Financial Accounting Theory

Accounting is defined as the process of recording, classifying, and summarizing in monetary terms the financial transactions and the interpretation thereof (Ramnik, 2002). Accounting is the process of conveying the financial information about a business entity to users of the information. The users of financial information include various stakeholders of the business such as managers, government, and creditor (Elliot & Elliot, 2004). The communication is mainly in the form of financial statements that show the monetary value of the economic resources under the company's management. The practice entails the selection of information that is relevant to the users and can be relied upon for decision-making. Accounting is critical in discovering the reasons for success and collapse of businesses.

Accounting and more so financial accounting relies on various accounting concepts; these concepts have significant impacts on the accounting practice. Accounting policies and concepts are highly subjective; this has significant impacts on the materiality of financial statements. Various accounting policies entail subjective valuations on different items. This allows users of financial statements to get a glimpse of the company by evaluating a single financial statement. For instance, the financial statements of a bank that has issued many new loans would look good on one report; however, high default rates would destroy the attractiveness of the financial statements. Thus, GAAPs would require the bank's management to estimate the default rates on loans and include the value along the new loans.

Financial statements are prepared to provide an estimation of the financial position of a business. This is a very subjective area of financial statements since it includes the estimation of future financial statement values. For instance, IAS 37 allows for the provision of a contingent asset and liability (Deloitte Global Services Limited, 2010). The determination of contingent assets and liabilities is highly subjective since it depends on the occurrence or nonoccurrence of some future event. Otherwise, financial statements could be prepared based on the prudence principle, which would only include objective and historical records. However, valuation methods that are based on historical costs are not good enough. The best methods are based on the estimation of future income, a process that is highly subjective (Kapferer, 2008).

There are overhead costs that are charged to inventory as opposed to being recognized in the cost of sales or other expense category. The proper allocation of the costs raises significant effects on the income reported in a period. Thus, it is critical for accountants to understand the costs that can be pooled for future allocation and the allocation process. The question arises on the costs that are to be shifted in the cost pool. The cost category with uncertainty is the rework labor, spoilage, and scrap. These costs can be treated either way. The rule is that the rework, spoilage, or scrap costs that fall within the normal must be allocated in the cost pool; however, the unusual amounts must be written off at once (Bragg, 2002). This is a highly subjective area; historical records should be maintained to provide a basis for allocating the costs on either category. The estimation of fair values is another highly subjective area of accounting requiring significant judgment in the estimation of the extent and the timing of future cash flows. If it can be determined, that the estimated fair value of a reporting unit is less than the carrying unit, an impairment charge is recognized in the financial statements (Bratton, 2002). However, the future is uncertain and leads to the creation of provision accounts that entail a lot of subjectivity.

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Management accounting influence decisions and judgments by providing information and influencing the processing of information. The direction and extent of influence is dependent on management's knowledge, experience, and ability and the components of the task and its contents (Chapman, Hopwood & Shields, 2007). Subjective decisions entail the management decisions being influenced by various variables. Under favorable conditions, predictability is high, and accounting estimates are consistent with the underlying economic relations. However, unfavorable conditions complicate the estimation process. Examples of subjective management decisions include profit predictions and product pricing decisions.

In conclusion, accounting as the process of conveying monetary financial information to users of financial statements entails various subjective decisions. Financial managers are concerned with the estimation of fair values, costs, and other components of financial statements. These estimations entail subjective decision-making. On the other hand, management accountants undertake various decisions that are dependent on personal judgments. Additionally, auditors undertake decisions on materiality of the misstatements in the financial statements. The materiality principle is highly dependent on the auditor's personal judgment and experience. Thus, we can conclude that accounting entails various subjective decisions that are highly dependent on personal decisions of account professionals.

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