chapter 7-1 accounting principles financial accounting, sixth edition chapter 7

Chapter 7-1

Accounting PrinciplesAccounting Principles

Financial Accounting, Sixth Edition

Chapter Chapter 77Chapter Chapter 77

Chapter 7-2

1. Explain the meaning of GAAP and identify the key items of the conceptual framework.

2. Describe the basic objectives of financial reporting.

3. Discuss the qualitative characteristics of accounting information and elements of financial statements.

4. Identify the basic assumptions used by accountants.

5. Identify the basic principles of accounting.

6. Identify the two constraints in accounting.

7. Understand and analyze classified financial statements.

8. Explain the accounting principles used in international operations.

Study ObjectivesStudy ObjectivesStudy ObjectivesStudy Objectives

Chapter 7-3

Accounting PrinciplesAccounting PrinciplesAccounting PrinciplesAccounting Principles

Monetary unitMonetary unit

Economic Economic entityentity

Time periodTime period

Going Going concernconcern

TheTheConceptualConceptual

Framework ofFramework ofAccountingAccounting

TheTheConceptualConceptual

Framework ofFramework ofAccountingAccounting

AssumptionsAssumptionsAssumptionsAssumptions PrinciplesPrinciplesPrinciplesPrinciplesConstraints Constraints

in in

AccountingAccounting

Constraints Constraints

in in

AccountingAccounting

Statement Statement

Presentation Presentation

and Analysisand Analysis

Statement Statement

Presentation Presentation

and Analysisand Analysis

Objectives of Objectives of reporting reporting

Qualitative Qualitative characteristicscharacteristics

Elements of Elements of financial financial statements statements

Operating Operating guidelinesguidelines

Revenue Revenue recognition recognition

MatchingMatching

Full Full disclosuredisclosure

CostCost

MaterialityMateriality

ConservatismConservatism

Summary of Summary of conceptual conceptual frameworkframework

Classified Classified balance sheetbalance sheet

Classified Classified income income statement statement

Analyzing Analyzing financial financial statements statements

An international An international perspectiveperspective

Chapter 7-4

Various users need financial information

Various users need financial information

The accounting profession has

attempted to develop a set of standards that are generally accepted and universally practiced.

Financial StatementsBalance SheetIncome StatementStatement of Retained EarningsStatement of Cash FlowsNote Disclosure

Financial StatementsBalance SheetIncome StatementStatement of Retained EarningsStatement of Cash FlowsNote Disclosure

Generally Generally Accepted Accepted

Accounting Accounting Principles Principles

(GAAP)(GAAP)

Generally Generally Accepted Accepted

Accounting Accounting Principles Principles

(GAAP)(GAAP)

The Conceptual Framework of The Conceptual Framework of AccountingAccountingThe Conceptual Framework of The Conceptual Framework of AccountingAccounting

SO 1 Explain the meaning of GAAP and identify SO 1 Explain the meaning of GAAP and identify the key items of the conceptual the key items of the conceptual framework.framework.

Chapter 7-5

Securities and Exchange Commission (SEC)

http://www.fasb.org/

http://www.sec.gov/

The Conceptual Framework of The Conceptual Framework of AccountingAccountingThe Conceptual Framework of The Conceptual Framework of AccountingAccountingOrganizations Involved in Standard Setting:

Financial Accounting Standards Board (FASB)


Chapter 7-6

Conceptual Framework - “…a constitution, a coherent system of interrelated objectives and fundamentals.”

FASB’s conceptual framework consists of the following:

1. Objectives of financial reporting.

2. Qualitative characteristics of accounting information.

3. Elements of financial statements.

4. Operating guidelines (assumptions, principles, and constraints).

The Conceptual Framework of The Conceptual Framework of AccountingAccountingThe Conceptual Framework of The Conceptual Framework of AccountingAccounting


Chapter 7-7

a)a) To provide information that is useful to those making To provide information that is useful to those making investment and credit decisions.investment and credit decisions.

a)a) To provide information that is useful to those making To provide information that is useful to those making investment and credit decisions.investment and credit decisions.

b)b) Helpful in assessing future cash flows.Helpful in assessing future cash flows.b)b) Helpful in assessing future cash flows.Helpful in assessing future cash flows.

c)c) Identify the economic resources (assets), the claims to Identify the economic resources (assets), the claims to those resources (liabilities), and the changes in those those resources (liabilities), and the changes in those resources and claims.resources and claims.

c)c) Identify the economic resources (assets), the claims to Identify the economic resources (assets), the claims to those resources (liabilities), and the changes in those those resources (liabilities), and the changes in those resources and claims.resources and claims.

Conceptual FrameworkConceptual FrameworkConceptual FrameworkConceptual Framework

Objectives of Financial Reporting

SO 2 Describe the basic objectives of financial SO 2 Describe the basic objectives of financial reporting.reporting.

