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Chapter 15

Accounting Principles

ACCT 100

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Objectives of the Chapter

1. Define the generally acceptedaccounting principles (GAAP).

2. Study the conceptual frameworkunderlying financial reports.

3. Study the accounting standardcompliance system in the United

States.4. Discuss the need for a set of global

accounting standards.

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3

Objectives of the Chapter (contd.)

5. Multiple-step income statement vs.single-step income statement.

6. Analyzing Financial Statements

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Environment and Theoretical Structure of Financial Acounting 4

1. General Accepted Accounting Principles(GAAP)

Accounting methods having substantialauthoritative support and used bybusiness entities in preparing financial

statements.

The support is from the Securities andExchange Commission (SEC).

The SEC is a government agency whichwas created by the Securities ExchangeAct of 1934.

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The Authorities Prescribe theAccounting Standards

Prior to 1973, two committees under theAICPA (American Institute of Certified PublicAccountants) were the authorities in the

private sector to be in charge of prescribingaccounting standards.

Since 1973, the financial accounting

standards board (FASB) became theauthority in the private sector to prescribeaccounting standards.

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Environment and Theoretical Structure of Financial Accounting 6

1934 CongressSEC Regulation S-X

ASR and FRRStaff Accounting Bulletins1938 Accounting Profession

AICPA

1938-1959 CAP ARBs (51)1959-1973 APB APB Opinions (31)1973 FASB . 1. Statement of Financial

Accounting Standards

2. Interpretations3. Concepts of FinancialAccounting

4. Technique Bulletins

5. Statements issued byEITF

Year Authority Official Release

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Problems Associated with AccountingStandards Developed Prior to 1973

Under CAP (Committees on AccountingProcedures) and APB (AccountingPrinciples Board), accounting standardswere developed on a problem-by-problem basis.

Accounting rule-making bodies (i.e.,CAP and APB) solved specificproblems.

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Problems Associated with AccountingStandards Developed Prior to 1973 (Contd.)

The problem-by-problem approachresulted in inconsistent accountingstandards.

The FASB developed a conceptualframework to serve as the foundation to

develop accounting standards.

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2. Conceptual Framework ofFinancial Reporting

Conceptual Framework of FinancialReporting: a system of interactiveobjectives and fundamentals which canlead to a set of consistent standards inpreparing financial reports.

The current accounting standard settingauthority (FASB) relies on thisframework to prescribe a set of

consistent accounting standards.

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Financial Reporting: A Theoretical StructureA Conceptual Framework for Financial Reporting

AssumptionsEntityGoing-Concern

Monetary unit

Periodicity

ConstraintsCost/BenefitMaterialityIndustryPractice

Conservatism

Objectives

Qualitative

Characteristicof AccountingInformation

Elements(SFAC No. 6)

Recognition andMeasurement Concepts

PrinciplesHistorical CostRevenueMatchingFull Disclosure

SFAC N0. 1

SFAC No. 8

SFAC No.5

First Level

Second Level

Third level

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SFAC No. 1(Level One of the Conceptual Framework)

Objectives of financial reporting:

Providing information

1. useful in making investment andcredit decisions;

2. useful in assessing future cash flows;

3. about entity resources, claims to theresources and changes of theseresources.

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SFAC No. 8 (Chapter 3: Qualitative Characteristics of UsefulFinancial Information ) (Level Two of The Framework)

Qualitative Characteristics of AccountingInformation

I. Primary Qualities1) Relevance

a) Predictive value

b) Confirmatory valuec) Materiality

2) Faithful Representationa) Complete

b) Neutralc) Free from error

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SFAC No. 8 (contd.)

II. Enhancing Qualitative Characteristics

1) Comparability(including consistency)

2) Verifiability

3) Timeliness4) Understandability

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SFAC No. 5 (Operating Guidelines)(Level Three of The Conceptual Framework)

Measurement and Recognition Concepts

I. Assumptions

1) Economic Entity

2) Going-concern (continuity)

3) Monetary unit

4) Periodicity (Period of time)

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SFAC No. 5 (contd.)

