History of Financial Accounting Theory

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The Accounting theory is a set of methodologies and assumptions that are used usually in the study and application of monetary reporting principals. The learn about of the Financial Accounting concept entails the study of historic foundations and improvement of it all along the way. Moreover, it is the manner in which the accounting practices are changed to be geared up into rules that normally information financial reporting. Usually, the most necessary component of the Financial Accounting idea is its usefulness. In the corporate world, this skill that economic reporting must supply vital statistics that can be relied upon in coming up with a decision in regard to managing a commercial enterprise or making necessary changes in a firm. The information provided by the financial reports should be flexible enough to capture the day to day changes that occur in companies.

Accounting as a subject has existed all along since the 15th century. This is because the world of business and economics has always existed all along with an accounting of the finances involved. Over the years, in tandem with the revolution in the business world, accounting has also evolved in order to capture the changes and trends that are seen in this world. The changes in accounting have also been necessary to avoid the loopholes that have been created by the evolution and globalization of business.

Accounting has a very long history that dates back to about hundred years ago when a scholar by the name Franciscan Monk, also known as Luca Pacioli came up with the idea of double entry. During those years, economic growth was steadily on the rise. Companies ensured that they took the lead in coming up with modern ways that saw to it that financial reporting was more clear, reliable, and even comparable. Investors would also benefit from the information that was tabulated in the financial statements. Accounting went on well until the stock market crash that happened in 1929. It was perceived that the crash had taken place due to misleading accounting information resulting into the inflated stock prizes. Alongside this, the accounting information provided was also said to be insufficient. Shortly afterwards there was another economic catastrophe – the Great Depression-that hit the United States (Edwards 2013).

The 1929 market crash and the Great Depression were the backgrounds upon which mounting pressure to establish worldwide accounting standards were found. A few years after the Great Depression, there was a major milestone that boosted the investor’s confidence. The Securities Act of 1933 and Securities Exchange Act of 1934 were charged with the task of finding ways of restoring investor’s confidence in the markets. The two Acts set up measures for full disclosure with regards to trading in the stock exchange markets. There was the formation of American Institute of Accountants and the New York Stock Exchange that have continuously reviewed and advised on accounting practices to ensure trading standards are met. Subsequently, there were widespread efforts in the UK and the entire Europe to create an international body that would devise and monitor international standards of accounting. As a result, the International Accounting Standards Committee was created in mid-1973. Since then the body has been working to see to it that international standards of accounting are achieved and maintained all throughout the world.

Question 2: Current GAAP

GAAP is an abbreviation for Generally Accepted Accounting Standards. It outlines the principles which guide the Accounting Practice not only in the US, but worldwide. Accountants aim at preparing financial reports which can be used by users of accounting information to make financial decisions. With this regard, the objective of GAAP is to provide accurate financial reporting so that;

Potential creditors and investors may make informed financial decisions regarding credit and investment

Firms can make long-term financial decisions

The performance of organizations may be improved. This is through monitoring year-on-year performance and devising strategies that lead to high profits and growth in the wealth of shareholders

Firms can have clear records of their financial performance for reference.

In order to objectively exercise its mandate, GAAP operates under 3 basic assumptions, five basic constraints, and five major principles. The basic assumptions are periodicity, business entity, and monetary unit. Periodicity is an assumption that a firm’s activities can be separated into definite time periods. The business entity assumption assumes that an organization is a legal entity which is separate from its owners. Then the monetary unit assumption assumes that businesses have a standard currency which is used in its financial records. In the US, the US dollar is often used to record financial transactions.

The basic constraints of GAAP

The constraints of GAAP include (1) Consistency which relates to the use of the same accounting methods and principles in every financial year. For instance if a company chooses to use the straight line method of depreciation, this should be their practice always. They are not expected to use any other method unless they can substantiate the need to change the method, (2) Conservatism demands that accountants choose to record the less favorable option. For instance, in the case of income, where there is a high and low amount for the same item, they are advised to record the lower amount, (3) Materiality refers to the significance of an item whereby accountants only record items whose omission will affect the decision of the users of the financial statements, (4) Cost principle requires that the benefits accrued from the financial reports should be higher than the cost of preparing them, and (5) Objectivity principle ensures that all the information recorded on the financial statements can be verified using objective evidence such as invoices and receipts.

GAAP’s major principles of financial reporting

Under the principles that govern accounting, the first basic one is the revenue recognition which states that revenue needs to be recorded as soon as it is earned. That means that whenever a customer takes goods on credit, revenue should be recorded in as much as the physical cash will not have been received yet. The matching principle, on the other hand, involves matching the revenues and expenses as objectively possible so that the firm may evaluate its actual performance and profitability.

