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Fundamental Principles of Accounting

Describe about the Financial Accounting for Practice of the Real World.

1. As the Accounting standard, the fundamental principle of the accounting states that the accounts should be based on the 3 principles i.e.

  • Prudence
  • Substance over form
  • Materiality

Wherein principle of prudence says that the provision should be made in the books of account for all possible known liabilities and losses even though the amount cannot be determined with surety and is best estimate. The most common examples to illustrate this principle are the provisions made for bad and doubtful debts, provision for discount on debtors, provision for contingency, provision for repairs and renewals, Provision for depreciation, provision for taxation, etc (McShane & Mary, 2010). This principle is used for accounting only for the interest of the stakeholders of the organization.

Provision for bad and doubtful debts as the name suggests is created in the books based on the past history of the recoverable of the entity. It is generally created as a percentage on the total debtors of the entity so that a best estimate of the good debtors can be presented in the financials. Good debtors means that there is a certainty that the amount will be recovered from those debtors. This will also help in having the correct picture of the current assets of the company. As and when the bad debts will occur in the future the amount will be deducted from the provision rather than hitting the profit and loss account directly.

Provision for discount on debtors is created in the books when the entity has a surety that it has to give discount to its debtors against the payment to be made by them in the coming years. A best estimate of such expense which will be incurred in the future years is required to be booked the current financial year so that the profit and loss account of the future years are not affected by these expenses. However the discount on debtor’s provision is created only on good debtors because the entity will be able to give benefit to its customers at its own expense only when the customers act in good faith.   

Provision for Contingency is created in the books only when the entity has a virtual certainty that the operations of the entity are binding upon some contracts which can be sued against it upon non- completion of the contract within the due time as mentioned therein. When such contracts are entered in by the entity and there are chances that the contracts will be not be able to be completed by the entity within the due date as mentioned therein, a provision is required to be made in its books during the current year in order to prevent its books to get hit by a huge loss in the coming years.

Provisions in Financial Accounting

Provision for Repairs and Renewals is created in the current year for the expense which might take place in the coming years on repairs and renewals. This estimate is done based on the past expenses which have already been done in the books of accounts (Brealey et. al, 2011)

Hence, it proves that Although the statement of financial performance is a record of past achievement, the calculations required for certain expenses involve estimates of the future.’

Based on the past performance of the company, an estimate can be made for the future operations of the company, however nothing can be ascertained with surety since there are various factors attached to the operations of the organization. The market scenario changes every second day, the credit policies keeps on changing, the policies of the management are also responsible for the profits to be earned for the company. The funds generated during the past year got slow in the work in progress of the goods being manufactured. Only when the goods will be completely manufactured and will be sold in the market, automatically the sales position of the company will improve and cash will be generated therein as projected by you. The labor cost increased during the year as the quantity of the product getting manufactured during the year has increased as compared to the previous year. Though these products are still under work in progress, hence the cost of the same are reflecting in the financials of the organization but the profit in respect of the same is not being captured during the current year financials (Albrecht et. al, 2011). As the quantity being manufactured has increased, hence there was need to purchase more machinery by the organization. A huge cash outflow took place because of the need to purchase machinery by the organization. A provision for depreciation has also reduced the profit of the organization during the current financial year. The profits as projected by you will only be seen in the next quarter. Wherein the book profits as well as the cash position of the organization will improve once the products will enter the market for sales (Albrecht et. al, 2011). We were also not able to realize all our debtors of the previous financial year and moreover we were required to pay all our creditors in cash. This also resulted in financial crunch during the financial year. We will have to draft credit policies for our debtors so that the amount can be realized faster from them. We can also offer cash discount which will also help us in collecting cash from our debtors earlier. Though the financials are showing loss, it is merely a book loss and this loss will automatically convert into profits in the coming quarter. The fixed costs on account of electricity and rent have also increased during the year (Kaplan, 2011). Though the administration and selling expenses has gone down because the main expense is incurred during the year was in relation to goods being manufactured and the costs in respect of sales will take place only during the coming year. The figures as mentioned in the financials are absolutely correct and there is no falsification in the representation of accounting statement. Please consider the points as mentioned above.

