Explaining Basic Accounting Concepts
and Business Structures
Explaining Basic Accounting Concepts and Business Structures
It was not long ago where financial reporting of some companies felt like the famous quote from the movie Forrest Gump, “Life is like a box of chocolates; you never know what you are going to get.” It is important for accountants to learn from companies like Enron and follow the tried and true basic concepts of generally accepted accounting principles. This paper will briefly describe the sources of generally accepted accounting principles, describe effective accounting information, describe the difference between cash and accrual based systems, and describe some different types of business structures.
First, it is important to discuss generally accepted accounting principles. Also known as GAAP, these are the rules and practices of financial reporting that over time has been deemed appropriate because it can be applied universally for businesses. There are many sources of GAAP but some major sources include: FASB Standards, Interpretations, and Staff Positions; APB Opinions; and AICPA Accounting Research Bulletins. Due to these sources, the FASB has created a hierarchy of these sources. The three major sources mentioned above are the most authoritative sources for finding generally accepted accounting principles and are included in Category (A) of the hierarchy. If a certain situation is not addressed by any of these sources then Category (B) should be investigated. Category (D) is the least authoritative. The highest ranking source is the accounting principle that should be used (Kieso, Weygandt, & Warfield, 2007, Chapter 1, Financial Accounting and Accounting Standards). This hierarchy is important to follow so that business of all types can still have relatively consistent and comparable financial reports.
In addition, accounting information should be effective. By effective, it means that financial reporting should be relevant, reliable, comparable, and consistent. It should provide information that is “useful to those making investment and credit decisions, who have a reasonable understanding of business and economic activities; helpful to present and potential investors, creditors, and other users in assessing the amounts, timing, and uncertainty of future cash flows; and about the economic resources, the claims to those resources, and the changes in them” (Kieso, Weygandt, & Warfield, 2007, Chapter 2, Conceptual Framework Underlying Financial Accounting). It is important that readers of the financial report are able to decipher it and know what the numbers mean.
Next, there are two main systems of accounting. A cash based system is when companies record revenues when they receive the cash, or payment. Likewise, expenses are only recorded when the bill is actually paid. This system is prohibited under GAAP because these conditions go against the revenue recognition principle and the matching principle (Kimmel, Weygandt, & Kieso, 2007, Chapter 4, Accrual Accounting Concepts). In contrast, an accrual based system records revenue at the time it has been earned. It also records expenses when they are incurred regardless of when the invoice is paid (Kimmel, Weygandt, & Kieso, 2007, Chapter 4, Accrual Accounting Concepts).
Now, there are structure options businesses have when forming. A business owned by one person can form a sole proprietorship. Sole proprietorships are easy to set up and the owner has sole control of the operation. A small bookkeeping business is an example of this. A business owned by two or more people can form a partnership. Partnerships are generally formed to increase economic resources. Many law firms and accounting firms are partnerships. Both of these offer some tax advantages as well. A business can also form a corporation so that it is a separate legal entity owned by stockholders....
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