A CCOUNTING T HEORY U NDERLYING F INANCIAL A CCOUNTING.

ACCOUNTING THEORY UNDERLYING FINANCIAL ACCOUNTING

Introduction to Introduction to Accounting TheoryAccounting Theory

What is Accounting TheoryWhat is Accounting Theory Accounting Theory & Policy Accounting Theory & Policy

MakingMaking MeasurementMeasurement

Accounting Theory is Accounting Theory is defined asdefined as

the basicthe basic assumptionsassumptions definitionsdefinitions principles andprinciples and concepts that concepts that

underlie the rule underlie the rule making by a making by a legislative bodylegislative body

the reporting of the reporting of accounting and accounting and financial financial

informationinformation applicable to applicable to

financial financial accounting, not toaccounting, not to governmental orgovernmental or managerialmanagerial

Accounting Theory Accounting Theory includesincludes

Conceptual Conceptual FrameworksFrameworks

Accounting Accounting LegislationLegislation

ConceptsConcepts Valuation ModelsValuation Models Hypotheses and Hypotheses and

TheoriesTheories

Accounting Theory Accounting Theory DefinedDefined

173

“. . . a set of basic conceptsand assumptions and related

principles that explain andguide the accountant’sactions in identifying,

measuring, andcommunicating economic

information.”

Accounting theory provides a Accounting theory provides a logicallogical frameworkframework for accounting practice. for accounting practice.

Structure of Accounting Structure of Accounting Theory Theory FormalFormal ApproachApproach

Development Development of Accounting of Accounting

StandardsStandards

Development of Development of Accounting StandardsAccounting Standards

Development of Development of Accounting StandardsAccounting Standards

History ..History .. Prior to Securities act of 1933 and 1934 Prior to Securities act of 1933 and 1934

little financial reporting was required.little financial reporting was required. The securities acts assigned the power of The securities acts assigned the power of

accounting role making for publicly held accounting role making for publicly held companies to SECcompanies to SEC

They also required most publicly held They also required most publicly held companies to be audited by independent companies to be audited by independent CPAsCPAs

The (SEC) in turn delegated rule making to The (SEC) in turn delegated rule making to American Institute of Certified Public Accountants American Institute of Certified Public Accountants (AICPA).(AICPA).

The Committee on Accounting Procedures (CAP) The Committee on Accounting Procedures (CAP) was formed by (AICPA) in 1938-59 and issued 51 was formed by (AICPA) in 1938-59 and issued 51 Accounting Research Bulletins (ARBs).Accounting Research Bulletins (ARBs).

Accounting Principles Board (APB) issued 31 Accounting Principles Board (APB) issued 31 Opinions from 1959-73Opinions from 1959-73

The financial Accounting Foundation (FAF) was The financial Accounting Foundation (FAF) was created by (AICPA) in 1973 and oversees 2 other created by (AICPA) in 1973 and oversees 2 other bodies:bodies: Financial Accounting Standards Board (FASB) has Financial Accounting Standards Board (FASB) has

issued over 140 Statements (SFASs)from1973-presentissued over 140 Statements (SFASs)from1973-present Governmental Accounting Standards Board (GASB)Governmental Accounting Standards Board (GASB)

The Standard Setting Process: The Standard Setting Process: Parties InvolvedParties Involved

The Standard Setting Process: The Standard Setting Process: Parties InvolvedParties Involved

The The International Accounting International Accounting Standards CommitteeStandards Committee (IASC) was formed (IASC) was formed in 1973.in 1973.

The objective was to The objective was to narrow divergencenarrow divergence in in international financial reporting.international financial reporting.

There are many similarities between U.S. There are many similarities between U.S. and International accounting standards.and International accounting standards.

The The concernconcern is that international standards is that international standards may not be as rigorous as U.S. standards.may not be as rigorous as U.S. standards.

International Accounting International Accounting StandardsStandards

International Accounting International Accounting StandardsStandards

HistoryHistory19731973 International Accounting Standards International Accounting Standards

Committee (IASC) founded by Committee (IASC) founded by 1010

national accountancy organisations. national accountancy organisations. 19811981 All members of IFAC became All members of IFAC became

members of IASC.members of IASC.19991999 100+ countries. Structure reviewed.100+ countries. Structure reviewed.20012001 International Accounting Standards International Accounting Standards

Board (IASB) began operations.Board (IASB) began operations.20052005 Europe, Australia, 90+ countries Europe, Australia, 90+ countries

adopting IFRSadopting IFRS

Board (14)(approves IAS

[IFRS], ED, SIC [IFRIC])

7 Liaison Members

Intnl. Financial Reporting Interpretations Committee

(12+1)(publishes draft

Interpretations and prepares draft of final

Interpretations)

Standards Advisory Council (SAC)

(advises Board)

Trustees (19)(appoint Board, IFRIC and

SAC)(6 North America, 6 Europe,

4 Asia/Pacific, 3 Other)

National standard setters (Australia/NZ, Canada, France, Germany, Japan, UK, US.)

IASBStructure

StructureStructure

IASC FoundationIASC Foundation

19 trustees:19 trustees: 6 from North America6 from North America 6 from Europe6 from Europe 4 from Asia Pacific4 from Asia Pacific 3 from any area3 from any area

Appoint IASB members, SAC and IFRICAppoint IASB members, SAC and IFRIC Monitor IASB’s effectiveness, raise funds, Monitor IASB’s effectiveness, raise funds,

approve budget, responsible for approve budget, responsible for constitutionconstitution

Standards Advisory Standards Advisory Council (SAC)Council (SAC)

About 50 members from throughout the About 50 members from throughout the world.world.

