Principles of Accounting

What It Is

ACCOUNTING PRINCIPLES represent a standard, generally accepted means of presenting financial disclosures to shareholders (including, but not limited to, investors, managers, customers, lenders, suppliers).

Why It Matters

Accurate, transparent accounting practices are extremely important both internally and externally.  This is a short list of the parties interested in organizations’ financial statements:

    • Potential investors/lenders – financial statements are a key piece of information used by commercial banks, private investors, and most any other source of capital to evaluate the long-term efficacy and profitability of your business.  *Non-profit connection: agencies that provide grant money to non-profits can be thought of as “investors”. Grantors like large, private foundations and government agencies usually provide the most significant resources, but also have the strictest financial reporting requirements.
    • Distributing Profits – no matter how your organization is structured, good records are necessary to ensure fair and equitable distribution of profits.  If you operate as a partnership, these records are necessary to determine the correct share for each partner.   Corporations must determine what fraction of company profits will be paid out as dividends to shareholders.  *Non-profit connection: even revenue-generating non-profits sometimes choose to distribute a share of earnings to their employees (there are financial incentives to do so).
    • Planning for the Future – financial statements provide a snapshot of the fiscal health of the business as well as trends over time.  They are especially helpful for information such as: what is happening to my profits over time? What is happening with my sales revenue over time? Are my expenses increasing over time?  *Non-profit connection: even though “revenues” may not be a typical entry in the non-profit’s dictionary, questions about expenses and spending are key to any non-profit’s future.  A well thought out, well justified budget is a key component of any request for funding.
    • Internal Controls – one-time, extraordinary events happen, however, it is especially important for managers to ask themselves why that non-recurring item occurred.  *Non-profit connection: this is every bit as important for effective non-profit managers.
    • Complying with Federal and State Tax Policies – sales tax, payroll tax, and tax returns are just a few of the government compliance issues businesses must deal with.  *Non-profit connection: this is every bit as important in non-profits!

FINANCIAL RECORDKEEPING: THE BASICS

Going Further

Getting to Know the Basic Financial Statements 

While the responsibility for specific knowledge of accounting standards and preparation lies mainly with accountants and auditors, responsible managers should understand the components of the primary financial statements as well as the performance indicators that they communicate.  We have illustrated some of the basics of bookkeeping, but accounting in practice is very nuanced.  To go into more depth, you might consider a class at your local college or university.  Below is are the two of the most basic and relevant accounting courses:

    • Principles of Financial Accounting
    • Principles of Managerial Accounting

Here is a list of U.S. Community Colleges by state.

Advanced Steps

Become Familiar with Alternative Accounting Methods and How They are Changing Over the Coming Years

GAAP (Generally Accepted Accounting Practices) – The term “generally accepted accounting principles” describes a set of guidelines and frameworks set forth by the U.S. federal advisory committee called The Federal Accounting Standards Advisory Board (FASAB or “The Board”).
In October 1999, the American Institute of Certified Public Accountants (AICPA) Council designated FASAB as the body that establishes accounting principles for federal entities.

IFRS (International Financial Reporting Standards) – Similarly, IFRS is a set of financial reporting standards.  IFRS however is set by the International Accounting Standards Board (IASB), an independent, privately-funded accounting standard-setter based in London, UK.

IFRS are used in many parts of the world, including the European Union, Hong Kong, Australia, Malaysia, Pakistan, GCC countries, Russia, South Africa, Singapore and Turkey. As of August 27, 2008, more than 113 countries around the world require or permit IFRS reporting.