Chapter 7-8

According to the FASB conceptual framework, the According to the FASB conceptual framework, the objectives of financial reporting for business objectives of financial reporting for business enterprises are based on?enterprises are based on?

a.a. Generally accepted accounting principlesGenerally accepted accounting principles

b.b. Reporting on management’s stewardship.Reporting on management’s stewardship.

c.c. The need for conservatism.The need for conservatism.

d.d. The needs of the users of the information.The needs of the users of the information.


(CPA adapted)(CPA adapted)

Review:Review:

SO 2 Describe the basic objectives of financial SO 2 Describe the basic objectives of financial reporting.reporting.

Chapter 7-9

Question:How does a company choose an acceptable accounting method, the amount and types of information to disclose, and the format in which to present it?

SO 3 Discuss the qualitative characteristics of SO 3 Discuss the qualitative characteristics of accounting accounting information and elements of information and elements of financial statements.financial statements.

Answer:

By determining which alternative provides the most useful information for decision-making purposes (decision usefulness).


Chapter 7-10

Relevance – making a difference in a decision.

Predictive valueFeedback valueTimeliness

ReliabilityVerifiableRepresentational faithfulnessNeutral - free of error and bias

Qualitative Characteristics



Chapter 7-11

Comparability – Information that is measured and reported in a similar manner for different companies is considered comparable.

Consistency - When a company applies the same accounting treatment to similar events from period to period.

Qualitative Characteristics



Chapter 7-12

RevenueRevenue

ExpensesExpenses

GainsGains

LossesLosses

AssetsAssets

LiabilitiesLiabilities

EquityEquity

“Moment in Time” “Period of Time”

Elements of Financial Statements



Chapter 7-13

Illustration: Identify the element or elements associated with items below.

(a) Obligation to transfer (a) Obligation to transfer resources arising from a resources arising from a past transaction.past transaction.

(b)(b) Items characterized by Items characterized by future economic benefit.future economic benefit.

(c)(c) Arises from income Arises from income statement activities that statement activities that constitute the entity’s constitute the entity’s ongoing major or central ongoing major or central operations.operations.

Elements

(a)AssetsAssets


Equity Equity

RevenueRevenue

ExpensesExpenses

(b)

(c)

(c)



Chapter 7-14

AssetsAssets


Equity Equity

RevenueRevenue

ExpensesExpenses

(d) (d) Residual interest Residual interest in the net assets of the in the net assets of the enterprise.enterprise.

(e) (e) Increases assets Increases assets through sale of product.through sale of product.

Elements

(a)

(b)

(c)

(c)

(d)

(e)

Illustration: Identify the element or elements associated with items below.



Chapter 7-15

Operating Guidelines


Chapter 7-16

Assumptions provide a foundation for the accounting process.

Monetary Unit

Economic Entity

Periodicity

Going Concern

SO 4 Identify the basic assumptions used by SO 4 Identify the basic assumptions used by accountants.accountants.

AssumptionsAssumptionsAssumptionsAssumptions

Chapter 7-17

Only transaction data capable of being expressed in terms of money should be included in the accounting records of the economic entity.



Monetary Unit

Chapter 7-18

Economic events can be identified witha particular unit of accountability.



Economic Entity

Chapter 7-19 SO 4 Identify the basic assumptions used by SO 4 Identify the basic assumptions used by

accountants.accountants.


Time Period

The economic life of a business can be divided into artificial time periods.

Chapter 7-20 SO 4 Identify the basic assumptions used by SO 4 Identify the basic assumptions used by

accountants.accountants.


Going Concern

The enterprise will continue in operation long enough to carry out its existing objectives.

Chapter 7-21

Accounting principles dictate how economic events should be recorded and reported.

Revenue Recognition

Matching (Expense Recognition)

Full Disclosure

Cost

SO 5 Identify the basic principles of accounting.SO 5 Identify the basic principles of accounting.

PrinciplesPrinciplesPrinciplesPrinciples

Chapter 7-22

Revenue Recognition - companies should recognize revenue in the accounting period in which it is earned.



Chapter 7-23

Matching - efforts (expenses) should be matched with accomplishment (revenues) whenever it is reasonable and practicable to do so. “Let the expense follow the revenues.”

Illustration 7-4Illustration 7-4 Expense Recognition



Chapter 7-24

Illustration 7-5Illustration 7-5 Basic Principles

Matching

Principle



Chapter 7-25

Full Disclosure – Provided through financial statements, notes to the financial statements, and supplementary information.




Chapter 7-26

Cost Principle – the price, established by the exchange transaction, is the “cost”.




Chapter 7-27

Illustration: Identify which basic principle of accounting is best described in each item below.

(a) Norfolk Southern Corporation reports revenue in its income statement when it is earned instead of when the cash is collected.

(b) Yahoo, Inc. recognizes depreciation expense for a machine over the 2-year period during which that machine helps the company earn revenue.

(c) Oracle Corporation reports information about pending lawsuits in the notes to its financial statements.

(d) Eastman Kodak Company reports land on its balance sheet at the amount paid to acquire it, even though the estimated fair market value is greater.

Revenue Revenue RecognitionRecognition

MatchingMatching

Full Full DisclosureDisclosure

CostCost



Chapter 7-28

Constraints permit a company to modify generally accepted accounting principles without reducing the usefulness of the reported information.

