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Understanding Accounting Fundamentals

The purpose of this topic is to provide an overview of general accounting principles. These principles are discussed in the following sub-topics:

The primary purpose of accounting is to establish a processing and communication system that summarizes financial information about business enterprises into understandable segments. In this sense, accounting acts as a management tool for an enterprise's economic activities.
One of the main reasons for accounting is financial reporting. The objectives of financial reporting are as follows:

  • For investors, creditors, and others outside the organization, financial statements provide information useful in assessing amounts, timing, and uncertainty of prospective cash receipts from dividends or interest and the proceeds from the sale, redemption, or maturity of securities or loans. Information in the reports includes listings of economic resources, owner's equity income, and cash flows. These reports also include explanations and interpretations by the management to assist the reader in understanding the financial information presented.
  • For the enterprise, financial statements provide information useful in assessing the amounts, timing, and uncertainty of prospective net cash flows to the related company, in order to make rational management decisions.

The following are types of useful accounting information:

  • Liquidity: Amount of time until an asset is converted into cash or a liability is paid.
  • Financial Flexibility: Ability to adapt to unexpected needs and opportunities.
  • Operating Capability: Ability to maintain a given level of operations.
  • Return on Investment: Amount of return on capital that may be distributed to investors or reinvested. Measure of overall company performance.
  • Risk: Uncertainty of unpredictably of the future results.

Qualitative characteristics of useful accounting information include:

  • Understandability: Information should be understandable to external users who have a reasonable knowledge of business and economic activities.
  • Decision Usefulness: Information should be useful in users' decision making.
  • Relevance: Capacity to make a difference in a decision, which includes predictive value, feedback value and timeliness.
  • Reliability: Reasonably free from error or bias and faithfully represents what it is intended to represent.
  • Verifiability (Objectivity): Ability of measurers (accountants) to agree that measurement results can be duplicated.
  • Representational Faithfulness (Validity): Degree of correspondence between reported measurements and economic resources, obligations and transactions, and events causing changes in the items.
  • Neutrality: Absence of bias and completeness of information.
  • Comparability: Enables users to identify and explain similarities and differences between two or more items of information.
  • Consistency: Conformity of information from period to period.
  • Constraints: Limits to help identify useful accounting information. Includes cost benefit analysis and materiality.

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