Depreciation as a Valuation Adjustment

Regards

Depreciation is an effect in which the value of assets such as equipments, buildings, trucks, cars etc creates decrease in the net income and stockholders’ equity. This happens by passing an entry in the asset account called “Depreciation Expense” and accumulated depreciation is credited (Horngren, 2013).

The annual depreciation is determined on the basis of a) original cost, b) estimated salvage value and c) useful life. It should be taken as an allocation or amortization of the cost of the asset and not as a valuation technique. Valuation concentrates on determining the potential life of an asset but also on the basis of how much someone is ready to pay or the “fair value” of an asset. Depreciation is much simpler than that. It is simply the distribution of the used value of the asset over the useful life. It is following the matching concept as the accountant is matching the cost of the asset to the periods in which the revenues were generated from this asset (Brealey et. al, 2011).

There are separate tax laws for depreciation and it is a deductible expense for business i.e businesses can get tax breaks on the depreciation amounts. The financial reporting of depreciation is different from the tax related reporting due to this reason.

Depreciation is also a non-cash expense as allocating this no cash is being moved here or there.

Hence valuation which is discovery of a saleable price of an asset is a different technique altogether and cannot be said to be equal to depreciation.

There is no point in depreciating buildings because their value increases

A business depreciates a building for financial reporting purposes in every accounting period for the use of its operations. Depreciation will reduce the value of the building over its useful life in the balance sheet and reduces net income as an expense in the Income statement. An estimate of the use of the building can be recorded as an expense (Brigham & Ehrhardt, 2011).

In simple entry, Depreciation account is debited and building account which is a real account of balance sheet is credited.  The normal Depreciation account is a normal line item reported each year in the Income statement. In the next step, the accumulated depreciation account is also credited with the same amount. This Accumulated depreciation account is carried forward each year and is total of the value of the building so far. The Depreciation amount is added to this “Accumulation Depreciation” amount. This new “Accumulation Depreciation” is reported in the Balance sheet as “Less Accumulation Depreciation” one line below the Buildings account. This will give the true value of the building which stands in that financial year (Choi & Meek, 2011).

Depreciating Buildings

Depreciating a building is necessary for financial statements purposes and shows the real used value of the asset. Its value might keep increasing but this “used” value has to follow the matching principle and the final “Accumulated depreciation” will not exceed the original value of the building (Christensen, 2011).

In many countries this practice of depreciating buildings has been done away with and given a zero percent depreciations status. This is to remove the unnecessary record-keeping for the purpose of showing the operational usage.

4. One reason why companies move from being a public one to a private one is to remove all the tedious work of regulatory filings and focus on strategic, long – term goals. The public sentiment may create share prices volatility which might be harming the company’s image. This might create issues in stock holding and to remove such issues, companies may want to issue fixed term covenants which private investors are ready to buy (Davies & Crawford, 2012). This will also give space for a private-equity firm to be a part of the investment and the company can take advantage of having an active shareholder who can give guidance in the growth path of the company instead of multiple shareholders of the public company where they might not be constructive. A business would opt for conversion of partnership or sole proprietorship into a private limited company because of the following reasons. Firstly, businesses require huge amount of money to maintain economic growth and therefore, they need to borrow money. In structures like partnership, every partner are liable for the amount of debt raised and in a sole proprietorship, the proprietor is individually liable for everything that means if the business gets sued, the proprietor himself may lose everything and get sued. Moreover, this is not in the case of a private limited company because in such a structure, only the amount that is invested in initiating the business might get lost in case of any trouble. There is no such danger of attaching personal properties to repay debt obligations like that in partnership and the personal property of directors will remain safe that does not prevail in proprietorship structures. Secondly, private companies easily incorporate equity funding, as there is a clear difference between the directors and shareholders of the company. In fact, private equity and venture capitalists are more unlikely to invest in any other structures like partnership or proprietorship. This is because there is only one proprietor in a sole proprietorship while partnership would require these investors to become partners of their firm (Deegan, 2011). Hence, as private companies are investment-ready in nature, these are more preferable than any other form of structure. Therefore, businesses are keen to choose private companies over partnership and sole proprietorship.