The full disclosure principle requires that the amount of information disclosed and used should be enough to allow the users of the financial statements to make informed decisions. Finally, the historical cost principle is the practice where liabilities and assets of a company are recorded based on their costs of acquisition and not the market value. According to the American Institute of Certified Public Accountants’ Code of Ethics, departure from GAAP’s outlined principles is seldom encouraged. However, in any case the use of the GAAP principles leads to material misstatements of a company’s financial statements, a company may be allowed to depart from them.

Question 3: Compare and contrast US IFRS versus GAAP

The IFRS refers to the International Financial Reporting Standards. It is the standard of accounting that is used in more than 110 countries all around the world today. On the other hand, the GAAP refers to the Accepted Accounting Principles. GAAP is only applied in firms located in the US only.

The second difference between the IFRS and GAAP is that IFRS is considered to be a more principle based accounting standard than its counterpart GAAP which is normally seen to be more rule-based in contrast. Such therefore implies that the IFRS then brings out the economics of transactions much better than its counterpart which does not bring it out as much as IFRS does. It could be attributed to the fact that IFRS is a principle based system of accounting in general. The other point in which the two need to be compared and contrasted is the issue of how each of them treats acquired intangible assets. The acquired assets in the US GAAP are normally treated at its acquisition cost. This means that the assets and liabilities are costed based on amount spent to acquire them. On the other hand, under the IFRS assets are valued at either the fair value or at cost. However, there has to be uniformity in the application of either of these methods. As such, if a company decides to use fair value, then it should apply to all the fixed assets without discrimination.

Another difference is with regards to the treatment of impairment of assets. Under the GAAP, asset impairment is treated as an expense and as such cannot be reversed. However, the IFRS treatment is such that if the value of impairment increases, the amount of impairment can be taken back. Then IFRS treats the impairment hand in hand with revaluation. The other matter that needs to be compared and contrasted is on the issue of Inventory costs. The first in, first out (FIFO) method or weighted average cost method for accounting for inventory costs are usually not allowed in the IFRS. On the hand, the GAAP normally allows the Last-in, first-out (LIFO) or first in, first out (FIFO), or weighted average cost to be used as inventory estimates. Inventory reversal is not allowed in GAAP while it is permitted in some specific scenarios in IFRS.

The other important contrast is regarding write-downs of the two. In the IFRS, if the write-down is penned down, the implication is that there is a possibility that it can be changed later in the future if some specified criteria are normally met and abided by in the general terms as agreed. While this is so in IFRS, it is normally a nightmare in the GAAP system. It is impossible to revert what has been written down as inventory. Any reversal in this system is normally prohibited.

Also of importance to note are the requirements that are needed for financial accounts. Companies under GAAP are normally required to compile and publish an income statement, a balance sheet, cash flow statements, statement of comprehensive income, changes in equity, and footnotes. However, for IFRS all these statements are prepared except for the statement of comprehensive income.

Some similarities in both GAAP and the US IFRS are that in both cases accounting in business is done on the basis of a going concern. Secondly, both use FIFO and weighted average costs in estimating cost of inventory. Furthermore, both standards operate around companies’ revenue, expenses, assets, and liabilities. Then the statements prepared for financial accounting are the income statement, a balance sheet, cash flow statements, and changes in equity (Bohušová 2014).

Question 4: Problem areas revealed in the debate arena

In guiding the accounting principles in the US and all over the world, the IFRS and GAAP have exhibited numerous shortfalls. The first major problem area is with regards to the universal standards. The application of IFRS varies in different countries because it allows for “carve-ins” and “carve-outs.” As a result we have companies that apply the unaltered IFRS such as those in Canada and Australia. However, there are countries such as India and China that alter the standards so that it “suits” them. Comparing companies from these two groups of countries will obviously give inaccurate results (Isard 2017).

A second problem area is revenue recognition. The practice is that revenue is recognized whenever it is earned. However, there are companies such as those that deal in electronics and social media who have had to deviate from this standard. This is because they are unable to recognize their estimated future costs and revenues. As such they have resorted to alternative measures of performance such as non-GAAP, especially the adjusted Earnings before Interests, Taxes, Depreciation, and Amortization (EBITDA). However, this measure gives different values and so other solutions need to be sought to curb this limitation of the accounting standards. For example in 2015, Twitter recorded a net loss of $521 million according to GAAP. However, the non-GAAP adjusted EBITDA was $557 million while the net income was $276 million. Such variations cast doubts on the validity of the use of the accounting standards.

