What accounting is and why businesses need it

In depth

Who sets the rules

Outsiders can rely on financial statements only if businesses prepare them in a consistent way, so reporting in each jurisdiction follows an agreed body of rules, called generally accepted accounting principles (GAAP). This lesson introduces two standard setters: the American one and the international one.

In the United States the rules are written by the Financial Accounting Standards Board (FASB), an independent, private-sector, not-for-profit organisation established in 1973 and based in Norwalk, Connecticut. Its standards are collected in the FASB Accounting Standards Codification, the source of authoritative US GAAP for nongovernmental entities: public and private companies and not-for-profit organisations.

The FASB’s authority over public companies comes through the Securities and Exchange Commission (SEC), the federal agency that protects investors in US securities markets. Under the Securities Exchange Act of 1934 the SEC requires periodic reports from companies whose securities are publicly traded, and the securities laws let it set the accounting standards those reports use. Rather than write them itself, it recognises the FASB as the designated standard setter for public companies, a status it reaffirmed in 2003. A private company such as Lantern files nothing with the SEC, but its bank or a future investor may ask for GAAP statements, so Lantern keeps its books under US GAAP.

Many other jurisdictions use International Financial Reporting Standards (IFRS), formally IFRS Accounting Standards, which are written by the International Accounting Standards Board (IASB). The IASB is an independent standard-setting body within the IFRS Foundation, a not-for-profit, public interest organisation that set up the IASB in 2001. Each jurisdiction decides whether to adopt them: the IFRS Foundation reports that companies in more than 140 jurisdictions are required to use them, but which companies must use them, and which merely may, varies. In the United States, the SEC requires domestic public companies to use US GAAP. Since a rule issued in December 2007, it has accepted statements prepared under IFRS as issued by the IASB from foreign private issuers (foreign companies whose securities trade in the United States), without a reconciliation to US GAAP.

The conceptual framework

Standards on individual topics, such as leases or revenue, rest on a shared foundation called a conceptual framework: a set of concepts that says what financial reporting is for and what makes information useful. Standard setters use it to keep their standards consistent with one another. Under IFRS, companies also use it to develop an accounting policy when no standard covers a transaction. The FASB’s framework is its Concepts Statement No. 8, issued in chapters, among them the objective and the qualitative characteristics in September 2010, at the end of a joint project with the IASB, and the elements of financial statements in December 2021. The IASB issued its current Conceptual Framework in March 2018. The two agree on most of what follows; the boxes note where they part.

The objective of financial reporting

Both frameworks start from the same objective. The FASB states it this way, and the IASB’s paragraph 1.2 is worded almost identically:

The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders, and other creditors in making decisions about providing resources to the entity.

FASB Concepts Statement No. 8, Chapter 1, paragraph OB2

Three phrases carry the weight. General purpose means the reports are designed for many readers at once rather than tailored to one. Existing and potential investors, lenders and other creditors are the primary users, because they provide the business with money and many of them cannot insist on private reports. Decisions about providing resources covers buying, selling or holding shares and debt, making and settling loans and, the IASB adds, voting on or otherwise influencing how management uses the business’s resources. Both frameworks admit that such reports cannot give users everything they need; users also draw on other sources, such as the state of the economy and the industry.

What makes information useful: the qualitative characteristics

The frameworks name the qualities that make financial information useful. Two are fundamental, and information must have both. Four are enhancing: they make relevant, faithfully represented information more useful, but they cannot rescue information that lacks the fundamental two.

Relevance

Information is relevant if it is capable of making a difference to users’ decisions. It does so through predictive value (it helps users form expectations, as March’s catering revenue helps Ana and the bank estimate April’s), confirmatory value (it confirms or corrects earlier expectations), or both.

Materiality

Information is material if leaving it out or misstating it could change or influence the decisions of the people relying on the report. Whether something is material depends on the size and the nature of the item in one particular business, so no single dollar threshold fits every business.

Faithful representation

Information faithfully represents what it claims to describe if it is complete (nothing a user needs is left out), neutral (not slanted, by the choice of figures or how they are presented, to create a favourable or unfavourable impression) and free from error (no errors or omissions in the description, and a sound process behind any estimate). Free from error does not mean perfectly precise: an estimate, such as how many years the espresso machine will last, can be represented faithfully if it is made with care and clearly described as an estimate.

