Decision makers often wish to compare the financial statements of several firms. To permit valid comparisons, the firms’ statements need to be based on the same set of accounting principles, which are the rules and procedures used to produce the financial statements.
To illustrate how one event might be accounted for in more than one way, consider a movie production company that has just produced a new film costing $25,000,000. Assume that a balance sheet is to be prepared before the film is marketed. Does the firm have a $25,000,000 asset? The real value of the film rests on its capability to generate future revenues. A successful film will generate revenue that is many times greater than its cost; an unsuccessful film may not even cover its cost. At the balance sheet date, the future revenue is unknown.
As a potential investor or creditor, how would you prefer that this film be reflected on the balance sheet? Two obvious alternatives are $25,000,000 and $0. The latter is clearly more conservative; it results in a lower asset value. Some financial statement readers would prefer this conservative approach. Others would maintain that management expects to reap at least $25,000,000 in revenue; otherwise, they would not have undertaken the project. Thus, they feel that $25,000,000 is the most reasonable figure. There is no obvious answer to this issue. However, to permit valid comparisons of various firms’ balance sheets, the same accounting principle should be used. Current accounting practice, in general, is to record assets at historical cost; in this case, the movie would be recorded at $25,000,000.
- The Financial Accounting Standards Board (FASB)
- The Securities and Exchange Commission (SEC)