Benefits of Moving from Public to Private Companies

Sole proprietorship is a one-man show and the major advantage of moving to private company or LLC (limited liability company) is liability. A sole proprietor is accountable for all the debts and liabilities since he is the key man running the entire business. Here even his personal property and assets can be attached in case the venture goes bust and has to be liquidated to pay the creditors. In a private company, only his business assets are liable to go and outsiders cannot claim anything beyond these to settle the claims. The private company is an entity in its own and can be sued or closed without affecting the sole proprietors. The liability of each member is limited by the number and face value of the shares he/she holds in the company. Businesses would opt for a private company over public company due to the following reasons. Firstly, private companies pursue flexibility on structuring their company as a limited liability, corporation, or any other entity so that it can serve in the best interest of the company. It is structured so that the company income flows through the owners, who are then taxed at lower rates than corporations are. This also allows the owners of private companies prevent the risk of double-taxation. However, a public company is not so flexible enough to serve better interests of the company. Secondly, owners of private companies possess complete authority over operational decisions and they do not worry about interference and expectations of shareholders. Nevertheless, in a public company, shareholders are generally focused on its current earnings and might even exert pressure to enhance earnings in short-term that can in turn enhance the value of their stock. The executive management team of public company possessing a long-term vision may be frustrated due to such pressurization (Libby et.al, 2011). Furthermore, due to such deviation from motives, public companies are often vulnerable to hostile takeovers but privately held companies cannot have their company and resources sold out from beneath them. Lastly, private companies possess a significant right over disclosure and reporting requirements that can benefit their competitors but public held companies are vulnerable to shareholder litigation with charges of fraud and misrepresentation when things deviate from the plan (Melville, 2013). Therefore, businesses might choose a private company over public company.


5.
As a first-year accounting student, the viewpoint of Irene that accrual accounting provides useful information about the financial performance and position of an organization than the statement of cash flow is entirely topsy-turvy in nature.

Irene’s dilemma regarding cash flow statement that it is a step in wrong direction must be because of such confusion. The superiority of accrual accounting over the statement of cash flows is central to the ascertainment of objectives and nature of financial reporting. Accounting records prepared by using cash basis identifies expenses and income as per the real-time cash flow. Income is recorded when funds are received rather than based upon when it’s actually earned, and expenses recorded as payment has been made rather than as they are actually incurred. Therefore, Irene must consider that under this method, it is possible to defer taxable income so that receipt of payment does not happen in the current year. Similarly, it is also possible to enhance the expenses by paying bills as they are received, in advance of due date. Therefore, accrual accounting does not provide a clearer picture of the financial position and performance of a company. Besides, statement of cash flows is simpler than accrual accounting, provides a more appropriate picture of cash flow, and income is not subject to taxes until it is actually received (Merchant, 2012). In response to the same, the importance of cash flow statement in depicting a clearer picture of the financial position and performance of a business are that firstly, the cash information is very hard to manipulate as it just depicts cash in and out and is not affected by accounting accruals or policies. Secondly, it assists in making appropriate projections regarding the company’s future liquidity position and therefore, arrange for shortfalls in money by conducting arrangements in advance and in case of extra money, it assists in earning extra return out of such idle funds. Thirdly, it serves as a filter for the investors and analysts to judge whether the company has prepared financial statements perfectly or not because if a discrepancy arises in the cash position depicted through the balance sheet, it signifies statement of cash flows are incorrect. Lastly, cash flow accounting helps in offering an analytic framework for linking present, past, and future financial performance of the company. In other words, it depicts both the ability of the company to pay its way in future and planned economical policy (Needles & Powers, 2013). Moreover, many advocates of cash flow accounting suggest that the problems of determination of income and valuation of assets are so enormous that they propose the derivation of a separate accounting system and compulsorily incorporate statement of cash flows in the financial statements of the company. They believe that cash flow statement provides significant information about cash management and cash that any other system like accrual system of accounting can individually provide (Northington, 2011). On a whole, Irene must reconsider her thoughts on the efficacy of cash flow statement over accrual system of accounting. 