Meets three times each yearMeets three times each year Provides advice to IASB on prioritiesProvides advice to IASB on priorities Informs IASB of implications of proposed Informs IASB of implications of proposed

standardsstandards

IASBIASB

Has the sole responsibility for setting Has the sole responsibility for setting standards.standards.

Approves principles-based standards, – Approves principles-based standards, – does not issue detailed application does not issue detailed application guidelines.guidelines.

Addresses business ventures – not public Addresses business ventures – not public sector, government or not-for-profit sector, government or not-for-profit activities.activities.

International Financial International Financial Reporting Interpretations Reporting Interpretations

Committee (IFRIC)Committee (IFRIC) 12 voting members and a non-voting 12 voting members and a non-voting

chairman chairman Provide guidance on reporting issues not Provide guidance on reporting issues not

specifically addressed in IASB’s standards, specifically addressed in IASB’s standards, or where unsatisfactory or conflicting or where unsatisfactory or conflicting interpretations have developed.interpretations have developed.

IASBIASB

… … is committed to developing, in the is committed to developing, in the public interest, a public interest, a single setsingle set of of high high qualityquality, global accounting standards , global accounting standards that require that require transparent and transparent and comparable informationcomparable information in financial in financial statements … statements …

IASBIASB Has an agreement with FASB to achieve Has an agreement with FASB to achieve

convergence of standards.convergence of standards. Works in close co-operation with other Works in close co-operation with other

national standard setters.national standard setters. Board members have liaison Board members have liaison

responsibilities with a large number of responsibilities with a large number of countries and international organisations.countries and international organisations.

ProcessProcess

Comment period for each documentComment period for each document Decisions made in open, public Decisions made in open, public

meetingsmeetings Explain basis for conclusions in each Explain basis for conclusions in each

standardstandard Voting – approval by 8 of 14 Voting – approval by 8 of 14

membersmembers Dissenting views publishedDissenting views published

ProcessProcess ResearchResearch Discussion PaperDiscussion Paper Exposure DraftExposure Draft StandardStandard ImplementationImplementation

Objectives of the Objectives of the Conceptual FrameworkConceptual Framework

Objectives of the Objectives of the Conceptual FrameworkConceptual Framework

The Framework is to be the The Framework is to be the foundationfoundation for building a set of for building a set of coherent accounting standards coherent accounting standards and rules. and rules.

The Framework is to be a The Framework is to be a reference of basic accounting reference of basic accounting theorytheory for solving emerging for solving emerging practical problems of reporting.practical problems of reporting.

FASB’S CONCEPTUAL FASB’S CONCEPTUAL FRAMEWORK FRAMEWORK

FASB’S CONCEPTUAL FASB’S CONCEPTUAL FRAMEWORK FRAMEWORK

The The conceptual frameworkconceptual framework developed by the developed by the FASB serves as the basis for resolving accounting FASB serves as the basis for resolving accounting and and reporting problems. reporting problems.

The The FrameworkFramework was to be the foundation for building was to be the foundation for building a set of coherent accounting standards and rules. a set of coherent accounting standards and rules. The conceptual framework consists of:The conceptual framework consists of:

1 1 objectives of financial reporting;objectives of financial reporting;2 2 qualitative characteristics of qualitative characteristics of accounting information; accounting information;3 3 elements of financial statements; &elements of financial statements; &4 4 Operating guidelines (assumptions, Operating guidelines (assumptions,

principles, and constraints).principles, and constraints).

Conceptual Framework for Financial Conceptual Framework for Financial ReportingReporting

Conceptual Framework for Financial Conceptual Framework for Financial ReportingReporting

OBJECTIVES OF OBJECTIVES OF FINANCIAL REPORTINGFINANCIAL REPORTING

OBJECTIVES OF OBJECTIVES OF FINANCIAL REPORTINGFINANCIAL REPORTING

The The FASBFASB concluded that the objectives of financial concluded that the objectives of financial reporting are to provide information that:reporting are to provide information that:

11 Is useful to those making investment Is useful to those making investment

and credit decisions.and credit decisions.

22 Is helpful in assessing future cash flows.Is helpful in assessing future cash flows.

33 Identifies the economic resources (Identifies the economic resources (assetsassets),),

the claims to those resources (the claims to those resources (liabilitiesliabilities), ),

and the changes in those resources and and the changes in those resources and

claims.claims.

Hierarchy of Accounting Hierarchy of Accounting QualitiesQualities

Hierarchy of Accounting Hierarchy of Accounting QualitiesQualities

External Financial External Financial StatementsStatements


First: Users and their needs:First: Users and their needs:

Side of economic interestSide of economic interest Users with direct Interest.Users with direct Interest. Users with indirect Interest.Users with indirect Interest.

Side of the relation of businessSide of the relation of business Internal usersInternal users External UsersExternal Users

USERS AND USES OF ACCOUNTING

USERS AND USES OF ACCOUNTING

Marketing managersProduction supervisors

Finance directorsCompany officers

InvestorsCreditors

Tax authoritiesRegulatory agencies

CustomersLabor unions

Internal Users

External Users

QUESTIONS ASKED BY INTERNAL USERS

Is cash sufficient to pay bills?

What is the cost of manufacturing each unit of product?

Can we afford to give employee pay raises this year?

Which product line is the most profitable?

