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Now, let's say a few words about accounting, assumptions,
principles, pronouncements, as we labeled them the previous episode standards.
Well, to say standards is probably not the best thing,
so we will go here a little bit more specifically.
Well, let's put it, Accounting Principles.
So here, we have the following hierarchy, if you will.
So we start with assumptions,
then we go to principles,
and then go pronouncements.
So these are many but more specific pronouncements.
So on this page,
I will specify assumptions.
Normally, they are four.
Assumption One.
This is Specific Enterprise.
So what we're talking about here is that in accounting,
we deal with the specific company or project.
For example, if this is a company in which there is only one owner,
so this is sole proprietorship.
Then we do not mix up two pockets,
the left one and the right one,
because the owner can say,
"Well, my left pocket is the corporate pocket,
the company pocket, meaning to say, and my right pocket is my own one."
So here, we make specific distinction between what is on the individual level,
what is on an enterprise level.
Now, the next thing is Going Concern.
Well, companies indeed, they are born and sometimes they die,
but in accounting, we treat an enterprise as a process that does not have an end.
So we can say, "Well,
if we did that over this period of time,
then we can expect that it will go further."
Well, this is not such a bad idea because even if
the company sort of ends up to a certain point when it can no longer develop,
then most often, the company does not disappear.
Someone else buys it or it is merged with someone else.
So this is a good idea.
But the key story here is that we do not come to a certain point and say,
"Well, at this point, we have to finish everything up.
We have to divide all the material assets between the claim holders at this time."
So if we did it that way,
that would be a lot more cumbersome and would really ignore this idea of going forward.
Now, the next thing is the Unit of Measure.
So we are talking about the fact that we measure all items in accounting in certain,
most often, monetary units while specifically in financial accounting,
it's almost always monetary.
In managerial accounting, there are
some exceptions and sometimes certain important issues,
they are measured in physical units.
But for now, we can say well,
that may be US dollar, for example.
And then, the fourth assumption is the Time Period.
So we say that we prepare our statements,
let's say, monthly or quarterly or annually.
It depends upon the standards of certain industry.
But generally, we say that this covers a certain period of time.
Well, we remember the balance sheet is in the beginning and in the end,
but the income statement covers this whole period.
Why is that so?
Because people require this information on a regular basis that is sort of timely.
And that is why these major assumptions,
they set the overall background for all other things.
Now, we move on to the principles.
And again, these principles are quite well-known,
but I will quote some of them openly.
Well, Objectivity, Consistency.
I will put them,
and then say a few words about them when needed.
Full Disclosure.
Then the Cost principle.
Then Revenue Realization principle.
Then the Matching principle,
and then sometimes, it's called modifying
but I would put them in pieces like Conservatism.
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Then sometimes they'll materiality.
Well some people divide them further.
But let's talk about that.
Well objectivity, why is that important?
Because the information is produced for the external users.
So if there is a bias,
if someone believes that this should be painted this or that way,
that creates a problem.
Now consistency, that means that if we use certain approaches, procedures,
rules, standards for one period of time then we will do that further on.
Why? Because we cannot change the rules along the game.
Otherwise, because for example when people saw it this way
they can expect that you will abide by the same rules further.
That's also important for external users.
Full disclosure.
That means that there are no minor things here.
So basically, if for example you have an asset that has potential problems,
then you have to make a note of that.
If you let's say sold,
completed a significant project, collected the money,
but if you have obligations for that,
let's say warranty, then you have to disclose that.
Because maybe that will require some spending on your side,
or some important use of resources.
Then the cost principle,
that means that when you buy a piece of equipment for example,
you record the amount at which you purchased that.
And then that is used as a base.
Later on this equipment becomes depreciated for example,
but you do not change this initial cost.
For example if tomorrow that equipment can be purchased at
a much lower cost you still keep it at the same cost as you bought it.
That is important to see the basis,
and from this basis you proceed further.
Now for us, these students of finance,
I would say that I would first point them out right now.
The next couple of principles may be key.
This is revenue realization, matching, and conservatism.
Why did I underline them?
What is revenue realization?
It's important to see that if you are engaged in a certain project,
then at some point in time you receive money for that.
But the question is when can you recognize that you receive some income?
Let me give you the most regular example.
You are an insurance company that collects all policy premium on January one.
So you collected a pile of cash,
and for the whole year,
there will be no longer any cash inflows.
But you will have to pay this cash out in these insurance in covered cases.
So basically you cannot recognize all this pile of cash as your revenue right away,
because then people will come to you and say well,
you have to cover us.
So it's not only the fact that you do not know exactly your costs,
but this is not yet your revenue.
This is just the cash advance.
By the same token,
you have to clearly see when it happens to costs this or that way.
Some costs you have to incur immediate,
some of them we have to capitalize,
and so on and so forth.
Now I would say that matching probably is the key principle for us.
And remember I said that we are not satisfied by the use of only the status of cash flow.
Instead we use income statement and the balance sheet.
And oftentimes, it's the matching principle that is in the ground
of many approaches and pronouncements and actions in accounting.
So when we talk about depreciation,
that's all about the matching principle.
When we talk about incurrence of certain costs,
it's about the matching principle.
We will see throughout this course,
how important it is,
and how it helps us,
how the understanding of this helps us to come up with the proper proxies for cash flows.
And then finally conservatism.
Here we say that if we have some gains,
we do not recognize them until they are actually achieved.
When we have potential losses,
we in some cases might be better off if we accept them right away.
Let me, for the first time,
recall here to the story of the S&L crisis in the 80s or last century.
Remember we said that if all these mortgages were kept on the balance sheet of S&Ls,
at their market price,
that corresponds to conservatism,
then there will be no zombie organizations.
So you can see that sometimes the cost principle is great,
but at the same time there was a combination of the cost principle and conservatism.
So these principles, they are the core,
the foundation of the huge amount of various pronouncements,
and various approaches procedures,
and rules how financial statements must be prepared,
and how they should be interpreted.
Like I said before,
we normally do not go deeper in these details,
but we always keep in mind that
these principles are behind all the major things that we study in
accounting with respect to what we know about it and how we deal with that in finance.
And now let me wrap this up by one very simple thing.
Well it seems to us that these principles are not the only key,
but are very natural.
And the question arises,
how come that anyone thinks about that?
This is so trivial,
so natural to always abide by these rules.
Why are we spending time on that?
Why are we putting so much focus on that?
Well let me remind you of the famous,
or better to say infamous Enron case of the end of the 90s.
When for a long period of time the company was purposefully misleading its stakeholders.
And what makes it even worse is that
the then number one accounting firm, Arthur Andersen,
at that time was actively supporting the production of
these fake financial statements as we'd call them right now.
So sometimes, although all that is kept in mind but there are abuses.
And the existence of these abuses,
and the damage produced unfortunately forces us to keep this in mind,
and we need to abide by that.
So here I am wrapping up these principles.
Well, I mentioned before that these principles,
they are at the core of GAAP,
Generally Accepted Accounting principles,
and their pronouncements is also
the accounting principles that are used in other countries.
So from now on,
we will say a few more things about the more general approach to that,
and we have to take a journey backwards a couple of centuries ago.
And in the next episode,
we will discuss what was sort of the origin of accounting.
Namely it's double entry bookkeeping.
Konstantin KontorDirector and Professor of Finance and Strategy
