GAAP PowerPoint #3

1. 1.01 Generally Accepted Accounting Principles – Accounting Constraints, Concepts, Assumptions, and Principles GAAP PowerPoint #3

2. Hierarchy of Qualitative Information Cost/Benefit Discussed in PPT #2 Materiality www.fasb.org

3. Constraints • A constraint is a limit, regulation, or confinement within prescribed bounds. • This term refers to the accounting guidelines that border the Hierarchy of Qualitative Information • They consist of: • Cost Effectiveness • Materiality • Conservatism

4. Cost Effectiveness Constraint • Also called Cost Benefit Constraint • The cost of providing accounting information should not exceed the benefit of the information it is reporting. • Example: Your checkbook register and bank statement differs by $0.10. Rather than waste time to find the $0.10, the accountant should record the amount as miscellaneousexpense or income.

5. Materiality Constraint • Material means big enough to make a difference in the user’s decision-making process. • States that the requirements of any accounting principle may be ignored when there is no effect on the decisions of the user of financial information. • Example: A company purchases a Trashcan for $10. Per GAAP, this amount should be capitalized as an asset and depreciated. Because the amount is immaterial, the $10 can be recorded as an expense.

6. Conservatism Constraint • Accountants use their judgment to record transactions that require estimation. • Conservatism helps the accountant choose between 2 equally likely alternatives. • Requires the accountant to record the transaction using the less optimistic choice. • Example: There is the potential for a customer to sue the company. Although, the customer may choose not to sue, the accountant will disclose this potential lawsuit to investors.

7. Concepts • Concepts are the ground rules of accounting that should be followed when preparing financial statements. • These are: • Recognition Concept • Measurement Concept

8. Recognition Concept • States that an item should be recognized (recorded) in the financial statements when: • It can be defined by GAAP assumptions and principles • It can be measured • It is relevant to decision-making by users • It is reliable

9. Measurement Concept • States that every transaction is measured by the stated unit of measurement, such as the dollar • The stated procedure of valuing assets, liabilities, equity, revenue, and expenses as defined by GAAP

10. Assumptions • Assumptions are agreed upon rules of accounting, and are basic, understood beliefs. • There are Four Basic Assumptions of Accounting: • Economic Business Entity • Going Concern • Monetary Unit • Time Period

11. Economic Business Entity Assumption • All of the business transactions should be separate from the business owner’s personal transactions • There should be no co-mingling of personal funds with business funds.

12. Going Concern Assumption • Financial statements are prepared under the assumption that the company will remain in business indefinitely unless there is sufficient evidence otherwise. • If there is evidence that a company may possibly have a going concern issue, this must be disclosed in the financial statements.

13. Monetary Unit Assumption • Assumes a stable currency is going to be the unit of record. • FASB accepts the nominal value of the US Dollar as the monetary unit of record unadjusted for inflation.

14. Time Period Assumption • The entity’s activities are separated into periods of time such as months, quarters or years. • Transactions must be accounted for within the time period they occur regardless of when cash is exchanged.

15. Principles of Accounting • Principles are accounting rules used to prepare, present, and report financial statements. • Principles dictate how events should be recorded and reported.

16. Cost Principle • Assets are recorded at historical cost, not fair market value. • For example, if a company purchases a building for $500,000 it should be recorded as such, and should remain on the books for that amount until disposed of. • If the building appreciates to $700,000 in the next few years, no adjustment should be made.

17. Full Disclosure Principle • All information pertaining to the operations and financial position of the entity must be reported within the period of time in question. • Circumstances and events that make a difference to financial statement users should be disclosed.

18. Revenue Recognition Principle • Revenue is earned and recognized upon product delivery or service completion, without regard to when cash is actually received. • Also called accrual basis accounting • Example: A customer purchases inventory from a company on credit. Even though no cash has yet been received, the sale is recorded.

19. Matching Principle • The costs of doing business are recorded in the same period as the revenue they help generate, regardless of when the money is actually paid. • Also called accrual basis accounting • Example: A company orders merchandise on credit and has 30 days in which to pay. This purchase is recorded immediately, even though no cash has been paid.

20. Questions for Understanding/Discussion • Explain what is meant by “The benefits of accounting information must exceed the costs.” • What is meant by the term materiality in financial reporting? • What is meant by the term conservatism in financial reporting? • Explain the Going Concern assumption. • Explain the Time Period assumption. • Explain the accounting principles that guide accounting practice.