Principles of Financial Accounting

There are several fundamental principle of financial accounting. These are: 
1) Revenue Recognition - Gives the basis of recognizing revenue
2) Matching expense with revenue  - Matching of expense to revenue. Incur expenses when you recognition revenue. 
3) Objectivity - Accounting info must be verifiable and reliable
4) Consistency - Similar accounting policies and methods for the same company should be applied consistently over time.
5) Materiality - information that is significant should be include in accounting statements
6) Conservatism - Apply prudence and use accounting methods that do not overstate assets and revenues and understate liabilities and expenses.
7) Comparability -  If companies use similar accounting standards, it is possible to compare the performance of different companies using the financial statements. 
8) Relevance - Financial statement should be relevance for decision making. 

You may be surprised that the accounting principles are often manipulated by senior executives. Companies like Take-Two (developers of Grand Theft Auto), Enron and Halliburton used to have aggressive revenue recognition policies, booking revenue advance of actual sales.

Investment Analysis - Financial Accounting

Over the next few posts, I am going discuss about financial accounting and financial statement analysis. 

While there are many blogs and websites that discuss about how to carry out a valuation of a company, not many content discuss about financial accounting and financial statement analysis. I shall explain the importance of financial accounting in the series of posts.

What is financial accounting and why study it? 

Financial accounting allows external decision makers (creditors, investors, suppliers and customers) of the company to make decision based on financial information about the company These information are typically organised into four basic financial statements: Income statement, Balance Sheet, Cashflow statement and Statement of Retained Earnings. These statements are interrelated to one another.

What are the uses of the statements? 
Firstly, with the knowledge about the financial information about the company, decision makers can evaluate the performance of the business. Next, we can determine the important Key Performance Indicator of the company: revenue growth, profit growth, profit margin, debt to equity ratio etc. Finally, valuation of the company can be carried out by investors using the statements.

We assume in good faith of corporate managers and accountants, relying on the accounting system (GAAP, IFRS) will be able to produce a set of accurate financial statements reflecting the company's health. Ideally, these statements should accurately reflect the performance of the company, but does it? 

According to Richard Zeckhauser from Harvard, corporations report slightly higher or lower earnings compared to the corresponding quarter of the previous year. Zeckhauser and his team also found that corporations post small increases far more than they post small declines. Some companies also take a "big bath" by maximizing the reported setback through impairment and accelerating future expenses into the current quarter.

After reading Zeckhauser's research, does these statements accurately reflect the performance of the company? Users of financial statements will need to be careful when analysing these statements.What is apparent might be a veil of deception.