Materiality

Conservatism

Constraints in AccountingConstraints in AccountingConstraints in AccountingConstraints in Accounting

SO 6 Identify the two constraints in accounting.SO 6 Identify the two constraints in accounting.

Chapter 7-29

Materiality - an item is material if its inclusion or omission would influence or change the judgment of a reasonable person.

Illustration 7-6Illustration 7-6 Constraints



Chapter 7-30

Conservatism - When in doubt, choose the method that will be least likely to overstate assets and income.

Illustration 7-6Illustration 7-6 Constraints



Chapter 7-31

Illustration What accounting constraints are illustrated by the items below?

(a) Crimson Tide Corporation does not accrue a contingent lawsuit gain of $650,000.

(b) Sun Devil Corporation expenses the cost of wastebaskets in the year they are acquired.

ConservatismConservatism

MaterialityMateriality



Chapter 7-32

Summary of Conceptual FrameworkSummary of Conceptual FrameworkSummary of Conceptual FrameworkSummary of Conceptual Framework

Chapter 7-33

Classified Balance Sheet

Statement Presentation and Statement Presentation and AnalysisAnalysisStatement Presentation and Statement Presentation and AnalysisAnalysis

SO 7 Understand and analyze classified financial SO 7 Understand and analyze classified financial statements.statements.

Illustration 7-8Illustration 7-8 Standard classification

Chapter 7-34




Illustration 7-9Illustration 7-9 Proprietorship balance sheet

A proprietorship, the balance sheet uses the term“Owner’s equity” instead of “Stockholders’ equity”

Chapter 7-35




Illustration 7-10Illustration 7-10 Partnership balance sheet

In a partnership, each partner has a separate capitalaccount.

Chapter 7-36

Classified Income Statement



A multiple-step income statement generally includes the following.

Sales revenue Cost of goodsOperating Other revenues and gainsOther expenses and losses

Two additional items are income tax expense and earnings per share.

Chapter 7-37




Illustration 7-11Illustration 7-11 Income taxes

Chapter 7-38


Net IncomeEarnings Per Share

= Number of Common Shares

Outstanding


Indicates the net income earned by each share of outstanding common stock.


Chapter 7-39

Analyzing Financial Statements



Three major characteristics are generally used:

Liquidity,

Profitability, and

Solvency.

Chapter 7-40

Liquidity



This ratio means that current assets are more than two times greater than current liabilities.

Chapter 7-41



Working capital provides some indication of the company’sability to meet its existing current obligations.

Liquidity

Chapter 7-42



Profitability

Chapter 7-43



Profit Margin Percentage measures the percentage of each dollar of sales that results in net income.

Profitability

Profitability ratios measure the income or operating success of a company for a given period of time.

Chapter 7-44



Return on Assets is an overall measure of profitability.

Profitability

Return on Common Equity shows the percentage of net income earned for each dollar of owners’ investment.

Chapter 7-45



Debt to Total Assets measures the percentage of total assets that creditors, as opposed to stockholders, provide.

Solvency

Solvency measures the ability of an enterprise to survive over a long period of time.

Chapter 7-46


SO 8 Explain the accounting principles used in international SO 8 Explain the accounting principles used in international operations.operations.

An International Perspective

There are few recognized worldwide accounting standards. The International Accounting Standards Board (IASB), of which the United States is a member, is working to obtain conformity in international accounting practices.

Chapter 7-47

Scandals and bankruptcies at Enron, WorldCom, and other companies brought many changes to the way America does business.

Many companies have developed a code of ethics to:

deter wrongdoing

promote honest and ethical conduct

indicate that management takes ethics seriously.

Corporations Have Governance Structures—Do You?Corporations Have Governance Structures—Do You?

All About YouAll About YouAll About YouAll About You

Chapter 7-48

Some Facts:

Under Sarbanes-Oxley, a company must disclose whether it has a code of ethics.

Enron had a code of ethics. Enron’s board of directors knowingly waived requirements of the code so that the CFO could set up and run special purpose entities.

In a recent survey of 1,436 workers, 34% said that they have seen unethical activities at their workplace, but only 47% said they are likely to report these activities.


Corporations Have Governance Structures—Do You?Corporations Have Governance Structures—Do You?

Chapter 7-49

Stockholders often lose money as a result of unethical behavior by management and they often file lawsuits against the company in an effort to recoup these losses.


Source: Elaine Buckberg, Todd Foster, and Ronald I. Miller, “Recent Trends in Shareholder Class Action Litigation: Are WorldCom and Enron the New Standard?” NERA Economic Consulting, www.nera.com (accessed June 26, 2006).

Chapter 7-50

What Do You Think?What Do You Think?

Many universities have become concerned about student cheating. Many schools now have student ethics codes. Do you think that these ethics codes serve a useful purpose?


YES: Anything that will reduce unethical behavior is a good thing.

NO: The existence of an ethics code won’t affect student behavior.

Chapter 7-51

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