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Chapter 15

Accounting Principles

ACCT 100

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Objectives of the Chapter

1. Define the generally accepted accounting principles (GAAP).

2. Study the conceptual framework underlying financial reports.

3. Study the accounting standard compliance system in the United States.

4. Discuss the need for a set of global accounting standards.

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Objectives of the Chapter (contd.)

5. Multiple-step income statement vs. single-step income statement.

6. Analyzing Financial Statements

Environment and Theoretical Structure of Financial Acounting 4

1. General Accepted Accounting Principles (GAAP)

Accounting methods having “substantial authoritative support” and used by business entities in preparing financial statements.

The support is from the Securities and Exchange Commission (SEC).

The SEC is a government agency which was created by the Securities Exchange Act of 1934.

The Authorities Prescribe the Accounting Standards Prior to 1973, two committees under the

AICPA (American Institute of Certified Public Accountants) were the authorities in the private sector to be in charge of prescribing accounting standards.

Since 1973, the financial accounting standards board (FASB) became the authority in the private sector to prescribe accounting standards.

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Environment and Theoretical Structure of Financial Accounting 6

1934 Congress

SEC Regulation S-XASR and FRRStaff Accounting Bulletins

1938 Accounting ProfessionAICPA

1938-1959 CAP ……… ARBs (51)1959-1973 APB ………APB Opinions (31)

1973 FASB ……. 1. Statement of Financial Accounting Standards

2. Interpretations3. Concepts of Financial

Accounting4. Technique Bulletins5. Statements issued by EITF

Year Authority Official Release

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Problems Associated with Accounting Standards Developed Prior to 1973

Under CAP (Committees on Accounting Procedures) and APB (Accounting Principles Board), accounting standards were developed on a problem-by-problem basis.

Accounting rule-making bodies (i.e., CAP and APB) solved specific problems.

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Problems Associated with Accounting Standards Developed Prior to 1973 (Contd.)

The problem-by-problem approach resulted in inconsistent accounting standards.

The FASB developed a conceptual framework to serve as the foundation to develop accounting standards.

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Environment and Theoretical Structure of Financial Accounting 9

2. Conceptual Framework of Financial Reporting Conceptual Framework of Financial

Reporting: a system of interactive objectives and fundamentals which can lead to a set of consistent standards in preparing financial reports.

The current accounting standard setting authority (FASB) relies on this framework to prescribe a set of consistent accounting standards.

Environment and Theoretical Structure of Financial Accounting 10

Financial Reporting: A Theoretical StructureA Conceptual Framework for Financial Reporting

Assumptions•Entity•Going-Concern

•Monetary unit•Periodicity

Constraints•Cost/Benefit•Materiality•Industry Practice

•Conservatism

Objectives

Qualitative Characteristic of Accounting Information

Elements (SFAC No. 6)

Recognition and Measurement Concepts

Principles•Historical Cost•Revenue•Matching•Full Disclosure

SFAC N0. 1

SFAC No. 8

SFAC No.5

First Level

Second Level

Third level

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SFAC No. 1 (Level One of the Conceptual Framework) Objectives of financial reporting:

Providing information

1. useful in making investment and credit decisions;

2. useful in assessing future cash flows;

3. about entity resources, claims to the resources and changes of these resources.

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SFAC No. 8 (Chapter 3: Qualitative Characteristics of Useful Financial Information ) (Level Two of The Framework)

Qualitative Characteristics of Accounting Information

I. Primary Qualities

1) Relevancea) Predictive valueb) Confirmatory valuec) Materiality

2) Faithful Representation a) Complete

b) Neutralc) Free from error

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SFAC No. 8 (contd.)

II. Enhancing Qualitative Characteristics

1) Comparability(including consistency)

2) Verifiability

3) Timeliness

4) Understandability

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SFAC No. 5 (Operating Guidelines)(Level Three of The Conceptual Framework) Measurement and Recognition Concepts

I.Assumptions

1) Economic Entity

2) Going-concern (continuity)

3) Monetary unit

4) Periodicity (Period of time)

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SFAC No. 5 (contd.)II. Principles

1) Historical cost (exception: LCM of inventory)

2) Revenue recognition (exceptions:3) Matching4) Full Disclosure (footnote disclosure)

III.Constraints1) Cost-Benefit2) Materiality3) Industry Practice4) Conservatism

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3. The Accounting Standard Compliance System in the US The interrelationship of the SEC and

the FASB:

FASB: the current rule making body.