QUALITATIVE QUALITATIVE CHARACTERISTICS OF CHARACTERISTICS OF

ACCOUNTING INFORMATIONACCOUNTING INFORMATION


ACCOUNTING INFORMATIONACCOUNTING INFORMATION The FASB concluded that the overriding criterion The FASB concluded that the overriding criterion

for accounting choices is for accounting choices is decision usefulnessdecision usefulness.. To be useful, information should possess the To be useful, information should possess the

following qualitative characteristics:following qualitative characteristics:11 Relevance Relevance22 Reliability Reliability33 ComparabilityComparability

44 Consistency Consistency

Qualitative Characteristics Qualitative Characteristics of Accounting Informationof Accounting InformationQualitative Characteristics Qualitative Characteristics of Accounting Informationof Accounting Information

PrimaryPrimary qualities of accounting qualities of accounting information are information are relevancerelevance and and reliabilityreliability..

SecondarySecondary qualities are qualities are comparabilitycomparability and and consistencyconsistency of reported information. of reported information.

RELEVANCERELEVANCERELEVANCERELEVANCE

Accounting information has Accounting information has relevancerelevance if it if it makes a makes a differencedifference in a decision. in a decision.

RelevantRelevant information helps users forecast future information helps users forecast future events (events (predictive valuepredictive value), or it confirms or ), or it confirms or corrects prior expectations (corrects prior expectations (feedback valuefeedback value).).

Information must be available to decision Information must be available to decision makers before it loses its capacity to makers before it loses its capacity to

influence their decisions (influence their decisions (timelinesstimeliness).).

RELIABILITYRELIABILITYRELIABILITYRELIABILITY

ReliabilityReliability of information means that the of information means that the information is free of error and bias. In information is free of error and bias. In short, it can be depended on.short, it can be depended on.

Information is Information is verifiableverifiable, when, given the , when, given the same information, independent users can same information, independent users can arrive at similar conclusions.arrive at similar conclusions.

Information is Information is faithfulfaithful, when it represents , when it represents what really existed or happened. what really existed or happened.

Information is Information is neutralneutral, when it is free , when it is free from bias.from bias.

COMPARABILITY AND COMPARABILITY AND CONSISTENCYCONSISTENCY

COMPARABILITY AND COMPARABILITY AND CONSISTENCYCONSISTENCY

2003 2004 2005

ComparabilityComparability means that tmeans that the information he information should be comparable with accounting should be comparable with accounting information about other enterprises.information about other enterprises.

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

Secondary Secondary CharacteristicsCharacteristics

Secondary characteristics are: Secondary characteristics are: comparability and consistency of reported comparability and consistency of reported information.information.

For information to be For information to be comparable, it must comparable, it must bebe::

measured and reported in a similar manner for measured and reported in a similar manner for different different enterprises.enterprises.

useful in the allocation of resources to the useful in the allocation of resources to the areas of areas of greatest benefit.greatest benefit.

useful to users in identifying real differences useful to users in identifying real differences between between enterprises.enterprises.

Secondary Secondary CharacteristicsCharacteristics

Accounting information is consistent, ifAccounting information is consistent, if the same accounting principles are the same accounting principles are applied in a similar applied in a similar manner from one manner from one period to the next.period to the next.

Accounting principles may be changed, if Accounting principles may be changed, if the the change results in better reporting.change results in better reporting.

If principles are changed, the justification If principles are changed, the justification for, and the nature and effect of the for, and the nature and effect of the change, must be disclosed.change, must be disclosed.

Relevance1 Predictive value

2 Feedback value

3 Timely

Reliability1 Verifiable

2 Faithful representation

3 Neutral

Comparability

Useful Financial

Information has:





Consistency



Second: Basic Financial Second: Basic Financial StatementsStatements

Balance SheetBalance Sheet Income StatementIncome Statement Statement of Cash FlowsStatement of Cash Flows Statement of Stockholders’ EquityStatement of Stockholders’ Equity

FINANCIAL STATEMENTSFINANCIAL STATEMENTS

After transactions are identified, recorded, and After transactions are identified, recorded, and summarized, summarized, 4 financial statements 4 financial statements are prepared are prepared from the summarized accounting data:from the summarized accounting data:

11 A A balance sheet balance sheet reports the assets, liabilities, reports the assets, liabilities, and owner’s equity at a specific date.and owner’s equity at a specific date.22 An An income statement income statement presents the revenues and presents the revenues and expenses and resulting net income or net loss for a expenses and resulting net income or net loss for a specific period of specific period of time.time.33 A A statement of cash flows statement of cash flows summarizes summarizes information information about the cash inflows (receipts) about the cash inflows (receipts) and outflows and outflows (payments) for a specific (payments) for a specific period of time.period of time.44 An An owner’s equity statement owner’s equity statement summarizes the summarizes the changes in owner’s equity for a specific period of changes in owner’s equity for a specific period of time.time.

