Comparability of Transactions

Background

We've talked about how to record transactions, but in order to make the information even more useful, it'd be good if we could use it to compare current operations to past operations, and even to compare the performance of one financial entity to another...

Question

What are some ways that financial performance is made comparable to a. other time periods, b. other entities?

Answer

a. The reporting of transactions should cover equal time periods compared to other reported time periods,

b. Rules on how to record different kinds of transactions have been put into place, both in individual countries and internationally, to enhance comparability of financial performance of different entities. 

Analysis

We've talked about the recording of transactions but haven't covered the ways the recording of information can help a financial entity to enhance its performance and enable owners to make better decisions. So let's talk about that!

Let's talk about an example company and work our way through how comparability is important. Let's have that company be a new restaurant. It opens its doors for business at the start of Year 1.

The owners of the business would like to keep track of how the restaurant is doing and so they ask for updates from time to time from the store manager. The store manager, of course, would like to show the owners that he's doing a good job, and so without any further guidance from the owners, the manager will do what he can to make the restaurant look like it's doing well.

One thing the manager might do is to report more frequently when things are going well and less frequently when things are slow. The manager might not even report at all when things are going poorly! The restaurant could be running out of money and the owners wouldn't know!

And so the owners would want periodic reports on a regular basis to know how the restaurant is doing. Most businesses look at their operations on a yearly basis - and oftentimes they look at more periodic time periods as well (such as quarterly, monthly, and even weekly).

This reporting with equal time periods allows owners to compare how one time period (say Year 2) is doing compared to another equal time period (say Year 1). This makes the reporting more helpful - is Year 2 better than Year 1? Is it worse? What might be causing the difference?

This comparability of time periods makes the reports more useful.

Now let's expand this example a little bit.

A big restaurant chain is looking to buy a restaurant in the local area of our example restaurant. Let's say there are five contenders to be bought and our example restaurant is one of them. How will the big chain decide which to buy?

One big factor will be looking at the operating results of each restaurant and seeing which is doing the best. But here's the thing - if each restaurant has its own way of reporting operations, it becomes very hard for the big chain to figure out which restaurant is doing the best.

This type of consideration is why there are rules in place as to how to record transactions - so that different companies can be compared on an equal footing. (I should note that the rules get stricter and stricter as the business gets more and more complicated).

There are different organizations that issue rules about how to account for transactions. Governments will sometimes issue rules on accounting, taxation bodies can do it as well. Organizations such as the Financial Accounting Standards Board (FASB) in the USA issue rules that big companies in the USA are required to follow. And internationally, there is a movement towards having a standardized set of rules so that the accounting rules in the USA and in, say Germany, are the same.

Vocabulary used:

For more information check out these links (comment to add your favourite link):

FASB

Where might you have come from?

Fact-orials Index

Accounting Principles

• Double Entry Accounting
• Recording Transactions
• Cash vs Accrual Accounting

Where might we go?

Accounting Principles

• Financial Entity 
• Accounting Reports