Reading: Lesson 2 - Ethics, principles and assumptions - The building blocks of Accounting

ETHICS

Ethics are the moral principles that govern a person's behavior or the conducting of an activity.  How can an end user of the accounting data know that it is accurate and dependable data?  Enron, HealthSouth and Freddie Mac are a few of the top-rated accounting scandals.   http://www.accounting-degree.org/scandals/   If the financial market cannot trust the financial statements of organizations, economic chaos, and possible disaster can occur. https://www.wsj.com/articles/SB1014119056684938600

Enron was one of the largest companies in America.  The corporate staff decided to get creative with their accounting processes and economic chaos occurred.  

Sarbanes-Oxley Act of 2002 (SOX) was passed on July 30, 2002. The act was passed to protect investors from corporate accounting fraud.  Financial disclosures on financial statements were improved because of the strict reforms of the act. http://www.soxlaw.com/ 

The Financial Accounting Standards Board (FASB) set the accounting standards. A U.S. government agency, Securities and Exchange Commission (SEC), relies on FASB to set the accounting standards.  FASB has developed standards called "generally accepted accounting principles (GAAP)".

The International Accounting Standards Board (IASB) set standards for countries outside of the United States. Their standards are called International Financial Reporting Standards (IFRS).  

Markets have become more and more global.  In an attempt to increase the comparability of the financial reporting, the FASB and the IASB have joined together to reduce the differences in the accounting standards.  This process is called convergence.   It has become an important issue and it is likely that someday there will be a single set of accounting standards.  

PRINCIPLES

Principles provide significant guidance.  The four major principles are:

1.) Historical Cost Principle (cost principle).  Assets and liabilities are measured based on their historical costs. Historical costs are the original value at its initial acquisition.  An example is Land. It is initially purchased at a value of $500,000.  The following year the fair market value of the land is $600,000; however, it remains on the books at the initial price of $500,000.

2.) Realization Principle.  This principle states that revenue is recognized when it is earned, regardless of when the cash is received and is reasonably certain that the cash will be received.  Long-term construction projects revenues are recognized over time based on their completion percentage.  If this principle is not applied, the revenue and net income will be overstated in one period and understated in the next.  

3.) Matching Principle.  Expenses are recognized in the same period as the related revenue.  At times this principle is not straightforward.  

Some expenses are not directly related to the revenue earned.  They may be indirectly related.  Salaries for office workers are an example of indirect expense to revenue.  Other expenses provide a benefit for the company. Prepaid rent for is an example of a benefit paid by the company.  Some expense such as advertising expenses are recognized in the month they are incurred.  This is because it is very difficult to determine when or even if revenue was generated by this expense.  

4.) Full-Disclosure Principle.  Information that could affect the decision of an external user should be included in the financial statements.  

ASSUMPTIONS 

The four basic assumptions are:

1.) Economic Entity Assumption.  This assumption requires that the entities activities be kept separate from their owners and other entities.  

2.) Going Concern Assumption.  When a business opens its doors, its main goal is to stay in business.  The going concern assumption anticipates that a business entity will remain in business indefinitely.  

3.)  Periodicity Assumption.  Businesses divided their financial reporting into time periods to report timely information.  Some agencies require quarterly and annual filings.  Other institutions require monthly reports.  

4.) Monetary Unit Assumption.  An entity will record data that can only be measured in dollars and cents.  Items such as an owner's health, the morale of its employees and customer service are not included in the financial records.  

TYPES OF BUSINESSES

Sole Proprietorship has one owner.  This type of business is easy to form.  The owner receives all the profits and is responsible for all the business's liabilities.  

Partnership - It has two or more owners.  If ownership changes, the partnership must be dissolved.  There are two types of partnerships:  general and limited.  

A general partnership is owned and operated by the partners.  They share in the profits and are personally liable for the liabilities of the partnership based on their percentage of ownership.

There is no "double taxation".  It does not pay taxes.  Instead, the partners pay taxes on their personal tax return based on their share in the organization.  

A Limited partnership has "silent partners".  They invest capital but do not have anything to do with the operations of the business or have voting power. Their liability is limited based on their capital investment.  

A Corporation is an entity separate from its owners.  It is expensive to create and follow regulations based on the state that it is incorporated in.   With a Corporation, there is "double taxation".  Federal and state taxes are paid by the corporation.  Stockholders receive dividends which are considered income and they must pay taxes on the dividends; hence, the double taxation.  

The owners and stockholders are not held liable for the debts and liabilities of the corporation.  It is easy to raise money by issuing stock.  The corporation never dies.  Unlike the partnership, a corporation does not dissolve when its owners pass away or they transfer their ownership.  

Limited Liability Company (LLC) - The owners are called "members".  The member's personal assets are protected from the liabilities of the LLC.  They receive the profits of the company.  The members are taxed on their personal income taxes for the profits.  Members need to make sure that personal transactions and business transactions are kept separate. A judge can rule against the limitation of liability for the members if not.