The Balance SheetThe Balance Sheet

Summarizes a firms assets, Summarizes a firms assets, liabilities, and owner’s equity liabilities, and owner’s equity at a at a moment in timemoment in time

Amounts measured at Amounts measured at historical historical valuesvalues and historical exchange and historical exchange ratesrates

Prepared according to IFRS, Prepared according to IFRS, IInternational nternational FFinancial inancial RReporting eporting SStandardstandards

The balance sheet provides information The balance sheet provides information for evaluating:for evaluating:

Capital structureCapital structure Rates of returnRates of return Analyzing an enterprise’s:Analyzing an enterprise’s:

LiquidityLiquidity Solvency Solvency Financial flexibilityFinancial flexibility

Balance Sheet: UsefulnessBalance Sheet: Usefulness

Basic Elements of Financial Basic Elements of Financial StatementsStatements

AssetsAssets:: Probable future Probable future economic benefits economic benefits resulting from past resulting from past transactionstransactions

LiabilitiesLiabilities: Probable : Probable future sacrifices of future sacrifices of economic benefits economic benefits resulting from past resulting from past transactionstransactions

EquityEquity: Residual or : Residual or ownership interestownership interest

Investment by OwnersInvestment by Owners: : Increases in net assetsIncreases in net assets

Distributions to Distributions to Owners:Owners: Decreases in Decreases in net assetsnet assets

Comprehensive Income:Comprehensive Income: All changes in equity from All changes in equity from non-owner sourcesnon-owner sources

Revenues:Revenues: Inflows from Inflows from entity’s ongoing entity’s ongoing operationsoperations

Expenses:Expenses: Outflows from Outflows from entity’s ongoing entity’s ongoing operationsoperations

Gains:Gains: Increases in equity Increases in equity from incidental from incidental transactionstransactions

Losses:Losses: Decreases in Decreases in equity from incidental equity from incidental transactionstransactions

Balance SheetBalance Sheet IncomeIncome StatementStatement

The Annual ReportThe Annual ReportUsually Contains ...Usually Contains ...The Annual ReportThe Annual ReportUsually Contains ...Usually Contains ...

– financial statements.financial statements.– notes to the financial statements.notes to the financial statements.– a summary of accounting methods a summary of accounting methods

used.used.– management discussion and analysis management discussion and analysis

of the financial statements.of the financial statements.– an auditor’s report.an auditor’s report.– comparative financial data for 5 to comparative financial data for 5 to

10 years.10 years.

Balance SheetBalance SheetBalance SheetBalance Sheet

Assets:Assets: probable future probable future economic benefitseconomic benefits

Liabilities:Liabilities: probable future probable future economic sacrificeseconomic sacrifices

Stockholders’ Equity:Stockholders’ Equity: residual residual interest, representing ownership interest, representing ownership interest (also called net assets) interest (also called net assets)

THE BASIC ACCOUNTING THE BASIC ACCOUNTING EQUATIONEQUATION

THE BASIC ACCOUNTING THE BASIC ACCOUNTING EQUATIONEQUATION

Assets Assets LiabilitiesLiabilities Stockholders’ Equity

Stockholders’ Equity

= +

resources owned bya business

claimsagainstthose assets

owners’ residual claim on

total assets

AssetsAssetsAssetsAssets Current Assets :cash & cash Current Assets :cash & cash

equivalents, short-term marketable equivalents, short-term marketable securities, accounts receivable, securities, accounts receivable, inventory, other)inventory, other)

Non Current Assets: Property, plant & Non Current Assets: Property, plant & equipment, Long-term equipment, Long-term

investments, investments,

and Other assets and Other assets

LiabilitiesLiabilitiesLiabilitiesLiabilities Current Liabilities Current Liabilities

(accounts payable, (accounts payable, accrued & other current accrued & other current liabilities)liabilities)

Long-term debtLong-term debt BondsBonds

Stockholders’ EquityStockholders’ EquityStockholders’ EquityStockholders’ Equity

Preferred stockPreferred stock Common stockCommon stock Other paid-in capitalOther paid-in capital Retained earningsRetained earnings Treasury stockTreasury stock Other comprehensive incomeOther comprehensive income Other equity itemsOther equity items

Operating guidelines Operating guidelines are classified as are classified as assumptionsassumptions, , principlesprinciples, and , and constraintsconstraints..

AssumptionsAssumptions provide a foundation for the accounting provide a foundation for the accounting process. process.

PrinciplesPrinciples indicate how transactions and other indicate how transactions and other economic events should be recorded.economic events should be recorded.

ConstraintsConstraints on the accounting process allow for a on the accounting process allow for a relaxation of the principles under certain relaxation of the principles under certain circumstances.circumstances.

THE OPERATING THE OPERATING GUIDELINES OF GUIDELINES OF ACCOUNTINGACCOUNTING

THE OPERATING THE OPERATING GUIDELINES OF GUIDELINES OF ACCOUNTINGACCOUNTING

BasicAssumptions

1. Economic entity 2. Going concern 3. Monetary

unit4. Periodicity

Principles

1. Historical cost2. Revenue

recognition3. Matching4. Fulldisclosure

Constraints

1. Cost benefit2. Materiality3. Industry

practices4. Conservatism

Recognition and Recognition and Measurement CriteriaMeasurement Criteria

Recognition and Recognition and Measurement CriteriaMeasurement Criteria

Most assets and liabilities are stated at Most assets and liabilities are stated at historical costhistorical cost..

Judgments and estimatesJudgments and estimates are used in are used in determining many of the items.determining many of the items.

The balance sheet does not report The balance sheet does not report items that can not be items that can not be objectively objectively determineddetermined..

It does not report information It does not report information regarding regarding off-balance sheet financing.off-balance sheet financing.

Balance Sheet: LimitationsBalance Sheet: Limitations

Income StatementIncome Statement

Revenues:Revenues: inflows from major operations inflows from major operations Expenses:Expenses: outflows from major operations outflows from major operations Gains & Losses:Gains & Losses: changes in equity from changes in equity from

peripheral activitiesperipheral activities Net income:Net income: bottom line all operating bottom line all operating

activities recorded on the income activities recorded on the income statementstatement

Comprehensive income:Comprehensive income: Changes in Changes in equity from all non-owner sources equity from all non-owner sources

Evaluate the past performance of Evaluate the past performance of the enterprise.the enterprise.