Thirdly, the “dot-com generation” has come with other unofficial measures of company earnings. These are slowly becoming acceptable and more convenient measures of earnings rather than the conventional accounting standards. Such measures include EBITDA, eyeballs, and page views.

The fourth area which needs to be checked is regarding fair value accounting. Fair value accounting deals with the recording of costs based on fair value or acquisition cost. There has been a great challenge for accountants and users of accounting information on what the “fair value” of an asset actually means. In most circles the meaning is not clear which tramples on the objectivity principle of accounting and instead introduces subjectivity in accounting. An intervention in 2008 by bodies that oversee accounting such as the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board did not augur well. They only brought further confusion to the accounting fraternity. Hence this is an area that needs to be assessed in the future (Sherman & Young 2016).

The fifth problem area is regarding the increasing pressure that executives and managers of companies are under to manipulate their financial records. The manipulation is normally in two forms: (1) misrepresenting the true value of the company and (2) manipulating the results indicating the profitability of the company and its asset base. Sometimes the manipulation is not done on the accounting records themselves. However, the operating decisions of a company are changed which in the long run affects the outcome in the financial reports. An example of such errors is the delay in recognizing an expense which translates to more profits or overprovision of restructuring costs and bad debts. Such errors if not detected may lead to material errors in financial reporting. Managers’ performance is today measured according to the profitability of the business. Hence a manager may deliberately tweak the financial reports to even keep their jobs!

Finally, the universal financial ratios used to compare companies may reflect the true worth of some companies (Abdul-Baki, Uthman, & Sannia 2014). For example innovative firms which operate in fast moving market niches are not comparable to other firms. As such these problem areas indicate to standards that need to be improved on in order to make accounting standards more acceptable as a standard way of measuring performance in organizations around the globe.

Question 5: Analyze points 2 and 3 in relation to the conceptual framework

GAAP and the US IFRS mostly back up the elements of the conceptual framework. This is especially with regards to the qualitative features of accounting information such as relevance, faithful representation, comparability, consistency, verifiability, timeliness, and understandability (Baumgartner 2014). They also reiterate the objectives of the accounting standards which is the provision of information which enables users to make informed and wise financial decisions. Relevance in the accounting conceptual framework relates to materiality, predictive, and confirmatory values. GAAP outlines that information is only material if they can significantly influence the decision of the user of that information. Otherwise the information becomes immaterial and not worthy of the accountants’ attention. Then there is the faithful representation which involves neutrality, completeness, and error free financial reporting. Full disclosure I one of the major principles in GAAP and IFRS.

There are areas that need to be assessed in financial reporting which affects the financial framework. One is the comparability of companies using metrics drawn from financial ratios. Some companies are not comparable due to the differences in sizes, customer base, asset base, human resources, and financial prowess. It would not be fair to compare the performance of a multinational company with that of a one-year old company. Secondly, consistency is not achieved easily in accounting. For instance when GAAP measures assets on the basis of acquisition cost while IFRS treats it by its fair value, there is no consistency. Consistency often encourages comparability of firms.

The conceptual framework also demands verifiability of accounting information, timeliness, and understandability. Understandability is about the information being understood by the users of the accounting information. Verifiability means that information can be cross-checked against documents such as invoices and receipts. Also, the financial statements are meant to be prepared periodically. This may be annual, biannually, or quarterly depending on the specific company involved. For example, banks normally prepare quarterly financial reports (Needles, Powers, & Crosson 2013).

Question 6: Appropriate courses of action

Appropriate courses of action involve use of historical information to assess the profitability and performance of companies. This means that whenever there is a great variation between past performance and the current performance, auditing of the accounting information is necessary. In fact, today most companies have employed auditors who assess their financial accounting information before they release the reports. As such, the accounting standards urge that only audited statements of financial position and audited income statements are released to users of accounting information.

Secondly, the accounting bodies need to revive debate fora that will be able to bring together stakeholders from all over the world to assess current practices. In cases of inconsistencies such as in application of the accounting standards in some countries and not others, a standard should be devised on how comparability should be approached. Perhaps there needs to be adjustments in these reports such that they are comparable.

In addition, the habit of injection of error into the accounting process should be stopped. This can be done by ensuring that accountants can verify every piece of information which is recorded on the financial statements. Furthermore, culprits of this heinous act need to be reported and investigated to bring back users’ confidence on the accounting information. Shareholders also need to come up with other ways of measuring managers’ performance besides profitability of the firms. It is human for an individual to act in desperation to keep their jobs. If realistic measures are explored then faithful representation will be restored in accounting.

