Basic Assumptions in Accounting

Basic Assumptions in Accounting Accounts are produced by all companies as a way of providing information to all third parties interested in the company’s performance. One of the primary aims of these accounts is to reduce the problems inherent in the agency relationship of the directors with the other interested stakeholders such as investors, employees and even government bodies. Due to the wide range of uses for accounts, it is little wonder that research into the way that these accounts are drafted and presented has had to lay down some fundamental assumptions in the way that accounts are written. However, in reality the assumptions that have underlined the analysis of accounts may, at times, be flawed, causing the overall analysis of these accounts to be at best incomplete and possibly even inaccurate (Hermanson, 2005)[1]. Assumption 1 – Accounts are Primarily for Shareholders This is a very common assumption and in many cases is not a damaging one. Even the law seems to support this assumption, with legislation requiring that annual accounts are produced and supplied to the shareholders (Companies Act 2006)[2]. This fuels the concept that the accounts are for the use of the shareholders, only. It is true, however, that accounts are largely for shareholders. The company belongs to the shareholders and is managed and run by the directors. This structure produces an agency problem with those running the business not being those individuals who ultimately benefit or suffer from its success or failure. Shareholders need the accounts in order to determine whether their investment is safe, whether they should be investing more, withdrawing their investment or asking certain questions of the board in relation to policies or activities. The accounts give valuable information to the shareholders in relation to the volume of sales, profitability, comparative analysis of key competitors and the overall value of the shares. Accounting standards have been developed with this key use in mind. It is necessary for all accounts to be audited by an independent auditor to determine that the accounts offer a true and fair value of the state of the financial position of the company. This is, of course, vital for the shareholders as they must trust the accounts being produced by the directors to be accurate, in order for them to make their investment decisions. Whilst all of these principles appear to be geared towards the shareholders, there are other users of the accounts that benefit equally from the standard set out in relation to published accounts. Other key users include the lenders. For many businesses, these stakeholders are absolutely vital and they will be largely interested in the same information as the shareholders, although will only really be concerned about whether the company has sufficient resource to pay back the loan that they have advanced to the company and that suitable security over assets exists (Watts, 2003)[3]. Employees are clearly interested in knowing the health and profitability of the company so that they can be comfortable with their own job security. However, this stakeholder group is often overlooked, despite its central role within the organisation. In addition, government agencies should not be overlooked, with agencies such as HM Revenue and Customs requiring information in order to collect the correct amount of corporation taxes (Brennan, 2000)[4]. Therefore, whilst shareholders may be the most visible group of stakeholders with an interest in the accounts, there are other stakeholders which also have an interest and should not be disregarded. Assumption 2 Accounting Measures a Concrete Reality which is Out There Prepared accounts are required to follow the basic principles such as relevance, understandability, consistency and comparability. Therefore, whilst accounts are prepared in line with the directors’ decisions and interpretations, there are certain underlying rules that must be followed to ensure that the accounts are as close to an unbiased, concrete reflection of the state of the business as is possible. In particular, this is important for the benefit of investor and shareholder comparisons. In order to make suitable judgements regarding investments and decisions about which company should be given support, the accounts of the two companies must be comparable. To be comparable the accounts must be as objective and factual as possible. However, just because it is desirable for the accounts to be a concrete reflection of what is ‘out there’ in the company does not mean that this is an assumption which can be drawn as being true. This need for consistency has been recognised by the International Accounting Standards Board which has developed, in so far as is possible, the financial reporting standards that companies need to follow in a bid to ensure that accounts are as close to being a concrete and comparable reflection as possible (Kroll, 2004)[5]. Take, for example, the way in which a company chooses to report its cash earned. The company could choose to operate on either a cash or on an accrual basis. Under the cash basis, the company would report income as soon as it actually arrives within the company, whereas the accrual basis shows the income earned at the time of the writing of the accounts, regardless of whether or not it has been already received. It is clear to see that the choice as to whether to follow a cash model or an accrual model will have a significant impact on the way in which the profit and loss appears in relation to the company. Other policies that are managed by international standards include issues such as the treatment of goodwill or depreciation, both areas that have traditionally allowed considerable director discretion. By having these basic accounting standards that companies must follow, there is certainly a move towards establishing concrete accounts. This, however, has not been fully achieved yet and, therefore, it is not fair to assume that all accounts are a completely concrete reflection of what is ‘out there’. Assumption 3 – Accounting Can be Neutral Clearly, it is desirable that financial accounts produced by companies are entirely neutral in the way that they are presented. Inaccuracy in accounts generally falls into two distinct categories, dishonesty or incompetence. Dishonesty has several different gradients and may be as simple as the desire by the management team to present a certain aspect of the business, whilst minimising the importance of other activities within the business. One of the main ways that a company could ensure that there is no element of dishonesty in the accounts is to have external auditors checking the accounts to ensure that they are a fair and accurate reflection