Provide a basis for predicting Provide a basis for predicting future performance.future performance.

Help assess the risk or Help assess the risk or uncertainty of achieving future uncertainty of achieving future cash flows.cash flows.

Usefulness of Income StatementUsefulness of Income Statement

Items that cannot be measured Items that cannot be measured reliably are not reported in the reliably are not reported in the income statement.income statement.

Income numbers are affected by Income numbers are affected by the accounting methods employed.the accounting methods employed.

Income measurement involves Income measurement involves judgment.judgment.

Limitations of the Income Limitations of the Income StatementStatement

Comprehensive IncomeComprehensive Income

All changes in equity during a period, All changes in equity during a period, except those resulting from except those resulting from

investments by or distributions to investments by or distributions to owners.owners.

Must be displayed as:Must be displayed as: A separate statement of A separate statement of

comprehensive income ORcomprehensive income OR Combined income statement and Combined income statement and

comprehensive income statement comprehensive income statement OROR

Part of statement of stockholders’ Part of statement of stockholders’ equityequity

Other Comprehensive IncomeOther Comprehensive Income

11 The The Monetary unit assumption Monetary unit assumption states that only states that only transaction data that can be expressed in terms of transaction data that can be expressed in terms of money be included in the accounting records.money be included in the accounting records.

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

ASSUMPTIONSASSUMPTIONSASSUMPTIONSASSUMPTIONS

Customer Satisfaction

Percentage of International Employees

Salaries paid

Customer Satisfaction

Percentage of International Employees

Salaries paid

Should be includedin accounting recordsShould be includedin accounting records


22 The The Economic Entity Assumption Economic Entity Assumption states that the states that the activities of the entity be kept separate and distinct activities of the entity be kept separate and distinct from the activities of the owner of all other from the activities of the owner of all other economic entities.economic entities.Example: Example: BMWBMW activities activities can can be distinguished frombe distinguished from those those of other car manufacturers such of other car manufacturers such

as as MercedesMercedes..


33 The The Time period assumption Time period assumption states states that the economic life of a business can that the economic life of a business can be divided into be divided into artificial time periodsartificial time periods..

Example: Example: monthsmonths, , quartersquarters, and , and yearsyears

QTR 1QTR 2QTR 3QTR 4

2000 2001 2002JAN FEB MAR APR MAY JUN JUL AUG SEPT OCT NOV DEC

44 The The Going concern assumption Going concern assumption assumes that the assumes that the enterprise will continue in operation long enough enterprise will continue in operation long enough to carry out its existing objectives.to carry out its existing objectives.

Implications: Implications: depreciation and amortization are depreciation and amortization are used, plant assets recorded at cost instead of used, plant assets recorded at cost instead of liquidation value, items are labeled as fixed or liquidation value, items are labeled as fixed or long-term.long-term.


The The Revenue Recognition principle Revenue Recognition principle dictates that revenue should be dictates that revenue should be recognized in the accounting period in recognized in the accounting period in which it is earned.which it is earned.

When a sale is involved, When a sale is involved,

revenue is recognized at revenue is recognized at

the point of sale.the point of sale.

PRINCIPLES REVENUE PRINCIPLES REVENUE RECOGNITIONRECOGNITION

PRINCIPLES REVENUE PRINCIPLES REVENUE RECOGNITIONRECOGNITION

PERCENTAGE-OF-COMPLETION PERCENTAGE-OF-COMPLETION METHOD OF REVENUE METHOD OF REVENUE

RECOGNITIONRECOGNITION

PERCENTAGE-OF-COMPLETION PERCENTAGE-OF-COMPLETION METHOD OF REVENUE METHOD OF REVENUE

RECOGNITIONRECOGNITION In long-term construction contracts, revenue In long-term construction contracts, revenue recognition is usually required before the contract is recognition is usually required before the contract is completed. completed. The The percentage-of-completion methodpercentage-of-completion method recognizes recognizes revenue on the basis of reasonable estimates of revenue on the basis of reasonable estimates of progress toward progress toward completioncompletion.. A project’s progress toward completion is A project’s progress toward completion is measured by comparing the costs incurred in a measured by comparing the costs incurred in a year year to total estimated costs of the entire to total estimated costs of the entire project.project.

FORMULA TO RECOGNIZE FORMULA TO RECOGNIZE REVENUE IN THE PERCENTAGE-REVENUE IN THE PERCENTAGE-

OF-COMPLETION METHODOF-COMPLETION METHOD

FORMULA TO RECOGNIZE FORMULA TO RECOGNIZE REVENUE IN THE PERCENTAGE-REVENUE IN THE PERCENTAGE-

OF-COMPLETION METHODOF-COMPLETION METHOD

Costs Incurred(Current Period)

÷ =Total

Estimated Cost

PercentComplete(Current Period)

Total RevenueX =Revenue

Recognized(Current Period)

Percent Complete(Current Period)

FORMULA TO COMPUTE GROSS FORMULA TO COMPUTE GROSS PROFITPROFIT

IN CURRENT PERIODIN CURRENT PERIOD

FORMULA TO COMPUTE GROSS FORMULA TO COMPUTE GROSS PROFITPROFIT

IN CURRENT PERIODIN CURRENT PERIOD

Cost Incurred(Current Period)

_ =Gross ProfitRecognized

(Current Period)

RevenueRecognized

(Current Period)

The costs incurred in the current period are then The costs incurred in the current period are then subtractedsubtracted from the revenue recognized during the from the revenue recognized during the current period to arrive at the current period to arrive at the gross profitgross profit..