6.
The owner’s intention regarding capital that must be shown on the asset side in the statement of financial statement is not correct. In case of financial statements, capital shown as a liability depicts debt obligations that businesses have incurred in order to purchase their capital goods. So, in relation to this, capital is just being utilized as another term for loan. In other words, it is a specific kind of loan that is majorly utilized for a specific purpose and that is to buy capital goods (Parrino et. al, 2012). Furthermore, a broader meaning of capital that is generally use in few phrases such as ‘capital employed’ implies value of total assets including working capital and fixed assets. Such capital employed already appears as an asset in the balance sheet and its amount is exactly similar to the sources of funds shown in liability side. Therefore, there remains no doubt of not depicting capital as a major asset in the statement of financial position. In fact, a business cannot operate without funds required for working capital and fixed assets. These funds arise from two sources, borrowed funds, and owner’s funds. Both these are sources of funds that the company has received. Hence, both appear as a liability in balance sheet (Graham & Smart, 2012). Moreover, the confusion of the owner regarding capital shown as a liability will automatically disappear if he or she treats an entity as separate from that of its owners. Actually, capital is the investment of shareholders or investors but not of the company or business. A company just takes money from their owners for operating business. At some point of time, it must be returned to the owner and hence, it is the liability of the company. When a shareholder requires money, he immediately sells his shares. This implies that the same liability is transferred from one shareholder to another. However, the share capital in the balance sheet will remain same. Therefore, as per the concept of business entity, whenever a company or business liquidates, the share capital shown on the liability side must be returned to its shareholders. Another reason as to why capital is considerable as a liability and not asset is that when a person invests money in bank, he or she gets earnings in the form of interest. Each of these funds is shown on the liability side of bank’s balance sheet. It is more probably like a loan taken by a bank from his customer. In the similar way, a company issues shares and utilizes the money obtained from the shareholders to conduct business. Therefore, when a company earns revenue, a shareholder also gets an earning from the purchased shares by him. The company can provide dividend to these shareholders if their money is shown on the liability side of balance sheet (Williams, 2012). Hence, it is the liability of the company and it offers happiness to the shareholders by providing these rewards in the form of dividend. Therefore, the owner’s content that capital is a major asset and must be shown as an asset is incorrect.

References

Alter, S 2013, Work System Theory: Overview of Core Concepts, Extensions, and Challenges for the Future, Journal of the Association for Information Systems, vol. 14, no. 1, pp. 72-121.

McShane, S.L, & Mary, G 2010, Organizational Behavior: Emerging Knowledge and Practice for the Real World. Boston: McGraw-Hill Irwin

Albrecht, W., Stice, E. & Stice, J 2011, Financial accounting, Mason, OH: Thomson/South-Western.

Brealey, R., Myers, S. & Allen, F 2011, Principles of corporate finance, New York: McGraw-Hill/Irwin.

Brigham, E.F. & Ehrhardt, M.C 2011, Financial Management: Theory and Practice, USA: Cengage Learning.

Choi, R.D. & Meek, G.K 2011, International accounting,  Pearson .

Christensen, J 2011,  ‘Good analytical research’, European Accounting Review, vol. 20, no. 1, pp. 41-51

Davies, T. & Crawford, I 2012, Financial accounting, Harlow, England: Pearson.

Deegan, C. M 2011, In Financial accounting theory, North Ryde, N.S.W: McGraw-Hill.

Graham, J. & Smart, S 2012, Introduction to corporate finance, Australia: South-Western Cengage Learning.

Horngren, C 2013, Financial accounting,  Frenchs Forest, N.S.W: Pearson Australia Group.

Libby, R., Libby, P. & Short, D 2011, Financial accounting, New York: McGraw-Hill/Irwin.

Kaplan, R.S 2011, ‘Accounting scholarship that advances professional knowledge and practice’, The Accounting Review, vol. 86, no.2, pp. 367–383.

Melville, A 2013, International Financial Reporting – A Practical Guide, 4th edition, Pearson, Education Limited, UK

Merchant, K. A 2012, ‘Making Management Accounting Research More Useful’, Pacific Accounting  Review, vol. 24, no.3, pp. 1-34.

Needles, B.E. &  Powers, M 2013, Principles of Financial Accounting, Financial Accounting Series: Cengage Learning.

Northington, S 2011, Finance, New York, NY: Ferguson's.

Parrino, R., Kidwell, D. & Bates, T 2012, Fundamentals of corporate finance, Hoboken, NJ: Wiley

Williams, J 2012,  Financial accounting, New York: McGraw-Hill/Irwin.

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