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4. CONCEPTUAL FRAMEWORK OF ACCOUNTING Generally accepted accounting principles are a set of standards and rules that are recognized as a general guide for financial reporting.
Generally accepted means that these principles must have substantial authoritative support.
This support usually comes from the Financial Accounting Standards Board (FASB) and Securities and Exchange Commission (SEC).
The FASB has the responsibility for developing accounting principles in the United States.
5. FASB’S CONCEPTUAL FRAMEWORK The conceptual framework developed by the FASB serves as the basis for resolving accounting and reporting problems.
The conceptual framework consists of:
1 objectives of financial reporting;
2 qualitative characteristics of accounting information;
3 elements of financial statements; and
4 Operating guidelines (assumptions, principles, and constraints).
7. OBJECTIVES OF FINANCIAL REPORTING The FASB concluded that the objectives of financial reporting are to provide information that:
1 Is useful to those making investment and credit decisions.
2 Is helpful in assessing future cash flows.
3 Identifies the economic resources (assets), the claims to those resources (liabilities), and the changes in those resources and claims.
9. QUALITATIVE CHARACTERISTICS OF ACCOUNTING INFORMATION The FASB concluded that the overriding criterion for accounting choices is decision usefulness.
To be useful, information should possess the following qualitative characteristics:
1 relevance
2 reliability
3 comparability
4 consistency
10. 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 (feedback value).
Information must be available to decision makers before it loses its capacity to influence their decisions (timeliness).
11. Reliability of information means that the information is free of error and bias. In short, it can be depended on.
To be reliable, accounting information must be verifiable – we must be able to prove that it is free of error and bias.
The information must be a faithful representation of what it purports to be – it must be factual.
12. COMPARABILITY AND CONSISTENCY Comparability means that the information should be comparable with accounting information about other enterprises.
Consistency means that the same accounting principles and methods should be used from year to year within a company.
13. ILLUSTRATION QUALITATIVE CHARACTERISTICS OF ACCOUNTING INFORMATION
14. Operating guidelines are classified as assumptions, principles, and constraints.
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. ILLUSTRATION THE OPERATING GUIDELINES OF ACCOUNTING
16. 1 The monetary unit assumption states that only transaction data that can be expressed in terms of money 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.
17. 2 The economic entity assumption states that the activities of the entity be kept separate and distinct from the activities of the owner of all other economic entities.
Example: BMW activities can be distinguished from those of other car manufacturers such as Mercedes.
18. 3 The time period assumption states that the economic life of a business can be divided into artificial time periods.
Example: months, quarters, and years
19. GOING CONCERN ASSUMPTION 4 The going concern assumption assumes that the enterprise will continue in operation long enough to carry out its existing objectives.
Implications: depreciation and amortization are used, plant assets recorded at cost instead of liquidation value, items are labeled as fixed or long-term.
21. The revenue recognition principle dictates that revenue should be recognized in the accounting period in which it is earned.
When a sale is involved, revenue is recognized at the point of sale.
22. PERCENTAGE-OF-COMPLETION METHOD OF REVENUE RECOGNITION In long-term construction contracts, revenue recognition is usually required before the contract is completed.
The percentage-of-completion method recognizes revenue on the basis of reasonable estimates of progress toward completion.
A project’s progress toward completion is measured by comparing the costs incurred in a year to total estimated costs of the entire project.
23. ILLUSTRATION FORMULA TO RECOGNIZE REVENUE IN THE PERCENTAGE-OF-COMPLETION METHOD
24. ILLUSTRATION FORMULA TO COMPUTE GROSS PROFIT IN CURRENT PERIOD The costs incurred in the current period are then subtracted from the revenue recognized during the current period to arrive at the gross profit.
25. INSTALLMENT METHOD OF REVENUE RECOGNITION Another basis for revenue recognition is the receipt of cash.
The cash basis is generally used only when it is difficult to determine the revenue amount at the time of a credit sale because collection is uncertain.
The installment method, which uses the cash basis, is a popular approach to revenue recognition.
Under the installment method gross profit is recognized in the period in which the cash is collected.
26. Expense recognition is traditionally tied to revenue recognition.
This practice – referred to as the matching principle – dictates that expenses be matched with revenues in the period in which efforts are made to generate revenues.
To understand the various approaches for matching expenses and revenues on the income statement, it is necessary to examine the nature of expenses.
1 Expired costs are costs that will generate revenues only in the current period and are therefore reported as operating expenses on the income statement.
2 Unexpired costs are costs that will generate revenues in future accounting periods and are recognized as assets.
27. Unexpired costs become expenses in 2 ways:
1) Cost of goods sold – Costs carried as merchandise inventory become expensed when the inventory is sold. They are expensed as cost of goods sold in the period in which the sale occurs – so there is a direct matching of expenses with revenues.
2) Operating expenses – Other unexpired costs become operating expenses through use or consumption or through the passage of time.
28. ILLUSTRATION EXPENSE RECOGNITION PATTERN Operating expenses contribute to the revenues of the period but their association with revenues is less direct than for cost of goods sold.
29. The full disclosure principle requires that circumstances and events that make a difference to financial statement users be disclosed.
Compliance with the full disclosure principle is accomplished through
1 the data in the financial statements and
2 the notes that accompany the statements.
A summary of significant accounting policies is usually the first note to the financial statements.
30. The cost principle dictates that assets be recorded at their cost.
Cost is used because it is both relevant and reliable.
1 Cost is relevant because it represents a) the price paid, b) the assets sacrificed, or c) the commitment made at the date of acquisition.
2 Cost is reliable because it is a) objectively measurable, b) factual, and c) verifiable.
32. CONSTRAINTS IN ACCOUNTING Constraints permit a company to modify generally accepted accounting principles without reducing the usefulness of the reported information.
The constraints are materiality and conservatism.
1 Materiality relates to an item’s impact on a firm’s overall financial condition and operations.
2 The conservatism constraint dictates that when in doubt, choose the method that will be the least likely to overstate assets and income.
34. ILLUSTRATION 12-14 FOREIGN SALES AND TYPE OF PRODUCT World markets are becoming increasingly intertwined, and foreigners consume American goods.
Americans use goods from many other countries.
Firms that conduct operations in more than one country through subsidiaries, divisions, or branches in foreign countries are referred to as multinational corporations.
International transactions must be translated into U.S. dollars.