The costs incurred in the current period are then The costs incurred in the current period are then subtractedsubtracted from the revenue recognized during the from the revenue recognized during the current period to arrive at the current period to arrive at the gross profitgross profit..

Warrior Construction Co. has a contract to build a dam for Warrior Construction Co. has a contract to build a dam for $400 $400 millionmillion. It will take . It will take 3 years 3 years ((starting in 2000starting in 2000) at a construction ) at a construction cost of cost of $360 million$360 million. Assume that Warrior incurs . Assume that Warrior incurs $54 million in $54 million in 20002000, , $180 million in 2001$180 million in 2001, and , and $126 million in 2002$126 million in 2002 on the dam on the dam project. The portion of the project. The portion of the $400 million$400 million of revenue recognized in of revenue recognized in each of the 3 years each of the 3 years is shown below:is shown below:

Warrior Construction Co. has a contract to build a dam for Warrior Construction Co. has a contract to build a dam for $400 $400 millionmillion. It will take . It will take 3 years 3 years ((starting in 2000starting in 2000) at a construction ) at a construction cost of cost of $360 million$360 million. Assume that Warrior incurs . Assume that Warrior incurs $54 million in $54 million in 20002000, , $180 million in 2001$180 million in 2001, and , and $126 million in 2002$126 million in 2002 on the dam on the dam project. The portion of the project. The portion of the $400 million$400 million of revenue recognized in of revenue recognized in each of the 3 years each of the 3 years is shown below:is shown below:

REVENUE RECOGNIZEDREVENUE RECOGNIZEDPERCENTAGE-OF-COMPLETION PERCENTAGE-OF-COMPLETION

METHODMETHOD

REVENUE RECOGNIZEDREVENUE RECOGNIZEDPERCENTAGE-OF-COMPLETION PERCENTAGE-OF-COMPLETION

METHODMETHOD

The The gross profitgross profit recognized each period for Warrior Construction recognized each period for Warrior Construction Co. is as shown below. Use of the Co. is as shown below. Use of the percentage-of-completion methodpercentage-of-completion method involves some subjectivity. As a result, involves some subjectivity. As a result, errors are possibleerrors are possible in in determining the amount of determining the amount of revenue recognizedrevenue recognized. To wait until . To wait until completion would seriously distort the financial statements. If it is completion would seriously distort the financial statements. If it is not possible to obtain dependable estimates of costs and progressnot possible to obtain dependable estimates of costs and progress , , then the then the revenue should be recognized at the completion daterevenue should be recognized at the completion date and and not by the percentage-of-completion methodnot by the percentage-of-completion method..

The The gross profitgross profit recognized each period for Warrior Construction recognized each period for Warrior Construction Co. is as shown below. Use of the Co. is as shown below. Use of the percentage-of-completion methodpercentage-of-completion method involves some subjectivity. As a result, involves some subjectivity. As a result, errors are possibleerrors are possible in in determining the amount of determining the amount of revenue recognizedrevenue recognized. To wait until . To wait until completion would seriously distort the financial statements. If it is completion would seriously distort the financial statements. If it is not possible to obtain dependable estimates of costs and progressnot possible to obtain dependable estimates of costs and progress , , then the then the revenue should be recognized at the completion daterevenue should be recognized at the completion date and and not by the percentage-of-completion methodnot by the percentage-of-completion method..

GROSS PROFIT RECOGNIZED GROSS PROFIT RECOGNIZED PERCENTAGE-OF-COMPLETION PERCENTAGE-OF-COMPLETION

METHODMETHOD

GROSS PROFIT RECOGNIZED GROSS PROFIT RECOGNIZED PERCENTAGE-OF-COMPLETION PERCENTAGE-OF-COMPLETION

METHODMETHOD

INSTALLMENT METHOD OF INSTALLMENT METHOD OF REVENUE RECOGNITIONREVENUE RECOGNITION

INSTALLMENT METHOD OF INSTALLMENT METHOD OF REVENUE RECOGNITIONREVENUE RECOGNITION

Another basis for revenue recognition is the receipt Another basis for revenue recognition is the receipt of cash.of cash. The The cash basiscash basis is generally used only when it is is generally used only when it is

difficultdifficult to determine the revenue amount at the to determine the revenue amount at the time of a credit sale because collection is time of a credit sale because collection is uncertainuncertain.. TheThe installment methodinstallment method, which uses the cash basis, , which uses the cash basis, is a popular approach to revenue recognition.is a popular approach to revenue recognition. Under the installment method gross profit is Under the installment method gross profit is

recognized in the period in which the cash is recognized in the period in which the cash is collected.collected.

Cash Collections from Customers

Gross Profit Percentagex =

Gross Profit Recognized during the

Period

GROSS PROFIT FORMULA- GROSS PROFIT FORMULA- INSTALLMENT METHODINSTALLMENT METHOD

GROSS PROFIT FORMULA- GROSS PROFIT FORMULA- INSTALLMENT METHODINSTALLMENT METHOD

Under Under installment methodinstallment method, each cash collection , each cash collection from a customer consists offrom a customer consists of

11 a a partial recovery of the cost of goods soldpartial recovery of the cost of goods sold and and

22 partial gross profit from the salepartial gross profit from the sale.. The formula to recognize gross profit is shown The formula to recognize gross profit is shown below.below.

Under Under installment methodinstallment method, each cash collection , each cash collection from a customer consists offrom a customer consists of

11 a a partial recovery of the cost of goods soldpartial recovery of the cost of goods sold and and

22 partial gross profit from the salepartial gross profit from the sale.. The formula to recognize gross profit is shown The formula to recognize gross profit is shown below.below.