of the company situation. Furthermore, with the financial reporting standards that have now been developed to ensure neutrality in the published accounts, companies are required to state definitively if they have deviated from the financial reporting standards, so that any move away from neutrality can be immediately and categorically identified. Therefore, whilst not all accounts will always be unbiased or neutral, identifying where neutrality has been deviated from, companies are now required to draw attention actively to this fact, thus increasing transparency. The use of external auditors in the preparation of the accounts is also a useful check and balance to ensure lack of misleading statements in the accounts (Cottingham, 1995)[6]. Despite all these measures, there remains the biased element of the accounts in the chairman’s statement. This is the opportunity for the board of directors to state their opinion and to detail the rationale of the company in terms of previous decisions and the direction which the company is taking in the longer term. This element of the report will naturally result in a non-neutral position (Goch, 1975)[7]. Company accounts are produced, as established earlier, for the benefit of many stakeholders, although primarily they are used by the shareholders and lenders to assist their investment decision. It is only natural, therefore, that companies will choose to forward their best possible position for the accounts. Whilst there are checks and balances in place in the form of financial reporting standards and the requirement of the independent auditor, it is fair to state the accounts are not entirely neutral, at all times. Assumption 4 Accountants are Professionals and Have the Ability to use Sound Judgement Accountants are used at all levels by companies of all sizes to manage the financial affairs of the company and ultimately to produce the accounts for external use, on an annual basis. All qualified accountants are required to be members of professional bodies such as Institute of Chartered Accountants of England and Wales and have strict codes of professional ethics in relation to the way in which they conduct their role (Riahi-Belkaoui, 1992)[8]. Despite the need for these accountants to be controlled and to be managed in a way that they conduct their role, it is essential that they are given suitable freedom to exercise their own professional judgement. Increasing transparency requirements and the greater degree of prescription that is being placed on the accounting profession, in terms of financial reporting standards and requirement is changing the role of accountants in the preparation of accounts. Accounting standards have resulted in accountancy becoming much more of a science than an art form. There is a danger in this shift of emphasis. Accountants are professionals and their sound professional judgement is essential in ensuring that the most accurate company accounts are produced. However, this sound professional judgement is only useful if it is unbiased to the company itself, i.e. through an independent accountant or auditor (Thomas Keim, 2003)[9]. Internal accountants who are employees of the company are under the influence of the directors and, as such, may have an unhelpful level of bias towards the company. In this case, where there are competing requirements, accountants cannot be relied upon to exercise the same degree of sound professional judgment. Published accounts are only as good as the information that is supplied to the accountants preparing these accounts. If accountants are not given the full information in relation to the company, they will simply not produce accurate accounts, regardless of how sound their professional judgment is (Chisnall, 2001)[10]. Professional accountants, as a whole, are required under their own code of ethics to exercise professional judgment when conducting their roles and this is generally followed. Constraints are increasingly being placed on the way in which accountants can prepare accounts and this is restricting the ability to exercise professional judgment in all cases. Care must also be taken when considering accountants who are biased due to their position with the company. Conclusions Many assumptions are made when it comes to published financial accounts. In almost all cases, these assumptions are not universally true and care should always be taken to reconsider these assumptions, whenever accounts are being analysed. Any deviations from these assumptions could dramatically impact on the way in which the company accounts are viewed by all stakeholders concerned. Bibliography Brennan, N. Gray, S.J., 2000. Accountants’ reports on profit forecasts: regulation and practice. Managerial Auditing Journal, 15, 9. Chisnall, P., 2001. Fair value accounting – an industry view. Balance Sheet, 9, 1. Cottingham, J. Hussey, R., 1995. The Prevention of Misleading Accounts Through Disclosures of Related Party Transactions. Journal of Financial Regulation and Compliance, 3, 4. Goch, D., 1975. The Changing Face of the Annual Report. Managerial Finance, 1, 3. Hermanson, R.H., Edwards, J.D. Maher, M.W., 2005. Accounting Principles. 8th ed., Freeload Press, Inc. Riahi-Belkaoui, A., 1992. Morality in Accounting. Quorum Books. Kroll, K.M., 2004. The Lowdown on Lean Accounting: A New Way of Looking at the Numbers. Journal of Accountancy, 198. Thomas Keim, M. Grant, C.T., 2003.To Tell or Not to Tell: An Auditing Case in Ethical Decision Making and Conflict Resolution. Issues in Accounting Education, 18. Watts, R. L., 2003. Conservatism in Accounting Part I: Explanations and Implications. Accounting Horizons, 17. Footnotes [1] Hermanson, R.H., Edwards, J.D. Maher, M.W., 2005. Accounting Principles. 8th ed., Freeload Press, Inc. [2] Companies Act 2006. Section 413. [3] Watts, R.L., 2003. Conservatism in Accounting Part I: Explanations and Implications. Accounting Horizons, 17. [4] Brennan, N. Gray, S.J., 2000. Accountants’ reports on profit forecasts: regulation and practice. Managerial Auditing Journal, 15, 9. [5] Kroll, Karen M., 2004. The Lowdown on Lean Accounting: A New Way of Looking at the Numbers. Journal of Accountancy, 198. [6] Cottingham, J. Hussey, R., 1995. The Prevention of Misleading Accounts Through Disclosures of Related Party Transactions. Journal of Financial Regulation and Compliance, 3, 4. [7] Goch, D., 1975. The Changing Face of the Annual Report. Managerial Finance, 1, 3. [8] Riahi-Belkaoui, A., 1992. Morality in Accounting. Quorum Books. [9] Thomas Keim, M. Grant, C.T., 2003. To Tell or Not to Tell: An Auditing Case in Ethical Decision Making and Conflict Resolution. Issues in Accounting Education, 18. [10] Chisnall, P., 2001. Fair value accounting – an industry view. Balance Sheet, 9, 1.