Financial accounting information is used by managers, investors, financial analysts, creditors, regulators, and even employees and customers on occasion. All of these people need to understand both the current financial status of an organization, as well as the events that caused a change in that status from some prior point in time. As such, the purpose of an accounting system is to collect, summarize, and report information concerning an organization’s financial performance, and the impact of various business events on its financial status.
Financial accounting relies on a set of Generally Accepted Accounting Principles, or GAAP, to help assure financial statement readers that they see a reliable and accurate representation of the economic performance of an organization. GAAP are based on nine concepts that have existed for decades. There has been, and continues to be considerable debate in the financial community about the validity and utility of these concepts, and alternatives frequently are proposed. For the moment, however, the nine concepts discussed in this note prevail.
The principle of depreciation is based on several of these concepts, and to understand it fully, we need to review the nine concepts. This note does so briefly. It then discusses depreciation, its relationship to several of the concepts, and how it it computed.
CONCEPT #1. ENTITY
This is a simple but important concept. In financial accounting, records are kept and financial statements are prepared for the organizational entity as distinct from its owners.
CONCEPT #2. DUAL-ASPECT
Accounting’s roots can be traced to the Italian Renaissance and the then-emerging city states. At that time, there was a need for improved record keeping, both to avoid mistakes in keeping track of financial information, and to provide merchants with better information on the financial performance of their businesses. To deal with the problem, a Franciscan monk, Fra. Luca Pacioli, devised the system of double-entry bookkeeping. Fra. Pacioli, a mathematician, reasoned that if, instead of making a single entry to the accounts each time a transaction took place, a merchant made two entries in two different places, there would be a system of checks and balances. His insight gave rise to the dual aspect concept of accounting, which underlies the balance sheet.
Since all accounting-related events result in two (sometimes more) entries to the accounts, there is a fundamental equality on a balance sheet. Specifically, an entity’s assets must be equal to the sum of its liabilities and its equity. This equality can only be preserved if two (or more) entries are made each time an accounting event occurs. An entity’s assets are what it owns or has claim to; its liabilities and equity represent how it has financed these assets. Liabilities represent financing from lenders and equity represents financing from owners plus the entity’s retained earnings.
CONCEPT #3. MONEY MEASUREMENT
Items that appear on financial statements are expressed exclusively in monetary terms. Items that can be counted must be expressed in monetary terms, and anything that cannot be measured in monetary terms is excluded from the financial statements.1
CONCEPT #4. GOING CONCERN
Bankruptcies are a reality in any market economy. For a variety of reasons, some organizations cannot survive the discipline of the marketplace. Their products or services may not be what consumers want, or they may not control their costs effectively, or they may be badly managed in other ways. In addition, many organizations may be merged with or acquired by other organizations.
1 Considerable work is underway at the moment to measure and report on intangible assets, i.e., assets that cannot be measured in monetary terms, such as the skill of an entity’s labor force. It is likely that some form of intangible reporting will emerge in the next decade or so.