PREPARED BY:SYAZLIANA HJ. KASIM

KAMARUZZAMAN MUHAMMADFACULTY OF ACCOUNTANCY

UiTM SHAH ALAM

After studying this chapter, you should be able to:1. Explain the meaning of generally accepted accounting

principles and identify the key items of the conceptual framework.

2. Describe the basic objectives of financial reporting.

3. Discuss the qualitative characteristics of accounting information and elements of financial statements.

FINANCIAL ACCOUNTING FINANCIAL ACCOUNTING

FINANCIAL ACCOUNTINGFINANCIAL ACCOUNTING

4. Identify the basic assumptions used by accountants.

5. Identify the basic principles of accounting.

6. Identify the two constraints in accounting.

7. Identify business cycles

8. Identify relevant financial statements

9. Differentiate between trading company and manufacturing company.

After studying this chapter, you should be able to:

PREVIEW

Monetary unit

Economic entity

Time period

Going concern

AssumptionsThe Conceptual Framework of

Accounting

Objectives of reporting

Qualitative characteristics

Elements of financial statements

Operating guidelines

Principles

Revenue recognition

Matching

Full disclosure

Constraints in Accounting

Materiality

Conservatism

Summary ofconceptual framework

International Accounting Standards

Differences

Uniformity

STUDY OBJECTIVE 1

................................

1. Explain the meaning of generally accepted accounting principles and identify the key items of the conceptual framework.

PREVIEW

Monetary unit

Economic entity

Time period

Going concern

AssumptionsThe Conceptual Framework of

Accounting

Objectives of reporting

Qualitative characteristics

Elements of financial statements

Operating guidelines

Principles

Revenue recognition

Matching

Full disclosure

Constraints in Accounting

Materiality

Conservatism

Summary ofconceptual framework

International Accounting Standards

Differences

Uniformity

CONCEPTUAL FRAMEWORK OF ACCOUNTINGCONCEPTUAL 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 International Accounting Standards Board (IASB), Financial Accounting Standards Board (FASB) and Securities and Exchange Commission (SEC).

The FASB has the responsibility for developing accounting principles in the United States.

FASB’S CONCEPTUAL FRAMEWORK FASB’S CONCEPTUAL FRAMEWORK

The conceptual framework serves as the basis for resolving accounting and reporting problems.Under the conceptual framework consists of:

Objectives of financial reporting;Qualitative characteristics of accounting information;Elements of financial statements; andOperating guidelines (assumptions principles, and constraints).

STUDY OBJECTIVE 2

................................

2 Describe the basic objectives of financial reporting.

PREVIEW

Monetary unit

Economic entity

Time period

Going concern

AssumptionsThe Conceptual Framework of

Accounting

Objectives of reporting

Qualitative characteristics

Elements of financial statements

Operating guidelines

Principles

Revenue recognition

Matching

Full disclosure

Constraints in Accounting

Materiality

Conservatism

Summary ofconceptual framework

International Accounting Standards

Differences

Uniformity

OBJECTIVES OF FINANCIAL REPORTINGOBJECTIVES OF FINANCIAL REPORTING

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.

STUDY OBJECTIVE 3

................................

3 Discuss the qualitative characteristics of accounting information and elements of financial statements

PREVIEW

Monetary unit

Economic entity

Time period

Going concern

AssumptionsThe Conceptual Framework of

Accounting

Objectives of reporting

Qualitative characteristics

Elements of financial statements

Operating guidelines

Principles

Revenue recognition

Matching

Full disclosure

Constraints in Accounting

Materiality

Conservatism

Summary ofconceptual framework

International Accounting Standards

Differences

Uniformity

QUALITATIVE CHARACTERISTICS OF ACCOUNTING INFORMATIONQUALITATIVE CHARACTERISTICS OF ACCOUNTING INFORMATION

To be useful, information should possess the following qualitative characteristics:

1. relevance2. reliability3. comparability4. consistency

RELEVANCERELEVANCE 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). i.e. the information no longer timely for decision.

