Basic Accounting Concepts and Business Structures
Different types of businesses use different accounting methods, small businesses tend to use the cash-basis of accounting, whereas the accrual method is a requirement for large business with revenue more than 5 million. Uniformity of accounting information is important when making decisions for or about a business. A hierarchy of sources provides structure for the generally accepted accounting principles (GAAP). Along with the hierarchy of sources, the Financial Accounting Standards Board (FASB) identify qualitative characteristics to distinguish between useful and inferior information and to ensure accounting information assists in decision making.
Qualities of Accounting Information
There are internal and external users of accounting information for decision-making. Internal users are managers within a company that use the information to plan, organize, and run the business, “These include marketing managers, production supervisors, finance directors, and company officers” (Kimmel, Weygandt, & Kieso, p. 6, 2007). External users can be investors, “make decisions to buy, hold, or sell stock,” creditors, “suppliers and bankers use accounting information to evaluate the risks of granting credit or lending money” (Kimmel, Weygandt, & Kieso, p. 6, 2007). External users also include taxing authorities, customers, labor unions, and regulatory agencies. For decision makers to make decisions using the information, they have available, a level of understandability must occur. Understandability allows users to see the importance of the information and its usefulness; the information must also be relevant and reliable.
Relevance
To predict an outcome by looking at past, present, and future events, accounting information must be relevant. It can also give a user feedback on past events, that allow the user to confirm or change prior expectations. Accounting information will become irrelevant over time, so it must be provided in a timely manner to aide in decision-making (Kimmel, Weygandt, & Kieso, p. 6, 2007).
Reliability
Accounting information must be reliable. According to Kieso, Weygandt, and Warfield (2007), “Accounting information is reliable to the extent that it is verifiable, is a faithful representation, and is reasonably free of error and bias” (p. 33). Verifiable, faithfully represented information will lead to better decision-making both internally and externally. The information must also have neutrality, showing both favorable and unfavorable information must be shown, as both are important. Accounting information from different businesses must also have a sense of uniformity, which is the purpose of the generally accepted accounting principles (GAAP).
Sources of Generally Accepted Accounting Principles
The GAAP is composed of sources that assist companies in producing accounting information consistent with the qualitative characteristics identified by the FASB and create uniformity in the accounting profession. The FASB is developing “The Hierarchy of Generally Accepted Accounting Principles,” that categorizes the sources of the GAAP and provides a framework for use. Sources are placed into categories; (a) FASB Standards, Interpretations, and Staff Positions; APB Opinions; and AICPA Accounting Research Bulletins, (b) FASB Technical Bulletins; AICPA Industry Audit and Accounting Guides; AICPA Statements of Position, (c) FASB Emerging Issues Task Force; AICPA AcSEC Practice Bulletins and (d) Category (D) AICPA Accounting interpretations; FASB Implementation Guides (Q&A); widely prevalent and recognized industry practices (Kieso, Weygandt, & Warfield, 2007). The major and most authoritative sources of the GAAP fall into category A and the least authoritative in category D.
Hierarchy of Sources
When a contradiction occurs between categories the most authoritative should be followed. The hierarchy of sources is important because it sets a guideline for materials used, bringing more uniformity to accounting information. When the major sources of the GAAP lack guidance, companies can look to other sources, such as the FASB Concepts Statements, International Accounting Standards, and accounting articles (Kieso, Weygandt, & Warfield, 2007). The method of accounting a business uses is greatly influenced by their structure.
Business Structures
There are advantages and disadvantages in each structure of business. New companies must take into account different factors when determining the most suitable business structure, such as how many owners the business will have or if outside investment is necessary. New companies must choose between a sole proprietorship, a partnership, or a corporation.
Sole Proprietorship and Partnerships
A sole proprietorship has one owner, simple to set up, and gives the owner control over the business. Partnerships consist of more than one individual. People form partnerships for different reasons, such as monetary needs, or the need for certain skills or resources. In both a sole proprietorship and a partnership businesses will receive more favorable tax treatment; however, they are legally liable for any debt incurred by the business (Kimmel, Weygandt, & Kieso, p. 6, 2007). Corporations have investors whom receive shares of stock to indicate an ownership claim. Buying stocks is also relatively less expensive so it is easier for corporations to raise funds by selling them. Corporate investors tend to pay higher taxes, but have no personal liability for a corporation’s debt (Kimmel, Weygandt, & Kieso, p. 6, 2007). All types of businesses are involved in the same activities; financing, investing, and operating, which is why the accounting information must have uniformity between financial statements. The structure of a business helps to determine which method of accounting will be most useful to a company.
Accrual vs. Cash Accounting
The accrual basis of accounting uses the revenue recognition principle and the matching principle to recognize when revenue and expenses are received and paid. While the cash basis of accounting records the revenue or expense once a payment is received or made (Kimmel, Weygandt, & Kieso, p. 6, 2007). The accrual method gives a better representation of a company’s finances, adjusting entries is necessary when using this method to ensure the matching principle and revenue recognition are achieved. The cash method can generate misleading financial statements, because the revenue may reflect a different tax year than the corresponding expenses and is prohibited under the generally accepted accounting principles. Large companies use the accrual method, while smaller companies use the cash because it is simpler.
Conclusion
The type and size of a business help in determining the method of accounting used. It is important for businesses to use uniform methods for reporting accounting information to increase the value of the information. Businesses can do this by following GAAP and looking to the sources for guidance. Reference
Kieso, D. E., Weygandt, J. J., & Warfield, T. D. (2007). Intermediate Accounting (12th ed.). Retrieved from The University of Phoenix eBook Collection.
Kimmel, P. D., Weygandt, J. J., & Kieso, D. E. (2007). Financial Accouning: Tools for Business Decision Making (4th ed.). Retrieved from The University of Phoenix eBook Collection