Accounting basis 2

Global Leadership University

Accounting basis

Lecture 2

ACCOUNTING PRINCIPLES

Accounting gp principles p Revenue and Expense

CONCEPTUAL FRAMEWORK OF ACCOUNTING |

Generally y accepted p accounting gp principles p y

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set of standards and rules that are recognized as a general guide for financial reporting

Financial Accounting Standards Board (FASB) and Securities and Exchange Commission (SEC) The FASB has the responsibility for developing accounting principles.

ACCOUNTING INFORMATION MUST BE USEFUL

To b T be useful, f l information i f ti should h ld possess the following qualitative characteristics: 1 relevance 2 reliabilityy 3 comparability 4 consistency

RELEVANCE | |

Accounting information has relevance if it makes a difference in a decision.

Relevant information helps users forecast future events (predictive value), or it confirms or corrects prior expectations (f db k value). (feedback l )

RELIABILITY |

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Reliability R li bili off iinformation f i means that h the h information is free of error .

To be reliable, accounting information must be verifiable.

COMPARABILITY AND CONSISTENCY |

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Comparability means that the information should be comparable with accounting information about other enterprises.

C i Consistency means that the same accounting i principles i i and methods should be used from year to year within a company.

2005

2006

2007

CHARACTERISTICS OF USEFUL INFORMATION

THE OPERATING GUIDELINES OF ACCOUNTING | Operating guidelines are classified as assumptions, principles and constraints. principles, Assumptions provide a foundation for the accounting process. | Principles indicate how transactions and other economic events should be recorded. | Constraints on the accounting process allow for a relaxation of the principles under certain circumstances. |

Assumptions Monetary unit Economic entity Time period Going concern

Principl es

Revenue recognition Matching Full disclosure Cost

Constrai nts Materiality Conservatism

ASSUMPTIONS USED IN ACCOUNTING

ASSUMPTIONS Monetary unit assumption: y

only transaction data expressed in terms of money can be included in the accounting records

Example: employee satisfaction and percent of international employees are not transactions that should be included in the financial records.

Employee Satisfaction

Should be included ccou g in accounting records

Percentage of International Employees S l i paid Salaries id

ECONOMIC ENTITY ASSUMPTION Activities of the entity kept separate and distinct from the activities of the owner and d all ll other th economic i entities. titi Example: BMW activities can be di ti distinguished i h d from f th those off other th car manufacturers such as Mercedes.

THE ENTITY CONCEPT EXAMPLE |

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Assume that John decides to open p up pa and coffee shop.

g gas station

The gas station made Revenues 250,000 in profits, while the coffee shop lost Revenues 50,000.

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THE ENTITY CONCEPT EXAMPLE How much money y did John make? | At a first glance, we would assume that John made Revenues 200,000. | However, by applying the entity concept we realize that the gas station made Revenues 250,000 while the coffee shop lost Revenues 50,000. |

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GOING CONCERN ASSUMPTION

The entity y will continue to operate in the future.

TIME PERIOD PRINCIPLE |For

reporting purposes purposes, an organization’s life can be divided i t separate into t accounting ti periods i d y months, y quarters, y years, years

etc etc.

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Exh. 3.1

THE ACCOUNTING PERIOD

Annual 1

2

Semiannual 1

2

3

4

Quarter 1

2

3

4

5

6

7

Month

8

9

10

11

12

REVENUE RECOGNITION PRINCIPLE |Revenue

y At

is generally recognized

the time services are p performed;; or

y When

goods are sold and delivered to a customer. t

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REVENUE PRINCIPLE I plan to have you make my travel arrangements.

Air & Sea Travel, Inc. March 12

Situation 1 No transaction has occurred.

– Do Not Record Revenue

Air & Sea Travel, Inc. April 2

Situation 2 The client has taken a trip p arranged g by y 19 Air & Sea Travel. – Record Revenue

THE MATCHING PRINCIPLE |The

matching principle requires that all expenses incurred to generate t the th revenues recognized i d in i an accounting period be matched with those revenues.

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THE MATCHING PRINCIPLE |Another

y Let

view . . .

the expense follow the revenue.

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First the revenue . . .

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Th the Then th expense.

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GAAP RELATIONSHIPS IN REVENUE AND EXPENSE RECOGNITION Time-Period Time Period Assumption Economic life of business can be divided into artificial time periods Revenue-Recognition Principle

Revenue recognized R i d iin the accounting period in which it is earned

Matching Principle

Expenses p matched with revenues in the same period when efforts are expended to generate revenues

Full Disclosure Principle Illustration 1-14

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COST PRINCIPLE The cost principle dictates that assets be recorded at their cost. cost Cost= Purchase price + Preparing expenses |

BASIC PRINCIPLES USED IN ACCOUNTING

CONSTRAINTS IN ACCOUNTING

Materiality Convention |

A financial statement item is material if its omission or misstatement would tend to mislead the reader of the financial statements under consideration y

Materiality often depends on the size of the organization – what is material to one company might not be material to another company.

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DUAL ASPECT CONCEPT Accounting g information is based on the double entryy system. | Under this system, the two-sided effect of a transaction is recorded in the appropriate accounts.

ASSETS = LIABILITIES + OWNER’S EQUITY The Accounting Equation |

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REVENUE AND EXPENSES g for p products and REVENUES are inflows of assets in exchange services provided to customer as part of a company’s primary operations.

EXPENSES are outflows tfl off th the using i up off assets t from f providing products and services to customer.

Profit= Revenue - Expenses Profit

Revenue Recognition

Matching M t hi Principle

Accrual Basis Accounting

Yikes!! What is Accrual Basis Accounting?

ACCRUAL BASIS ACCOUNTING |Revenues

are recognized (recorded) when earned, earned without regard to when cash is received;

|Expenses

are recorded as incurred without regard to when they are paid.

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Per riodicity Assu umptiion

96 ?

97

98 ?

99

00 ?

01

02 ?

03

04

?

How do we recognize revenues?

Revenue Recognition ⇒ The Principle

How do we recognize expenses?

⇒ The Matching Principle

Accrual Basis Accounting

05 ?

Bertha, are Bertha there any other bases for accounting?

Yikes! I don’t know Claude Claude. We probably better ask the professor!

CASH BASIS ACCOUNTING |With

the cash basis . . .

y Reve Revenues ues

are a e recognized ecog ed in tthe e pe period od cash is received; and

y Expenses

are recognized in the period when cash is paid out.

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Bertha, are Bertha there any other bases for accounting?

Yikes! I don’t know Claude Claude. We probably better ask the professor!

MODIFIED CASH BASIS ACCOUNTING |With

the Modified Cash Basis . . .

y Current

period revenues and expenses are treated exactly as in the cash basis;

y Expenses

covering more than one accounting period are allocated over the useful life of the asset.

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