SEC: the enforcing agency of securities laws and accounting standards; regulating the stock market.

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4. The Need for International Accounting Standards

Companies doing business in more than one nations found that it is hard to comply with more than one set of accounting standards established by authorities in different nations.

In response to this problem, International Accounting Standards Committee (IASC) was formed in 1973 to develop a single set of global accounting standards.

The Popularity of the International Accounting Standards IASC created International Accounting

Standards Board (IASB) in 2001 to be in charge of prescribing the standards.

Since 2005, over 7,000 companies listed in the European Union used IASB standards.

Many other countries now also use IASB standards.

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The Convergence of the U.S. Accounting Standards and the International Accounting Standards

To increase the international comparability and the quality of US accounting standards, the FASB has been engaged in activities to increase the convergence of the accounting standards.

The FASB is working closely with the IASB toward the convergence of accounting standards (i.e., to develop a single set of global standards).

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Short-Term International Convergence (source: FASB Project Updates) The IASB and the FASB acknowledged

that convergence of IASB standards and U.S. GAAP is a primary objective of both Boards.

To achieve this objective and to improve the financial reporting in the US, the FASB started a short term project, conducted jointly with the IASB, to eliminate narrow differences between US GAAP and IASB standards in 2002.

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Current Compliances in the US

The U.S. firms filing reports with the SEC must use U.S. GAAP.

Foreign issuers filing reports with the SEC can use U.S. GAAP or the international standards.

The SEC abolished a requirement that non-US companies with US listings reconcile their financial reports to US GAAP in 2007.

Accrual Accounting and the Financial Statements 22

5. Income Statement Formats

Net sales revenue $150,000Cost of good sold (80,000)Gross margin 70,000Operating expenses Selling, Administration and Depreciation (40,000)Income form operations 30,000Other icome (expense): Interest revenue $2,000 Interest expense (9,000) Gain on sale of equipment 3,000 (4,000)Income before income tax 26,000Income tax expense (10,000)Net income $16,000

Multiple -Step Income Statement (see illustration 5-11 of textbook for an Example) :

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Income Statement Formats (contd.) Single-Step Income Statement (See Illus.5-12 of

textbook)Revenues:Net sales $150,000Interest revenue 2,000Gain on sale of equipment 3,000 Total revenue $155,000 Expenses:Cost of goods sold 80.000Selling, administrative and depr. 40,000Interest expense 9,000Income tax expense 10,000 Total expenses 139,000Net Income $ 16,000

Accounting for Merchandising Operations 23

Income Statement Formats (Contd.)

CGS=Beg. Inv.+Net Pur. – End. Inv. Net Pur. =Pur. –PR –PD + Freight-In Selling expenses include: salaries

expense (sales related), advertising expense, freight-out.

Administrative expenses include: salaries expense (administration related), utility expense, insurance expense.

Accounting for Merchandising Operations 24

Financial Statement Analysis 25

6. Analyzing Financial Statements

Liquidity

Measuring a company’s ability to pay current liabilities.

Current ratio = Current Assets

Current Liabilities Working Capital = Current assets –Current

Liabilities

Financial Statement Analysis 26

Solvency Ratio

Indicators of long-run solvency and stability of a company.

Debt ratio = Total Liabilities Total Assets

This ratio indicates the percentage of assets financed with debt.

Financial Statement Analysis 27

Profitability

Indicators of how effective a company has been in meeting its overall profit objectives, particularly in relation to the resources invested.

Financial Statement Analysis 28

Profitability (contd.)

a. Profit margin percentage (rate of return on sales)

= Net Income Net Sales

b. Return on assets

= Net Income Average Total Assets

c. Return on comm. stockholders’ equity

= Net Income - Preferred Dividends Average Stockholders’ Equity