II. Principles1) Historical cost (exception: LCM of

inventory)2) Revenue recognition (exceptions:3) Matching4) Full Disclosure (footnote disclosure)

III. Constraints1) Cost-Benefit2) Materiality3) Industry Practice4) Conservatism

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3. The Accounting StandardCompliance System in the US

The interrelationship of the SEC andthe FASB:

FASB: the current rule making body.SEC: the enforcing agency of

securities laws and accounting

standards; regulating the stockmarket.

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4. The Need for International AccountingStandards

Companies doing business in more thanone nations found that it is hard tocomply with more than one set of

accounting standards established byauthorities in different nations.

In response to this problem,

International Accounting StandardsCommittee (IASC) was formed in 1973to develop a single set of globalaccounting standards.

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The Popularity of the InternationalAccounting Standards

IASC created International AccountingStandards Board (IASB) in 2001 to be incharge of prescribing the standards.

Since 2005, over 7,000 companies listedin the European Union used IASBstandards.

Many other countries now also use IASBstandards.

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Th C f th U S A ti

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The Convergence of the U.S. AccountingStandards and the International AccountingStandards To increase the international

comparability and the quality of USaccounting standards, the FASB has

been engaged in activities to increasethe convergence of the accountingstandards.

The FASB is working closely with theIASB toward the convergence ofaccounting standards (i.e., to develop asingle set of global standards).

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Short-Term International Convergence(source: FASB Project Updates)

The IASB and the FASB acknowledgedthat convergence of IASB standards andU.S. GAAP is a primary objective of both

Boards. To achieve this objective and to improve

the financial reporting in the US, the

FASB started a short term project,conducted jointly with the IASB, toeliminate narrow differences betweenUS GAAP and IASB standards in 2002.

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Current Compliances in the US

The U.S. firms filing reports with theSEC must use U.S. GAAP.

Foreign issuers filing reports with the

SEC can use U.S. GAAP or theinternational standards.

The SEC abolished a requirement that

non-US companies with US listingsreconcile their financial reports to USGAAP in 2007.

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Accrual Accounting and the Financial Statements 22

5. Income Statement Formats

Net sales revenue $150,000Cost of good sold (80,000)Gross margin 70,000

Operating expensesSelling, Administration and Depreciation (40,000)

Income form operations 30,000Other icome (expense):

Interest revenue $2,000

Interest expense (9,000)Gain on sale of equipment 3,000 (4,000)

Income before income tax 26,000Income tax expense (10,000)

Net income $16,000

Multiple -Step Income Statement (see

illustration 5-11 of textbook for an Example) :

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Income Statement Formats (contd.)

Single-Step Income Statement (See Illus.5-12 oftextbook)

Revenues:Net sales $150,000

Interest revenue 2,000Gain on sale of equipment 3,000

Total revenue $155,000Expenses:Cost of goods sold 80.000

Selling, administrative and depr. 40,000Interest expense 9,000Income tax expense 10,000

Total expenses 139,000Net Income $ 16,000

Accounting for Merchandising Operations 23

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Income Statement Formats (Contd.)

CGS=Beg. Inv.+Net Pur. End. Inv.

Net Pur. =Pur.PRPD + Freight-In

Selling expenses include: salariesexpense (sales related), advertisingexpense, freight-out.

Administrative expenses include:salaries expense (administrationrelated), utility expense, insurance

expense. Accounting for Merchandising Operations 24

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Financial Statement Analysis 25

6. Analyzing Financial Statements

Liquidity

Measuring a companys ability to pay

current liabilities.

Current ratio = Current Assets

Current LiabilitiesWorking Capital = Current assetsCurrent

Liabilities

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Financial Statement Analysis 27

Profitability

Indicators of how effective a company

has been in meeting its overall profit

objectives, particularly in relation to theresources invested.

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Profitability (contd.)

a. Profit margin percentage (rate of return onsales)

= Net Income

Net Sales b. Return on assets

= Net Income

Average Total Assets c. Return on comm. stockholders equity

= Net Income - Preferred Dividends

Average Stockholders Equity