An Iowa farm machinery dealer had An Iowa farm machinery dealer had installment salesinstallment sales in its first in its first year of operations of year of operations of $600,000$600,000 and a and a cost of goods sold on cost of goods sold on installmentinstallment of of $420,000$420,000. Therefore, . Therefore, total gross profittotal gross profit is is $180,000$180,000 ( ($600,000 - $420,000$600,000 - $420,000), and the ), and the gross profit percentagegross profit percentage is is 30%30% ( ($180,000 ÷ $600,000$180,000 ÷ $600,000). The ). The collections on the collections on the installment salesinstallment sales were: were: First year, $280,000First year, $280,000 (down payments (down payments plus monthly payments), plus monthly payments), second year, $200,000second year, $200,000, and , and third year, third year, $120,000$120,000. The collections of cash and recognition of the gross . The collections of cash and recognition of the gross profit are summarized below (ignoring interest charges).profit are summarized below (ignoring interest charges).

An Iowa farm machinery dealer had An Iowa farm machinery dealer had installment salesinstallment sales in its first in its first year of operations of year of operations of $600,000$600,000 and a and a cost of goods sold on cost of goods sold on installmentinstallment of of $420,000$420,000. Therefore, . Therefore, total gross profittotal gross profit is is $180,000$180,000 ( ($600,000 - $420,000$600,000 - $420,000), and the ), and the gross profit percentagegross profit percentage is is 30%30% ( ($180,000 ÷ $600,000$180,000 ÷ $600,000). The ). The collections on the collections on the installment salesinstallment sales were: were: First year, $280,000First year, $280,000 (down payments (down payments plus monthly payments), plus monthly payments), second year, $200,000second year, $200,000, and , and third year, third year, $120,000$120,000. The collections of cash and recognition of the gross . The collections of cash and recognition of the gross profit are summarized below (ignoring interest charges).profit are summarized below (ignoring interest charges).

GROSS PROFIT GROSS PROFIT RECOGNIZED RECOGNIZED

INSTALLMENT METHODINSTALLMENT METHOD

GROSS PROFIT GROSS PROFIT RECOGNIZED RECOGNIZED

INSTALLMENT METHODINSTALLMENT METHOD

Expense recognition Expense recognition is traditionally tied to is traditionally tied to revenue recognitionrevenue recognition.. This practice – referred to as the This practice – referred to as the matching principle matching principle – dictates – dictates

that expenses be matched with revenues in the period in which that expenses be matched with revenues in the period in which efforts are made to generate revenues.efforts are made to generate revenues.

To understand the various approaches for matching expenses To understand the various approaches for matching expenses and revenues on the income statement, it is necessary to and revenues on the income statement, it is necessary to examine the nature of expenses.examine the nature of expenses.

11 Expired costs Expired costs are costs that will generate revenues only are costs that will generate revenues only in the in the current period and are therefore reported as current period and are therefore reported as operating operating expensesexpenses on the income statement. on the income statement.

22 Unexpired costs Unexpired costs are costs that will generate revenues in are costs that will generate revenues in future accounting periods and are recognized as future accounting periods and are recognized as assetsassets..

PRINCIPLES MATCHING PRINCIPLES MATCHING (EXPENSE RECOGNITION)(EXPENSE RECOGNITION)PRINCIPLES MATCHING PRINCIPLES MATCHING (EXPENSE RECOGNITION)(EXPENSE RECOGNITION)

Unexpired costs Unexpired costs become expenses in become expenses in 22 ways: ways:1)1) Cost of goods sold Cost of goods sold – Costs carried as – Costs carried as

merchandise inventorymerchandise inventory become become expensed expensed when the inventory is soldwhen the inventory is sold. They are . They are expensed as expensed as cost of goods sold in the period in which the sale cost of goods sold in the period in which the sale occursoccurs – so there is a – so there is a direct matching of expenses direct matching of expenses with revenueswith revenues..

2)2) Operating expenses Operating expenses – Other – Other unexpired costs unexpired costs become become operating expenses operating expenses through through use or use or consumptionconsumption or through the or through the passage of timepassage of time..

PRINCIPLES MATCHING PRINCIPLES MATCHING (EXPENSE RECOGNITION)(EXPENSE RECOGNITION)PRINCIPLES MATCHING PRINCIPLES MATCHING (EXPENSE RECOGNITION)(EXPENSE RECOGNITION)

CostIncurred

Asset Expense

EXPENSE RECOGNITION EXPENSE RECOGNITION PATTERNPATTERN

EXPENSE RECOGNITION EXPENSE RECOGNITION PATTERNPATTERN

Operating expenses Operating expenses contribute to the contribute to the revenuesrevenues of of the period but their the period but their association with revenues association with revenues is is less direct less direct than for than for cost of goods soldcost of goods sold..

Operating expenses Operating expenses contribute to the contribute to the revenuesrevenues of of the period but their the period but their association with revenues association with revenues is is less direct less direct than for than for cost of goods soldcost of goods sold..

Benefits Decrease

Provides FutureBenefit

Provides No Apparent FutureBenefits

The practice of expense recognition is The practice of expense recognition is referred to as thereferred to as the matching principle.matching principle.

TheThe matching principlematching principle dictates that efforts dictates that efforts (expenses) be matched with accomplishments (expenses) be matched with accomplishments (revenues).(revenues).