The U.S. Security and Exchange Commission (SEC) is currently working towards a unified set of accounting and reporting standards, stating, “An international language of disclosure and transparency is a goal worth pursuing on behalf of investors who seek comparable financial information to make well-informed investment decisions.” If the roadmap released by the SEC in August 2008 is successful, U.S. issuers would begin using IFRS in 2014.  A final decision is expected in 2011 following an evaluation by the commission.
*SOURCE: http://www.sec.gov/news/press/2008/2008-184.htm

Some key differences exist in reporting standards currently:

gaap-v-ifrs3

Resources (Links)

http://www.iasb.org/Home.htm

Summary of International Financial Reporting Standards (IFRS): http://www.iasplus.com/standard/framewk.htm

Federal Accounting Standards Advisory Board: http://www.fasab.gov/

Spotlight On Global Accounting Standards: http://www.sec.gov/spotlight/ifrsroadmap.htm

GAAP AND IFRS, STILL DIFFERENCES: http://www.ifrs.com/Backgrounder_GAAP_IFRS.html

http://www.sec.gov/rules/final/2008/33-8879fr.pdf

Trends

The U.S. Security and Exchange Commission (SEC) is currently working towards a unified set of accounting and reporting standards, stating, “An international language of disclosure and transparency is a goal worth pursuing on behalf of investors who seek comparable financial information to make well-informed investment decisions.” If the roadmap released by the SEC in August 2008 is successful, U.S. issuers would begin using IFRS in 2014.  A final decision is expected in 2011 following an evaluation by the commission.
*SOURCE: http://www.sec.gov/news/press/2008/2008-184.htm

Glossary of Related Terms

Assets: future economic benefits that the firm controls because of a past transaction (e.g. cash, accounts receivable, inventories, land, etc.)

Cash Flows from Operations (CFO): all cash inflows and outflows associated with normal, day-to-day aspects of running the business – exclusive of purchases and sales of major assets (which are shown under CFI).

Cash Flows from Investing (CFI): mainly cash from purchases and sales of long-term assets, CFI may also include cash flows from buying and selling debt and equity securities as well as lending monies (as opposed to borrowing monies, which falls under CFF).

Cash Flows from Financing (CFF): typically involves short-term debt, long-term debt, and/or shareholder equity accounts. Financing activities that would be included as part of CFF include: raising capital by issuing stock, raising capital by issuing debt, repurchasing stock, paying off debt (although payments of the interest associated with that debt fall under CFO), and paying dividends.

Debt to Income Ratio: debt capital divided by total assets. This will tell you how much an organization relies on debt to finance assets. When calculating this ratio, it is conventional to consider both current and non-current debts and assets. In general, the lower the organization’s reliance on debt can lead to a very heavy interest and principal repayment burden. However, when an organization chooses to forgo debt and rely largely on equity, they are also giving up the taxreduction effect of interest payments. Thus an organization will have to consider both risk and tax issues when deciding on an optimal debt ratio. For more information on these and other financial terms, click http://www.investorwords.com.

FIFO: stands for “First in First Out.”  This is the method of accounting for inventory which assumes that an item sold is that which has been in inventory the longest, and using the corresponding expense for the net income calculation. Liabilities – economic obligations to outsiders or claims against assets by outsiders. May be “short term” (“current” – due within one year) or “long term” (“non-current” – due after one year). Examples include accounts payable and bank loans payable.

Generally Accepted Accounting Principles (Standard Accounting Principles): the standard framework of guidelines for financial accounting which includes standards, conventions and rules for accountants to follow in recording and summarizing transactions and in the preparation of financial statements. These principles are regulared and standardized by the Financial Accounting Standards Board (FASB). For more information on generally accepted accounting principles, click http://www.fasab.gov/accepted.html.

Liquidity: the ability of firm to meet its obligations as they come due.

LIFO: one alternative method of accounting for inventory.  LIFO stands for “Last in First Out,” which in practice means that most recent cost of supply inputs are used as the cost of goods sold expense when figuring out net income.

Shareholders’ Equity: the difference left after the total amount of liabilities has been subtracted from total assets.  This amount represents capital contributed by owners (common stock) plus all retained earning not paid out as dividends.

Quick Ratio: a measure of the amount of liquid assets available to offset current debt (cash + accounts receivable / current liabilities). A health enterprise will always keep this ratio at 1.0 or higher. For more information on quick ratios, click http://www.businessplans.org/ratios.html.


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