RELIABILITYRELIABILITY 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.

COMPARABILITY AND CONSISTENCYCOMPARABILITY AND CONSISTENCY

2008 2009 2010

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.

Relevance1 Predictive value

2 Feedback value

3 Timely

Reliability1 Verifiable

2 Faithful representation

3 Neutral

Comparability

Useful Financial

Information has:

QUALITATIVE CHARACTERISTICS OF ACCOUNTING INFORMATIONQUALITATIVE CHARACTERISTICS OF ACCOUNTING INFORMATION

Consistency

Assumptions

Monetary unit Economic entity Time period Going concern

Principals

Revenue recognition Matching Full disclosure Cost

Constraints

Materiality Conservatism

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.

THE OPERATING GUIDELINES OF ACCOUNTINGTHE OPERATING GUIDELINES OF ACCOUNTING

STUDY OBJECTIVE 4

................................

4 Identify the basic assumptions used by accountants.

PREVIEW

Monetary unit

Economic entity

Time period

Going concern

AssumptionsThe Conceptual Framework of

Accounting

Objectives of reporting

Qualitative characteristics

Elements of financial statements

Operating guidelines

Principles

Revenue recognition

Matching

Full disclosure

Constraints in Accounting

Materiality

Conservatism

Summary ofconceptual framework

International Accounting Standards

Differences

Uniformity

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.

ASSUMPTIONSASSUMPTIONS

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

ASSUMPTIONSASSUMPTIONS2 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.

ASSUMPTIONSASSUMPTIONS

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

QTR 1QTR 2QTR 3QTR 4

2008 2009 2010JAN FEB MAR APR MAY JUN JUL AUG SEPT OCT NOV DEC

GOING CONCERN ASSUMPTIONGOING 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.

STUDY OBJECTIVE 5

................................

5 Identify the basic principles of accounting.

PREVIEW

Monetary unit

Economic entity

Time period

Going concern

AssumptionsThe Conceptual Framework of

Accounting

Objectives of reporting

Qualitative characteristics

Elements of financial statements

Operating guidelines

Principles

Revenue recognition

Matching

Full disclosure

Constraints in Accounting

Materiality

Conservatism

Summary ofconceptual framework

International Accounting Standards

Differences

Uniformity

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.

PRINCIPLES

REVENUE RECOGNITION

PRINCIPLES

REVENUE RECOGNITION

PERCENTAGE-OF-COMPLETION METHOD OF REVENUE RECOGNITIONPERCENTAGE-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.

FORMULA TO RECOGNIZE REVENUE IN THE PERCENTAGE-OF-COMPLETION METHODFORMULA TO RECOGNIZE REVENUE IN THE PERCENTAGE-OF-COMPLETION METHOD

Costs Incurred(Current Period)

÷ =Total

Estimated Cost

PercentComplete(Current Period)

Total RevenueX =Revenue

Recognized(Current Period)

Percent Complete(Current Period)

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. E.g. Salary expenses

2 Unexpired costs are costs that will generate revenues in future accounting periods and are recognized as assets. E.g. Insurance prepaid.

PRINCIPLES MATCHING (EXPENSE RECOGNITION)

PRINCIPLES MATCHING (EXPENSE RECOGNITION)

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.

PRINCIPLES MATCHING (EXPENSE RECOGNITION)

PRINCIPLES MATCHING (EXPENSE RECOGNITION)

PRINCIPLES FULL DISCLOSURE

PRINCIPLES FULL DISCLOSURE

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.

BASIC PRINCIPLES USED IN ACCOUNTINGBASIC PRINCIPLES USED 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

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

STUDY OBJECTIVE 6

................................