Materiality is why accountants don’t chase every cent. If Lantern’s bookkeeper misfiled a $3 roll of tape, no reader’s decision would change. But materiality is measured against the reader’s decision, not against the number alone. A $150 error would be trivial for a hotel group earning millions and large for Lantern, whose March profit is $990: about 15% of it. In practice accountants and auditors often begin with a percentage rule of thumb, such as 5% of profit, and the SEC’s staff accepts such a rule as an initial step, but only as the beginning of the analysis. A small error can still be material because of its nature: for example, if it turns a loss into a profit, masks a change in a trend, affects whether a business complies with a loan agreement, or conceals an unlawful transaction (SEC Staff Accounting Bulletin No. 99, 1999).

Both frameworks also recognise a constraint: cost. Information costs time and money to prepare, check and read, and the cost should be justified by the benefit. That is why a small business would sensibly record a $40 milk jug as an expense when it buys it instead of tracking it for years as it does an espresso machine.

The basic assumptions

Textbooks gather the starting points of financial accounting into four assumptions. Each one shapes what Lantern records.

Economic entity assumption

The business is treated as separate from its owners and from every other business, and its records contain only its own events. Ana’s savings account, her car and her mortgage are not Lantern’s, and if Lantern pays one of Ana’s personal bills, that is not a business expense. The assumption applies to a one-owner business too, even though the law does not separate a sole proprietor from her business.

Going concern assumption

Unless there is evidence to the contrary, the business is expected to keep operating for the foreseeable future. That is why Lantern records its espresso machine at cost and spreads that cost over the five years it expects to use it, instead of reporting what the machine would fetch in a forced sale tomorrow. If a business intends or is forced to stop trading, its statements may have to be prepared on a different basis, and they must say so.

Monetary unit assumption

Only events that can be measured in money are recorded, in one currency (US dollars for Lantern), and the currency is treated as a stable unit, so changes in its purchasing power through inflation are ignored. A loyal clientele or a talented barista may be valuable, but neither appears in Lantern’s accounts.

Time period assumption

The life of a business can be divided into artificial periods (months, quarters, years) so that results can be reported while they are still useful. In this course Lantern prepares statements every month so that you can see a whole cycle; most businesses produce monthly figures for their managers but close their books formally once a year, at the end of a twelve-month fiscal year that need not end on 31 December.

The basic principles

On top of the assumptions, four principles govern how events are recorded. Lesson 8 studies two of them in depth; here is what each says.

• Historical cost. Under the historical cost principle, assets are recorded at what they cost to acquire: the price paid plus the costs of getting them ready for use. Lantern’s espresso machine and grinder enter the records at $12,000, and stay there even if a similar machine soon costs more or a buyer offers less. Cost is verifiable, since there is an invoice, but it can drift away from current value, which is why the standards require current values for some items, such as certain investments.
• Revenue recognition. Revenue is recorded when the business delivers the goods or services it promised, not when cash arrives. Lantern earns $4,200 when it caters Meridian Partners’ conference on 12 March, although it is paid later; Harbor Tech’s $2,400 deposit is not revenue until the events take place.
• Expense recognition. Expenses are recorded in the period in which resources are used up to earn revenue (often summarised as matching expenses with revenue), not when they are paid for. Lantern’s $1,800 insurance policy becomes an expense at $150 a month over the year it covers.
• Full disclosure. Under the full disclosure principle, the statements and their notes should include everything a reader needs to understand them: the accounting methods used, the terms of a bank loan, a lawsuit filed against the business, a major event after the end of the period. The notes are part of the financial statements, not an optional extra.

Why trust matters

Financial statements are prepared by the managers whose performance they describe, which gives managers a reason to flatter the numbers. Two safeguards make the statements credible. The first is an audit: an independent accountant examines the records and the evidence behind them and gives an opinion on whether the statements present the business’s financial position and results fairly, in all material respects, in accordance with the applicable framework, such as US GAAP or IFRS. Public companies in the United States must be audited, and since the Sarbanes–Oxley Act of 2002, passed to combat corporate and accounting fraud, their auditors have been overseen by the Public Company Accounting Oversight Board (PCAOB). A private business such as Lantern is usually audited only when a lender, investor or regulator requires it.

The second safeguard is professional ethics. Certified public accountants in the United States follow the AICPA’s Code of Professional Conduct, whose principles include integrity, objectivity and independence, and due care; an auditor must be independent of the company audited, both in fact and in appearance. Ethics binds every accountant, not only auditors. A bookkeeper who records an owner’s holiday as a business expense, or books next month’s sales this month to meet a target, breaks faithful representation and the trust of every user who relies on the numbers.