The accounting process starts with the recording, classifying of data and ends with the reporting of the financial impact of the business transactions. It is considered an art not a science. It is not exact and cannot necessarily mean the same thing to any number of interested individuals or institutions. Accounting produces many different, correct answers under different procedures or circumstances that are currently available without violating Generally Accepted Accounting Principles – GAAP. This is a difficult problem for all those that rely on financial statements; therefore it should be the policy of every company to adopt accounting procedures/principles that are applied uniformly and consistently from one year to another.
The double entry accounting system evolved from a business need to account for everyday transactions of exchange. It started with descriptive journals listing daily transactions. As money was exchanging hands there was a need to include a monetary value column in the journals. As commerce and merchant activities increased it became necessary to measure the equity interest of all parties to a transaction. The Cash Transactions needed to be matched with Expenses. This lead to a secondary column, the double entry accounting system had become a reality.
The financial statements that were compiled from these early journals were very similar to present day statements. As industrialization increased the complexity of commercial operations, accounting procedures were forced to evolve. The costs of buildings and equipment were depreciated over time. Statements of Revenue and Expenses were produced. Unfortunately, non-uniform procedures were developed because there was no common framework that existed for establishing uniform consistent accounting principles or practices. This non-uniformity increased as increasingly difficult and complicated transactions developed.
As we can see accounting procedures evolved and adapted to a quickly changing business environment. There was never any general agreement or insight to address uniformity or consistency. The result was that individuals or institutions evaluating the financial information witnessed different and alternative practices. To evaluate different proposals from different companies became difficult indeed.
In order to develop the uniformity and consistency so desperately needed, a number of accounting groups began operation.
AICPA The American Institute of Certified Public Accountants founded in 1887 by a group of accountants and auditors. The institute became very prominent and influential and by the 1930s the AICPA was firmly established as the authoritative accounting body in the United States. In a joint effort with the committee of the New York Stock exchange standards for the publishing of financial statements came about.
CAP (1939-1958) Committee on Accounting Procedure. In 1939 the AICPA formed this committee to study current problems and to issue authoritative opinions on accounting practices and procedures. Unfortunately, CAP never addressed the question of a foundation of an accounting practice, instead focused on current problems and developing issues.
APB (1959-1973) Accounting Principles Board and the Accounting Research Division. The AICPA formed this group to study basic issues and assumptions and to provide input to resolve accounting controversies.
FASB Financial Accounting Standards Board established in 1972 the current private sector accounting authority. It has seven full-time members and they are backed by an advisory council consisting of government and corporate accountants, auditors, professors, analysts, and others who are interested in accounting issues and controversies. The board follows a very deliberate policy of seeking counsel and advice. The politics of the process are clearly recognized, generally acceptance is sought before rather than after the fact.
SEC Securities and Exchange Commission was established in 1934 to ensure adequate disclosure of financial and other data to keep investors fully informed about publicly held corporations. Publicly held companies that are listed on one of the organized exchanges or traded in the over-the-counter market are required to file with the Commission. Regulations govern the form and content of financial statements, and relevant accounting principles are defined in the Accounting Series Releases. The Commission has the authority to require compliance in the annual and quarterly filings and no publicly held firm can afford to jeopardize it position by resisting the SEC rules.
As an example of the depth of our discussion here, the preceding organizations are ever evaluating the conceptual framework of recognition, measurement and classification.
Recognition: When has a transaction occurred? Should a transaction be recognized for a non-cancelable, long-term lease of equipment? The cost is recorded as a depreciable asset and the present value of lease payments are recorded as a liability. Recognition is a difficult problem in real estate sale, franchise operations, consignment sales, installment sales, product warranties and revenue received on long-term construction contracts.
Measurement: Accounting values are based on the historical cost convention, in which monetary cost is used at the time of recognition. What happens in times of inflation? Conventional procedures do not distinguish between historical costs and current costs. High inflation means less purchasing power and replacement cost much higher. Are these comparisons relevant or deserve consideration? Historical Costs, Constant Dollar Costs, for which historical costs are adjusted by the consumer price index, or Current Values for specified items, measured by estimated replacement value.
Classification: When a machine is overhauled is the cost an expense or is it an asset part of the machine. Is this repair and maintenance or did this add to the useful life of the machine? How should interest costs, mineral exploration costs and pre-opening costs before a new plant becomes operational be classified? Capitalizing any expenditure that promises benefits or services in the future solves the problem. This theory is very easy, but in practice it is often very difficult to discern.
Then there are issues of summarization and the financial reporting of transactions. Here there are simplifying assumptions that increase the number of acceptable alternatives but three principles are in place that we can be guided by, the realization principle, the matching principle and the period allocation principle.
The Realization Principle: This principle recognizes revenue at the point of delivery, when there isn’t any remaining service or contingency existing. Revenue or sales are recorded when the product or service is received by the customer, not when the cash is received. This may seem easy to apply but think in the terms of long-term Construction Projects. Is the revenue recognized when the project is finally completed or should it be recognized on a percent of completion monthly, quarterly and annually as the project is completed?
Accounting is an evolutionary work of Art, constantly changing, evolving and ever adapting to our ever-changing way of life. An old Accountant once told me: when there is a problem with any kind of a transaction that includes some kind of transfer or monetary gain accounting can clearly follow and account for every change in any entity. There is no problem or phenomenon that an accountant cannot face or trace.
Ted Hind works with L&M Business Designs and is a freelance writer on accountancy.