Global Leadership UniversityGlobal Leadership University

Accounting basis

Lecture 2Lecture 2

ACCOUNTING PRINCIPLES

Accounting principlesg p pRevenue and Expense

CONCEPTUAL FRAMEWORK OF ACCOUNTINGACCOUNTING

Generally accepted accounting principles y p g p pset of standards and rules that are recognized as a general guide for financial reporting

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

ACCOUNTING INFORMATIONMUST BE USEFUL

T b f l i f ti h ldTo be useful, information should possess the following qualitative characteristics:1 relevance2 reliabilityy3 comparability4 consistency4 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 l )(feedback value).

RELIABILITY

R li bili f i f i h hReliability of information means that the information is free of error .To be reliable, accounting information must be verifiable.

COMPARABILITY AND CONSISTENCYCOMPARABILITY AND CONSISTENCY

Comparability means that the information should beComparability means that the information should be comparable with accounting information about other enterprises.C i i i iConsistency means that the same accounting principles and methods should be used from year to year within a company.

2005 2006 20072005 2006 2007

CHARACTERISTICS OF USEFUL INFORMATIONUSEFUL INFORMATION

THE OPERATING GUIDELINES OF ACCOUNTINGACCOUNTING

Operating guidelines are classified as assumptions, principles and constraintsprinciples, 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

Assumptions Principl Constrai

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

Monetary unit Economic entity Time period

esRevenue recognition Matching

ntsMateriality Conservatism

Time period Going concern Full disclosure

Cost

ASSUMPTIONS USED IN ACCOUNTING

ASSUMPTIONSMonetary unit assumption:

only transaction data expressed in terms of money can beonly 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

Percentage of International Employees

S l i id

Should be includedin accounting Salaries paidccou grecords

ECONOMIC ENTITY ASSUMPTION

Activities of the entity kept separateActivities of the entity kept separateand distinct from the activities of the owner

d ll th i titiand all other economic entities.Example: BMW activities can be

di ti i h d f th f thdistinguished from those of othercar manufacturers such as Mercedes.

THE ENTITY CONCEPT EXAMPLE

Assume that John decides to open up a gas station p p gand coffee shop.

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 did John make?yAt 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.coffee shop lost Revenues 50,000.

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GOING CONCERN ASSUMPTIONASSUMPTION

The entity will continueyto operate in the future.

TIME PERIOD PRINCIPLE

For reporting purposes an For reporting purposes, an organization’s life can be divided i t t ti i dinto separate accounting periods

months, quarters, years etcyears, etc.

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THE ACCOUNTING PERIOD

Exh.3.1

AnnualAnnual

1 21 2Semiannual

1 2 3 4Quarter

1 2 3 4 5 6 7 8 9 10 11 12

MonthMonth

REVENUE RECOGNITION PRINCIPLE

Revenue is generally recognized Revenue is generally recognized At the time services are performed; orp ;

When goods are sold and delivered to ta customer.

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REVENUE PRINCIPLE

Air & SeaAir & Sea Air & SeaTravel, Inc.

April 2

Air & SeaTravel, Inc.

March 12I plan to have you

make my travelarrangements.

The client has taken a trip arranged bySituation 2

The client has taken a trip arranged bySituation 1

No transaction has occurred.19

p g yp g yAir & Sea Travel. – Record Revenue

No transaction has occurred.– Do Not Record Revenue

THE MATCHING PRINCIPLE

The matching principle requires The matching principle requires that all expenses incurred to

t th i d i generate the revenues recognized in an accounting period be matchedwith those revenues.

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THE MATCHING PRINCIPLE

Another view Another view . . .Let the expense follow the revenue.

First the revenue . . .

Th th Then the expense.

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GAAP RELATIONSHIPS IN REVENUE AND EXPENSE RECOGNITIONAND EXPENSE RECOGNITION

Time-Period AssumptionTime Period Assumption

Economic life of businesscan be divided into

artificial time periods

Revenue-Recognition Principle Matching PrinciplePrinciple

R i d i

Matching Principle

Expenses matched with Revenue recognized in the accounting period in

which it is earned

prevenues

in the same period when efforts are expended to

generate revenues

Full Disclosure PrincipleFull Disclosure Principle

Illustration 1-14

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COST PRINCIPLE

The cost principle dictates that assets be recorded at their costrecorded at their cost.

Cost= Purchase price + Preparing expenses

BASIC PRINCIPLES USED IN ACCOUNTINGBASIC PRINCIPLES USED IN ACCOUNTING

CONSTRAINTS IN ACCOUNTINGCONSTRAINTS IN ACCOUNTING

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

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

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DUAL ASPECT CONCEPT

Accounting information is based on the double entry g ysystem.Under this system, the two-sided effect of a transaction is recorded in the appropriate accounts.transaction is recorded in the appropriate accounts.

ASSETS = LIABILITIES + OWNER’S EQUITYThe Accounting Equation

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REVENUE AND EXPENSES

REVENUES are inflows of assets in exchange for products and g pservices provided to customer as part of a company’s primary operations.

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

Profit= Revenue - ExpensesProfit Revenue Expenses

Revenue Accrual Basis Recognition Accrual Basis Accounting

M t hi Matching Principle

Yikes!! What is Accrual

Basis Accounting?Accounting?

ACCRUAL BASIS ACCOUNTING

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

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

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96 97 98 99 00 01 02 03 04 05ity

io

n96 97 98 99 00 01 02 03 04 05

? ? ? ? ? ?riod

icum

pti

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Per

Ass

u

How do we recognize revenues?⇒ The Revenue Recognition ⇒

PrincipleHow do we recognize expenses?

⇒ The Matching Principle

Accrual Basis Accounting

Bertha are Bertha, are there any other

bases for bases for accounting?

Yikes! I don’t know Claude We know Claude. We

probably better ask the professor!the professor!

CASH BASIS ACCOUNTING

With the cash basis With the cash basis . . .

Revenues are recognized in the period Reve ues a e ecog ed t e pe od cash is received; and

Expenses are recognized in the period when cash is paid out.

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Bertha are Bertha, are there any other

bases for bases for accounting?

Yikes! I don’t know Claude We know Claude. We

probably better ask the professor!the professor!

MODIFIED CASH BASIS ACCOUNTING

With the Modified Cash Basis . . .Current period revenues and expenses are treated exactly as in the cash basis;

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

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