I was asked to answer a question on financial accounting concepts on Quora. I felt that it is an issue worthy of sharing on my blog as well as we don’t often discuss why we have expectations when we prepare and audit financial statements – other than to say GAAP requires it.
The most basic concept underlying financial reporting (and the accounting procedures used to accumulate the data) is investment decision-making. Everything Mahesh spoke to, and what I am going to elaborate on, is premised on the need for some information for investment decisions.
FASB and IASB have concept statements. I am most familiar with US GAAP which is put out by FASB. But I believe both standards setters agree overall on the concept of information necessary for decision making.
And to ensure that investors receive accurate information based on these guiding concepts, it is important that reported information be verifiable (can be audited successful) and comparable to others in similar situations. This is why there are industry-specific principles and there is a focus on establishing an effective audit trail. Investors should be wary where there is first, not an independent examination of the statements and second, where the underlying accounting is totally dissimilar to everyone else in the industry. Sadly, it happens all too often.
If you are a small business and your bank requires you to prepare GAAP financial statements, it is important to understand that this is what they are looking for: Investment Decision information. It doesn’t matter if the financial statements are prepared by your bookkeeper or audited by an independent CPA. Your business is responsible for sharing financial information that the bank can use to make an investment (loan) decision. You have an obligation to ensure it is accurate, tells the whole story, can be compared to other businesses that are in the same industry as you, and ensure that whatever is recorded can be independently verified.
You, management, are responsible for the accumulation, summarization and reporting of the information. Management decides when to recognize revenues; or to have it be reported as unearned because the job isn’t done; Management decides if a product was actually sold; or was actually shipped to another warehouse across the country. There is an undeniable tension between management sharing accurate accounting information and investors receivable actionable investment information. You see this played out frequently in the press when you see a stock slide because a company missed its revenue target.
Accounting principles exist to put the concept into context. Accounting principles are not complex or difficult to employ, business is moving farther and farther away from simple transactions of shifting values from producer to consumer. Complex transactions make for challenging financial statements as investors cannot see where value begins and ends. So ask yourself, do you really want to invest in a company where you can’t tell who owns what and who is owed what? If not, demand that GAAP be followed; otherwise:
Caveat Emptor baby.