Another course of action to guard on inconsistency especially where GAAP, non-GAAP and IFRS measures are used is to find methods of streamlining the variation in the results. The inconsistency brings about confusion in cases where using one standard indicates that the company recorded profits whereas the other standard indicates losses. The international body should determine criteria that will eliminate such confusions.

Question 7: Biblical scriptures supporting Income tax and Accounting

The Bible is a wholesome book which addresses real life issues such as income tax and accounting. Jesus encouraged Christians to pay their taxes as required by the tax officials. A biblical story in the Gospel according to Mathew tells us how the Jesus and his disciples paid taxes when the tax authorities demanded it. Jesus categorically said, “Render to Caesar the things that are Caesar’s, and to God the things that are God’s” (Mathew 22:21, The New King James Version). Jesus understood that the taxes were paid to ensure the wellbeing of the people is taken care of. He did not argue with them in as much as in His capacity as God he could have refused to obey them. Similarly, Paul also urges the saints in the Roman church to ensure they pay their taxes. He writes to them saying, “Render therefore to all their due: taxes to whom taxes are due, customs to whom customs, fear to whom fear, honor to whom honor” (Romans 13:7). Paul acknowledges that the Christians had an obligation of paying taxes to the government as a source of revenue to run its operations. It is incredible that he was even aware of the custom duties which need to be paid. And so as he talks to them about faithfulness in spiritual matters, he deems tax payment as equally important. The two scriptures point to the fact that the Bible encourages people to pay all their taxes. In this regard, businesses and individuals need to submit their monthly income tax payments to the revenue authorities. Doing so not only denotes honor to the government, but to the state too. Furthermore, the living standards of people become bearable since the government provides its citizens with the basic needs.

Jesus, in the Parable of the talents, demonstrates the importance of accountability and profitability. In the Gospel of Mathew, Jesus says that a man was traveling to a far country. Instead of letting his business lying idle he gave it to the servants to manage. He gave one servant 5 talents, another 2 talents, and then to the third servant he gave 1 talent. The he went away and stayed for a long time. When he returned, the servant whom he gave 5 talents had earned 5 more talents. Similarly the one he had given 2 talents earned 2 more talents. However, the third servant hid his talent in the ground and gave back the 1 talent to the business man. In displeasure, the man said to him, “Well then, you should have put my money on deposit with the bankers, so that when I returned I would have received it back with interest…” (Mathew 25:27, New International Version).

The parable of the talents indicates that profitability is essential in any business. Hence, the shareholders will give resources to the business and require that it earns profits from it. Consequently, the shareholders’ wealth grows, the business expands, and the shareholders earn dividends from their investments. Therefore, the going concern of a business indicates that the business intends to keep doing business into the future. Any firm that does business to make lossess is misplaced in the market place. For profitability to take place, accounting of those resources which have been invested is essential.

Conclusion

Accounting standards have made it easier to record, analyze, report, compare, and verify financial transactions. They have made it possible to measure the performance of a business and its profitability objectively and accurately. However, there are problem areas such as comparability, revenue recognition, fair value accounting, and unofficial earning measures which need to be debated upon and resolved. This wil make these standards more acceptable and creditworthy to not only users of accounting information, but also to accounting professionals.

References

Abdul-Baki, Z., Uthman, A. B., & Sannia, M. (2014). Financial ratios as performance measure: A comparison of IFRS and Nigerian GAAP. Accounting and Management Information Systems, 13(1), 82.

Baumgartner, R. J. (2014). Managing corporate sustainability and CSR: A conceptual framework combining values, strategies and instruments contributing to sustainable development. Corporate Social Responsibility and Environmental Management, 21(5), 258-271.

Bohušová, H. (2014). General aaproach to the IFRS and US GAAP convergence. Acta Universitatis Agriculturae et Silviculturae Mendelianae Brunensis, 59(4), 27-36.

Edwards, J. R. (2013). A History of Financial Accounting (RLE Accounting)(Vol. 29). Routledge.

Isard, W. (2017). Methods of interregional and regional analysis. Taylor & Francis.

Needles, B. E., Powers, M., & Crosson, S. V. (2013). Principles of accounting. Cengage Learning.

Sherman H. D., & Young, D. S. (2016). Where financial reporting still falls short. Harvard Business Review. Retrieved on September 20, 2017 from https://hbr.org/2016/07/where-financial-reporting-still-falls-short

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