Introduction to Accounting - Essay Example

?Accounting is an information system that serves to identify, record, and communicate economic events of an organization to interested internal and external users. The main objective of an accounting system is to provide financial information that reflects the true “substance” of an organization and the true results of its business activities. Accounting just like any profession has a body of theory that consist of principles, assumptions and standards that together form the building blocks of a proper accounting system. The accounting profession has developed a series of standards that are generally accepted and universally practiced. This common set of recognized accounting standards are collectively known as Generally Accepted Accounting Principles (GAAP).These standards provide information in how to properly communicate economic events or transactions (Investorwords, 2011). The conceptual framework of accounting provides the required information and guidelines regarding the objectives of financial reporting, the qualitative characteristics of financial information, operating guidelines and composition and required elements of financial statements. According to Financial Accounting Standards Board (FASB) the goals of financial reporting are to provide information that: Its useful for making investment and credit decisions Is helpful in assessing the value of future cash flows Identifies assets, liabilities and serves to identify changes in those resources and claims (Obaidat, 2007). In order to make financial information useful there are certain qualitative characteristics that all accounting information must posses to prove useful in the decision making posses. These characteristics are (Cliffnotes, 2011): 1. Relevance-the accounting information provided to the user must make a difference in their decision making. Relevant financial information has to provide either predictive value, provide feedback value or both. Predictive value helps the user forecast future events, such as predicting future stock valuation or future earnings. Information that provides feedback value focuses on confirming or corrects prior information or assumptions . In order for information to be relevant it must be provided in a timely manner so it can provide the right information and at the correct timeframe where it can help guide the decision making process. 2. Reliability-It is expected that financial information must be free of material errors or persona bias. In order to be reliable the information provided must be verifiable, in order to prove that it is free from material errors or bias. As an additional requirement the substance of the information provided must be a faithful representation of the economic events which it summarizes. The last prerequisite of reliable information must be neutral or free of bias. 3. Comparability-the usefulness of financial information is maximized when it can be compared with similar accounting information of other businesses or enterprises. This comparability can only be achieved when the different companies adopt the same accounting principles. In general comparability extends to all accounting not to only financial statements but to all accounting procedures such as costing, inventory and expense recognition. Since there are variations in GAAP and procedures that can be utilized the company must fully disclose the accounting methods used for the recording of financial events or transactions. 4. Consistency-The principle of consistency simply means that a company must use the same accounting principles and methodology from year to year. If a company decides to change any of its accounting practices and adopts a new method, it is the responsibility of management to prove that the new method provides a more accurate or meaningful representation of the financial information. There are a series of operating constrains and guidelines that serve as the foundation to any financial account. These guidelines are classified as assumptions, principles and constraints (Investorwords, 2011). Accounting assumptions provide a foundation for all of the accounting process. There are four major accounting assumptions these are: 1. Monetary Unit Assumption-accountants will only record events or transactions of which its monetary value can be calculated. It is assumed under the monetary assumption that the monetary unit of measure remains constant over time. Subjective characteristics or qualities such as workers experience, skills, or brand position are important characteristics of any business, but do not form part of the financial accounting system since a monetary value cannot be adjudicated. 2. Going Concern Assumption-assumes that unless it is specified, the enterprise will continue in operation in order to carry out its current objectives. For example if going concern assumption was not used as a financial principle the company’s assets would have to be recorded at their liquidation value and not at their real costs. Also long term accounts could not be justified so the accounting implications of the going concern assumption in accounting are far reaching. 3. Economic Entity Assumption-it states that the economic activities or transactions of the entity or business must be kept separate from its owners or other constituents. 4. Time Period Assumption-states that the economic life of the business and its operations can be divided in artificial time periods, which help provide meaning to its financial reporting. By dividing its financial information into useful time segments such as weeks months or quarters, the company can provide information that’s most relevant to the end-user’s needs. 5. Materiality-the materiality constrain means that any item or information that could be useful to decision making process of an end- user, shall be considered relevant or material therefore should be fully disclosed. 6. Conservatism-when in doubt it is the duty of the company to choose the accounting method or principle for recording assets or revenues that is least likely to overstate the value of an asset or income. The accounting profession has developed a series of accounting principles that universally help dictate how economic events are recorded and reported to the users. There are four basic accounting principles (Weygandt, Kieso, Kimmel, 2002): 1. Revenue recognition Principle- dictates that revenue should be recognized in the period where it is legally earned. For example when a sale is performed, revenue is recognized in the point of sale. However there are two exceptions to where revenue recognition is deferred. For long-term-construction contracts the “percentage-of-completion” method estimates revenues in long term construction contracts on the basis of reasonable estimates of progress towards full project completion. Current revenues are estimated by comparing total project costs incurred for the period to the total estimated costs to complete the project. The “Installment method” of revenue recognition is usually used for cash type transactions where the account collection of a credit sale is uncertain. Under the installment method of accounting gross profit is recognized in the period when the cash is collected instead of when the revenue is realized. 2. Matching principle - Simply stated expense recognition is usually tied to the period in which efforts were made to generate those revenue streams, regardless when the expenses are paid or when the actual work was performed .Since its is sometimes difficult or too costly to determine the accounting period of every expense that is incurred there are several ways of recording expenses. Operating expenses are used for costs that can be expensed immediately or through the passage of time as in the case of prepaid insurance. Other expenses are allocated in using systematic allocation methods such as depreciation and amortization. 