Revenues earned

this monthare offset against....

expensesincurred inearning the

revenue

MATCHING PRINCIPLEMATCHING PRINCIPLEMATCHING PRINCIPLEMATCHING PRINCIPLE

Time-Period Assumption

Economic life of businesscan be divided into

artificial time periods

Revenue-Recognition Principle

Revenue recognized in the accounting period in

which it is earned

Matching Principle

Expenses matched with revenuesin the same period when efforts are

expended to generate revenues

GAAP RELATIONSHIPS IN GAAP RELATIONSHIPS IN REVENUE & EXPENSE REVENUE & EXPENSE


GAAP RELATIONSHIPS IN GAAP RELATIONSHIPS IN REVENUE & EXPENSE REVENUE & EXPENSE


Adjusting entriesAdjusting entries are needed to ensure that are needed to ensure that revenue revenue recognitionrecognition and and matching principlesmatching principles are followed are followed

11 Revenues are recorded in the period Revenues are recorded in the period earnedearned,, and...... and...... 22 Expenses are recognized in the period Expenses are recognized in the period incurredincurred..

WHY ADJUSTING ENTRIES WHY ADJUSTING ENTRIES ARE NECESSARYARE NECESSARY

WHY ADJUSTING ENTRIES WHY ADJUSTING ENTRIES ARE NECESSARYARE NECESSARY

PRINCIPLESPRINCIPLESFULL DISCLOSUREFULL DISCLOSURE

PRINCIPLESPRINCIPLESFULL DISCLOSUREFULL DISCLOSURE

The The full disclosure principlefull disclosure principle requires that requires that circumstances and events that make a difference to circumstances and events that make a difference to financial statement users be disclosed.financial statement users be disclosed.

Compliance with the full disclosure principle is Compliance with the full disclosure principle is accomplished through accomplished through

11 the the data in the financial statementsdata in the financial statements and and

22 the the notes that accompany the statementsnotes that accompany the statements.. A A summary of significant accounting policiessummary of significant accounting policies is is

usually the first note to the financial statements.usually the first note to the financial statements.

PRINCIPLESPRINCIPLESCOSTCOST

PRINCIPLESPRINCIPLESCOSTCOST

The The cost principlecost principle dictates that dictates that assets be recorded assets be recorded at their costat their cost..

Cost is used because it is both relevant and reliable.Cost is used because it is both relevant and reliable.

11 Cost is Cost is relevantrelevant because it represents because it represents a)a) the the price paid, price paid, b)b) the assets sacrificed, or the assets sacrificed, or c)c) the the commitment made at the date of commitment made at the date of acquisition.acquisition.

22 Cost is Cost is reliablereliable because it is because it is a)a) objectively objectively measurable, measurable, b)b) factual, and factual, and c)c) verifiable. verifiable.

BASIC PRINCIPLES BASIC PRINCIPLES USED IN ACCOUNTINGUSED IN ACCOUNTING

BASIC PRINCIPLES BASIC PRINCIPLES USED IN ACCOUNTINGUSED IN ACCOUNTING

Revenue Recognition

Duringproduction

At endof production

At point of sale

At timecash received

Revenue should be recognized in the accounting period in which it is earned (generally at point of sale).

Matching

Advertising Utilities

Delivery

Costs Matching Sales Revenue

Materials

Labor

Operating Expenses

Expenses should be matched with revenues

CEMENT

Cost

Assets should be recorded at cost.

Full Disclosure

Circumstances and events that make a difference to financial statement users should be disclosed.

* Financial Statements

* Balance Sheet

* Income Statement* Retained Earnings Statement

* Cash Flow Statement

CONSTRAINTS IN CONSTRAINTS IN ACCOUNTINGACCOUNTING


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

Constraints: The Cost Constraints: The Cost Benefit RuleBenefit Rule

Cost-Benefit RelationshipCost-Benefit Relationship• The cost of providing information The cost of providing information should not outweigh the benefit should not outweigh the benefit derived.derived.

• Costs and benefits are not always Costs and benefits are not always obvious or measurable.obvious or measurable.

• Sound judgment must be used in Sound judgment must be used in providing informationproviding information..

Constraints: MaterialityConstraints: Materiality

Materiality refers to an item’s Materiality refers to an item’s importance to a firm’s overall importance to a firm’s overall financial operations.financial operations.• An item must An item must make a differencemake a difference to be to be

material and be disclosed.material and be disclosed.• It is a matter of the It is a matter of the relative relative

significancesignificance of the element. of the element.• Both Both quantitative and qualitativequantitative and qualitative

factors are to be considered in factors are to be considered in determining relative significance.determining relative significance.

Constraints: Industry Constraints: Industry PracticesPractices

Industry PracticesIndustry Practices• The nature of some industries The nature of some industries

sometimes require departures sometimes require departures from basic accounting theory.from basic accounting theory.

• If application of accounting If application of accounting theory results in statements that theory results in statements that are not comparable or consistent, are not comparable or consistent, then industry practices must be then industry practices must be examined for possible examined for possible explanations. explanations.

Constraints: Constraints: ConservatismConservatism

Conservatism suggests that the Conservatism suggests that the preparer, when in doubt, choose preparer, when in doubt, choose a a conservative solutionconservative solution..

This solution will be This solution will be least likelyleast likely to overstate assets and income.to overstate assets and income.

Conservatism Conservatism does not suggestdoes not suggest that net assets or net income be that net assets or net income be deliberately understated.deliberately understated.



Materiality

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If dollar amounts of costs are small, GAAP does not have to be followed.

Conservatism

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

A CCOUNTING T HEORY U NDERLYING F INANCIAL A CCOUNTING.

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