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Postulates of Accounting
1. The Accounting Entity Concept
Rule: The entire business unit that is being
measured should be reported on, regardless of legal entity. Furthermore,
businesses are distinct, separate entities, whose records should not be
commingled with personal transactions of the owners, managers or any other
parties.
Issue: The accounting pronouncements are
permitting and even encouraging practitioners to allow companies to use
“off-balance sheet” transactions and unconsolidated subsidiaries. Investors,
however, have become cautious and uneasy when a company’s financials don’t
reflect the complete picture. The use of “off-balance sheet” assets and
liabilities, moreover, is spreading and is prevalent in many industries.
The whole area of unconsolidated subsidiaries, as
well as “off-balance sheet” assets and liabilities, needs to be addressed
and overhauled by the accounting scholars, regulators and practitioners.
This lack of transparency was one the critical
reasons why Enron imploded. The company had so many unconsolidated
transactions that they eventually lost control of the situation, and were
operating clueless as to their financial status. It demonstrated, more
importantly, why the cookbook approach to writing accounting regulations
failed.
The issue of what to consolidate, goes back decades.
It’s the old debate over whether to consolidate manufacturing divisions with
finance subsidiaries, but with a modern twist. Hopefully, the accounting
profession will finally get this issue under control. In the meantime, young
investors need to analyze their investments for risks, or benefits, from
activities not shown on the face of the financial statements.
2. The Accounting Period Concept
Rule: Business units are required to report
the changes in their wealth periodically.
At a first glance, this concept seems
straightforward, since most public companies disclose their operating
results and financial position quarterly, with audited statements prepared
annually. Moreover, most of the larger companies already produce internal
monthly financial statements. Companies are also given the option to report
on either a calendar or fiscal year-end basis, to coincide with their
business cycle.
Issue: The constraints of reporting, using
arbitrary time periods, causes a number of impediments. The initial obstacle
surrounding the accounting period concept was how to accurately apply
cut-off procedures involving cash and non-cash activities. This issue was
mainly resolved by using accrual accounting methods, depreciation
allocations, and percentage-of-completion accounting, to handle cut-off
issues.
The
problem, today, centers on companies that co-mingle ownership, as well as
time periods, in their press releases and annual reports.
The use of proforma financial statements (“what if
statements”) is one of those areas that needs improvement. The concern is
that the accounting model is based on historical information, while current
activity such as acquisitions, limits the usefulness of historical
statements.
The situation is further exacerbated by management’s
efforts to focus on the “what if,” or any other data, that reflects more
favorably on the company than the GAAP financials. In many cases, the
investors themselves are pushing for proforma information from their
companies. Proformas can camouflage the reality of an actual situation.
Additionally, auditors are now pushing for
restatements on all sorts of issues. Usually, restatements make the prior
results appear worse, thus making the future periods look better. In
essence, by changing the reported results, a company reports the same
transaction twice.
The constant use of restatements, and to a lesser
degree, proformas, can undermine the public’s confidence in the business
community and the financial markets. As a result, the accounting period
concept is under full scrutiny by the profession.
Young adults should make concerted efforts to break
through the information maze; focus on the reality of “what is,” and not on
the “what if” hype.
3. The Unit of Measurement Concept
Rule: The activities of a firm need to be
measured in monetary terms. The monetary unit depends on the country in
which the business resides. In the United States, dollars are used.
Issue: Money is the common denominator in
business. Nonetheless, even this simple postulate is becoming an issue, with
the increased use of barter transactions. Customer referrals, or business in
exchange for free or discounted services, are also problematic. It’s taking
the old banking practise, of keeping deposits at your bank in exchange for
free services, to the next level.
This is not just an academic theory. Today, most
investors have some degree of international diversification, but may not
understand that in many emerging markets, bartering is significant, and a
normal business procedure.
When evaluating your investments, be mindful that
ultimately it’s cash that builds wealth, not accounting exchanges or barter
transactions.
4. The Going Concern Concept
Rule: The financial statements should be based
on the assumption that an entity will continue its operations for the
foreseeable future.
Issue: The year 2000 recession resulted in the
unexpected failure of several Fortune 500 companies. The swiftness and
magnitude of losses surprised investors and underscored the importance of
disclosing going concern issues. Some investors have incurred major losses
from previously undisclosed going concern risks.
There have
been major improvements in the disclosure of trends, uncertainties and
risks. Companies are less apprehensive about disclosing going concern
issues. These new disclosures, moreover, give investors a good insight into
the operations of the business. This is not “boiler plate” legal
information, it’s “must reading.” These issues are discussed at the highest
levels of organizations
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detailed description of The Principles of Accounting
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