is acclaimed to cash or can readily be converted

spk_0 to cash. For example, accounts receivable. And when I say recognize, that is the point at which a

spk_0 transaction should be recorded on the general ledger. So revenue is recognized when we earn the

spk_0 revenue and we have a right to receive payment. FASB also states that expenses are generally recognized

spk_0 when an entity's economic benefits are consumed in a revenue earning activity. A decrease in economic

spk_0 benefit is a fancy way of saying that an expenses incurred because you either reduced an asset or

spk_0 you incurred a liability for business purpose. Notice that both of these things are credits,

spk_0 whether you reduce an asset or increase a liability, which makes sense that we would have to

spk_0 balance that transaction with a debit and it makes the most sense that debit is an expense account

spk_0 because that corresponds to the loss of economic benefit that occurred. An expense or loss can also

spk_0 be recognized if it becomes clear that a previously recognized future benefit of assets

spk_0 has been reduced or eliminated or if a liability has been incurred or increased without an

spk_0 associate increase in economic benefits. You should recognize expenses when they are incurred

spk_0 and they should be matched to the same period as the revenues that those expenses helped generate

spk_0 if feasible. This principle is known as the matching principle. How it generally works is that

spk_0 some expenses like cost of goods or will be matched with revenues recognized in the same period.

spk_0 Many expenses such as selling and administrative expenses will be recognized in the period which

spk_0 the expense is either paid with a credit to cash or is otherwise incurred with a credit to a liability

spk_0 account. I should also mention that financial statements usually include various notes that

spk_0 explain the methods used and offer information regarding different items. The notes to the financial

spk_0 statements are very important. These notes can get pretty lengthy depending on the size and complexity

spk_0 of the entity. I'd like to briefly touch on all of the main assumptions, principles, concepts,

spk_0 constraints and whatever else that they're calling these ideas used in a cruel accounting.

spk_0 First we have the business entity concept. This means that each business entity should be

spk_0 accounted for separately. A business that you are keeping a general ledger for has a distinct

spk_0 general ledger and is a distinct business entity from its owners and from other entities under

spk_0 common ownership. The going concern concept. Contrary to how the name sounds, this means that we are

spk_0 expecting the business to continue operating into the future indefinitely or at least into the

spk_0 foreseeable future. The materiality concept. Something is material if it is significant enough to be

spk_0 important to our audience. The monetary unit assumption. This assumes that all transactions

spk_0 can be expressed in monetary units. The periodicity assumption. This assumes that a company's business

spk_0 activity can be divided into artificial reporting periods such as annually, quarterly, monthly,

spk_0 etc. The historical cost principle. Businesses generally record most assets and liabilities at cost.

spk_0 The item is not going to be adjusted to reflected at fair market value on regular financial

spk_0 statements. You may see items reported at fair market value when something is being done for

spk_0 another purpose, like trying to determine the value of a business for example. Or it may be common

spk_0 in an industry to report a certain item at fair market value. This would be an example of an

spk_0 industry practice constraint which we will discuss. The revenue recognition principle. Revenue should

spk_0 be recorded when realized or realizable. This is a general rule for revenue recognition.

spk_0 There are a variety of different revenue recognition methods that can override this general principle.

spk_0 The matching principle. Expenses, especially our cost of goods sold, should be reported in the

spk_0 same period as the revenue related to those expenses. If the expense cannot be matched to revenues,

spk_0 it should be recorded in the period it was incurred. The full disclosure principle. Our financial

spk_0 records should include all of the relevant information necessary for our audience to understand

spk_0 the records. The cost benefit principle, which is the same idea as the cost constraint we discussed

spk_0 earlier. The cost to provide the information in our financial statements should not exceed the

spk_0 benefit received from that information. The conservatism principle. This means that we recognize

spk_0 expenses and liabilities as soon as possible. But we recognize revenues and assets only when we

spk_0 are sure that they are realizable. Think of this principle in that we are always being conservative

spk_0 and assuming the worst case scenario in terms of profitability. We like to understate income

spk_0 and assets in accounting rather than overstate them. The objectivity principle. This means that our

spk_0 reporting must be unbiased. It must be based on the best available information and should be

spk_0 reproducible. You must look at the desires of management in an objective way. Depending on certain

spk_0 factors, management of a company may be motivated to overstate or understate their income.

spk_0 And management knows that they may be able to achieve this through methods of revenue,

spk_0 recognition, or timing. The consistency principle. When we adopt a method for an item, we should

spk_0 continue to use that same method on that same type of item indefinitely, which helps make our

spk_0 financial statements comparable from period to period. Industry practices constraint. It may be

spk_0 common in an industry to deviate with recognition or reporting standards. If a deviation is made,

spk_0 that does not mean that the company stops using US GAP to report on all other items, only for that

spk_0 specific item. Another constraint is timeliness. Every project has a deadline, and there can be a

spk_0 challenge to provide relevant and useful information in a timely manner. That covers the assumptions,

spk_0 concepts, principles, and constraints of a cruel accounting, as well as some of the basic financial

spk_0 reporting objectives. This episode was a bit different than our previous episodes because we

spk_0 did not focus as much on the debits and credits. But it's good for you to get a handle on these

spk_0 different ideas now that you understand the debits and credits at a higher level. Once you

spk_0 better understand the accrual method under US GAP, then you can appreciate the differences between

spk_0 the accrual method and the cash basis or other methods of accounting. I hope you all learned a bit

spk_0 today. Please spend a moment to read and review the show. I appreciate those who have rated the show

spk_0 or reached out to me, and I'm glad that the series has helped many of you, and some of the emails

spk_0 have been very touching. I hope you may apply the knowledge in this series to bettering your own life

spk_0 or those around you. There are plenty of jobs in the accounting profession, and if you have a good

spk_0 grass, you can really do well for yourself. Thanks for joining me, and good luck!

17 - The Objectives of Financial Reporting & Concepts of Accrual Accounting

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