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Introduction to Fundamental Analysis

 - The Accounting Process
 - Postulates and Principles
    of Accounting
    * Postulates of Accounting
     * Principles of Accounting

 -
The Financial Statements
   * The Balance Sheet
   
* The Income Statement
    * The Cash Flow Statement
    *  Shareholders' Equity
        Statement

 


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

Click here:  for a detailed description of The Principles of Accounting

 

 

 

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