Basic_Accounting_Concept_and_Business_Structures

Basic Accounting Concepts and Business Structures Basic Accounting Concepts and Business Structures The Financial Accounting Standards Board (FASB) is responsible for the establishment and development of financial accounting standards based on a conceptual framework. This conceptual framework is the theory of accounting, which is used to develop the rules of financial accounting called “Generally Accepted Accounting Principles” (GAAP). The FASB prescribes a standard called “The Hierarchy of Generally Accepted Accounting Principles”. This standard categorizes the sources of GAAP (Kieso, Weygandt, & Warfield, 2007). According to Kieso, Weygandt, & Warfield’s book (2007) the house of FASB represents the hierarchy of the sources of GAAP. These sources are divided into four categories; A, B, C, and D. The category A includes the highest or major sources. FASB Standards, Interpretations, and Staff Positions; APB Opinions; and AICPA Accounting Research Bulletins are the major sources of GAAP. The source hierarchy requires companies to consider first the category A pronouncements to identify accounting treatments for an event. If these pronouncements are not able to provide support and guidance to address the event then the companies can consider the other sources from categories B through D. If a conflict arises between the pronouncements in categories B through D, companies should examine the higher category, which will be the category B. The FASB states the objectives of financial accounting and reporting in its conceptual framework. In order to meet these objectives, accounting information should dominate certain qualities; decision-specific and user-specific qualities. The main focus of accounting formation is on decision-specific qualities because the decision usefulness is the most important objective of financial accounting. The decision-specific qualities are divided into two qualities; primary qualities and secondary qualities. The two primary qualities, relevance and reliability, are the most critical ones (Kieso et al., 2007). Accounting information should be relevant to the decision, otherwise it will be useless. To have relevance, accounting information should possess the three other qualities; predictive value, feedback value, and timeliness (Kieso et al., 2007). For example a positive net income of a company is a feedback value that demonstrates the company’s profitability and its management’s productivity and effectiveness. On the other hand, when a company succeeds to maintain its net income positive for several consecutive years, this success is a predictive value that shows how much a company is capable in generating cash in the future. To make these values significant, companies are required to report information to net income in a timely manner. To have reliability, accounting information needs to be verifiable, neutral, and a faithful representation of business activities (Kieso et al., 2007). Verifiability is a quality that implies a general agreement among different measurers. This means that the measurers should obtain similar results when they are using the same methods. Neutrality means that accounting information should be unbiased. For example, companies should disclose information about the recalls and lawsuits. All companies are required to have a faithful representation of their business activities. For example, when a company reports inventory in its balance sheet, first the inventory should represent all items that intended to be sold and second the method that is used to calculate the inventory should be disclosed as a footnote in balance sheet. Two secondary qualities are comparability and consistency. Comparability of accounting information enables users to recognize similarities and differences between two different business activities or in the same company over time. Useful accounting information should be consistent. Consistency in accounting information means that similar accounting procedures should be practiced for the same company over time or for two different companies at the same point in time (Kieso et al., 2007). There are two different accounting systems to record revenues and expenses; accrual-basis and cash-basis. In accrual-basis accounting system, a company records revenues when it sells its products or provides services to its customers. In another word, in accrual-basis accounting we record revenues when we earn them, and we record expenses with the related revenues. Accrual-basis accounting systems foster two important principles in accounting; revenue recognition principle and matching principle. The revenue recognition principle indicates that we record revenue in the period in which we earn it (Kimmel, Weygandt, & Kieso, 2007). This means that if a company sells products or provide services to a customer in 2010, then the firm should report the revenues in its 2010 income statement. In cash-basis accounting system, we record revenues necessarily at the time we receive cash, and we record expenses at the time we pay cash. This accounting system violates the revenue recognition principle and the matching principle, and it is not accepted in preparing financial statements. Under cash-basis accounting, we may overstate or understate the revenues and expenses by manipulating cash. Thus, the accounting information provided under cash-basis accounting is not useful or valuable in decision making (Kimmel et al., 2007). The three major business structures are sole proprietorships, partnerships, and corporations. A sole proprietorship represents a single person’s ownership whereas a partnership represents multiple persons’ ownership. In these two types of businesses there are no outside investors. For example, a single person can form a sole proprietorship by establishing a computer repair business or form a partnership by establishing the same computer repair business with a friend. Corporation is an entity that legally separate from its owners. The owners are the stockholders. The owners finance the business by issuing common stocks (Kimmel et al., 2007). Coca-Cola, Microsoft, IBM, GM, and A Coca-Cola, Microsoft, IBM, GM, and American Eagle are examples of corporate business structures. These business organizations have their own advantages and disadvantages. The major advantage of the corporation is because of the limited liability of the owners or stockholders. This means that the owners are not personally responsible for the financial debts of the corporation. If business fails, owners or stockholders are not obliged to pay the financial obligations of the corporations more than of what they have invested by purchasing the company’s stocks. In contrast, a sole proprietorship or partnership is obliged to pay all its financial obligations and remaining debts. If they fail to do so, all the personal assets of owners will be surrendered in order to satisfy the debts. The disadvantage of corporation is its double taxation. In contrast, any income of a sole proprietorship or a partnership is taxed only once, and the personal income tax rates. Reference Kieso, D. E., Weygandt, J. J., & Warfield, T. D. (2007). Intermediate accounting (12th ed.). Hoboken, NJ: Wiley. Kimmel, P. D., Weygandt, J. J., & Kieso, D. E. (2007). Financial accounting: Tools for business decision making (4th ed.). Hoboken, NJ: Wiley.