3. Historical Cost Principle-This principle requires all assets to be recorded at the actual purchase price at the time of acquisition or its historical cost. Since the actual cost of an asset is relevant to the preparation of accurate financial statements. 4. Full Disclosure Principle-it is the company’s responsibility all relevant events or information that could make a difference in the financial position of the entity. Complying with the full disclosure principle occurs through the notes that accompany the company’s financial statements Understanding the basic nature of financial investments, the financial markets and the diversity of financial instruments available to the average investor can be overwhelming for the uninitiated or inexperienced. The process of analyzing and valuation of the individual securities as possible investing alternatives is known as security analysis (Investmentsmart, 2011).The process of security valuation is a time consuming and difficult process. The individual user must have the necessary financial know how to understand the characteristics of individual securities and the factors that affect its pricing. For example valuating stocks can be a difficult process because there are a variety of internal and external economic factors that can affect the perceived value of a stock in addition to the estimated expected return and risk or beta of each individual stock. On the other hand valuating bonds or annuities becomes a straightforward process since the expected interest yield of each is known and the relative risk of each instrument can be easily calculated from available data. Investors looking for direct investments options have the choice of investing in non-marketable securities or marketable securities either through a broker or purchasing directly through other means. A distinguishing characteristic of these non-marketable securities is that they represent direct transactions between the owner and the issuer Potential investors looking to purchase non-marketable securities have options such as savings deposits, certificates of deposit, money market deposit accounts and U.S. saving bonds. For example you as the owner of a bank’s saving account or certificate of deposit acquire these financial instruments directly from the issuing bank or financial institution. There are three types of marketable securities available to potential investors: the money market, the capital market and the derivatives market. Individuals have the option of direct investing in money market securities either through a broker or purchasing directly through other means (Terzo, 2011).The distinguishing characteristics of money market securities are short-term, highly liquid and low risk assets such as U.S. Treasury bills, negotiable certificates of deposit, and commercial paper. U.S. Treasury-bills are considered a risk-free investment for all practical purposes which represent the lowest level of possible risk in the money market securities. A brokerage firm provides individuals with broad options of direct investment in marketable securities or indirectly through buying shares of investment companies which in turn hold a portfolio of securities. Capital markets securities are divided in two categories: fixed income securities and equity investments. The distinguishing characteristic of fixed income securities is that all these securities have a specified payment schedule. Fixed income capital market securities traditionally come in the form of bonds. In a traditional bond arrangement, the borrower agrees to repay the borrowed principal at a specified maturity date and to pay the bond holder interest payments at specified intervals during the life of the bond (Jones, 2002).There are four major types of bonds available in the U.S. to potential investors; U.S. government, federal agency, municipal and corporate bonds. Of all the bond types U.S. Treasury bonds represent the lowest level of possible credit risk which is for all practical purposes is considered risk free just like U.S. Treasury Bills. U.S. Treasury bonds usually have a maturity of 10-30 years and they provide the bond holder with two semi-annual interest payments. Federal agency securities are issued by any government agency to fund any specific project. There are two types of federal credit agencies: federal agencies and federally sponsored agencies. The material difference is that securities of federal agencies are a part of the government, therefore fully-guaranteed by the U.S. government whereas federally sponsored agencies are privately owned institutions which are sponsored by the federal government but are not guaranteed by federal funds. Municipal bonds are issued and sold by states, cities, counties or other governmental entities which are not a part of the federal government and come in two types; general obligation bonds which are backed by “the full faith and credit of the issuer” and revenue bonds which are paid only by the revenue created by the project they were sold to finance. Finally corporate bonds are issued by most of the larger private corporations to help finance their operations. Typical corporate bonds are unsecured obligations which pay semi-annual interest payments and have a maturity from 20-40 years. Unlike treasury securities corporate bonds carry a risk of default so agencies such as Standard’s and Poor’s provide a relative rating for each type of bond to help investors better asses associated risks. Equity securities represent an ownership interest or stake in a private corporation. These securities which represent a residual claim-after payment of all fixed income obligations are typically sold as common stock and preferred stock. Common stock represents a percentage ownership interest of common shares outstanding or in circulation. If a corporation decides to go public and meets certain requirements, the company can list its stock offerings as a listed security in one or more of the stock exchanges or it may decide to trade its stocks over-the-counter as an unlisted stock. Preferred stocks have priority in payment of income compared with common stocks since preferred stock holders are paid after the bondholders but before the common stocks. Options and futures contracts are known as derivative investments. Derivatives are securities that derive their value from an underlying security or asset. Derivatives are traded trough exchanges and associated clearing houses where they can be traded cheaply and quickly. References Obaidat, A. (2007). Accounting Information Qualitative Characteristics Gap: Evidence from Jordan. International Management Review, 3(2), p. 1-7. [Accessed 1 May 2011] Cliffnotes.com (2011). Accounting Principles I. [Accessed 1 May 2011] Investsmart.com (2011). Factors of Security Analysis in Investment Management. < http://investsmart.biz/business-investment/factors-of-security-analysis-in-business-investment/> [Accessed 1 May 2011] Investorwords.com (2011). GAAP. [Accessed 1 May 2011] Jones, C. (1996). Investment: Analysis and Management (5th ed.). New York: John Wiley & Sons. Terzo, G. (2011). What are Marketable Securities? < http://www.wisegeek.com/what-are-marketable-securities.htm> [Accessed 1 May 2011] Quizlet.com (2011). Economic Entity Assumption. [Accessed 1 May 2011] Weygandt, J., Kieso, D., Kimmel, P. (2002). Accounting Principles (6th ed.). New York: John Wiley & Sons. Read More