6 Identify the two constraints in accounting.

PREVIEW

Monetary unit

Economic entity

Time period

Going concern

AssumptionsThe Conceptual Framework of

Accounting

Objectives of reporting

Qualitative characteristics

Elements of financial statements

Operating guidelines

Principles

Revenue recognition

Matching

Full disclosure

Constraints in Accounting

Materiality

Conservatism

Summary ofconceptual framework

International Accounting Standards

Differences

Uniformity

CONSTRAINTS IN ACCOUNTINGCONSTRAINTS 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.

CONSTRAINTS IN ACCOUNTINGCONSTRAINTS IN ACCOUNTING

Materiality

$$

$$

$$

$$

$

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.

CONCEPTUAL FRAMEWORKCONCEPTUAL FRAMEWORK

Objectives of Financial Reporting

Assumptions Principles

Operating Guidelines

Qualitative Characteristics of

Accounting Information

Elements of Financial Statements

STUDY OBJECTIVE 7

................................

7 Identify business cycles.

BUSINESS TRANSACTIONSBusiness cycle starts with the occurrence of

business transactions e.g. buying (purchase cycle) and selling of goods and services (revenue cycle) whether in cash and/or credit term.

Examples of related source documents from this cycle are invoices and receipts.

41INTEGRATED ACCOUNTING STUDY (FAR 360)

FINANCIAL ACCOUNTING MODULE

REVENUE AND RECEIPT CYCLES

Revenue cycle starts with sales of goods (cash and credit).

Sales will be recognized as the transactions occurred due to revenue recognition concept.

For cash transactions, cash collection is made immediately.

For credit transactions, cash will be received in the future depending on the credit terms.

Management requires debtors ageing reports for controlling purpose.

Debtors ageing report will be used to assess the repayment capability of the debtors as well as extend of bad debts that can occur.

INTEGRATED ACCOUNTING STUDY (FAR 360) FINANCIAL ACCOUNTING MODULE 42

EXPENDITURE AND PAYMENT CYCLES

Purchase cycle starts based on sales and production budget (cash or credit).

Purchase will be recognized on accrual basis.

For cash transaction, cash payment is made immediately.

For credit transaction, cash will be paid in the future depending on the credit terms.

Management requires creditor ageing reports for payment decision.Creditors ageing report will be used to assess the

cash requirement by the companyINTEGRATED ACCOUNTING STUDY (FAR 360)

FINANCIAL ACCOUNTING MODULE 43

INTEGRATED ACCOUNTING STUDY (FAR 360) FINANCIAL ACCOUNTING MODULE 44

Source Documents

Preparation of Financial

Statements

JOURNALS

LEDGERS

Extraction of the Balances of Accounts

Preparation of Pre-Adjusted Trial Balance

Recording Adjusting

Journal Entries

Extraction of Balances of

Accounts

Journalising of Closing Entries

Preparation of Post-Adjusted Trial Balance

Journalising

STEPS IN ACCOUNTING CYCLEIdentifying and recording the transactions in the

journal – a process called journalising.Making entries in the ledger from the journal – a

process called posting.Extracting the balances of the accounts in the

ledger.Preparing a pre-adjusted trial balance.Recording adjusting entries in the journal.Posting the adjusting entries to the ledger.Preparing a post-adjusted trial balance.Journalising the closing entries.Posting closing entries to the ledger.Balancing off the accounts in the ledger.

INTEGRATED ACCOUNTING STUDY (FAR 360) FINANCIAL ACCOUNTING MODULE 45

STUDY OBJECTIVE 8

................................

8 Identify relevant financial statements

FINANCIAL STATEMENTSFINANCIAL STATEMENTS

After transactions are identified, recorded, and summarized, 4 financial statements are prepared from the summarized accounting data:1 An income statement presents the revenues and expenses and resulting net income or net loss for a specific period of time.2 An owner’s equity statement summarizes the changes in owner’s equity for a specific period of time.3 A balance sheet reports the assets, liabilities, and owner’s equity at a specific date.4 A statement of cash flows summarizes information

about the cash inflows (receipts) and outflows (payments) for a specific period of time.

FINANCIAL STATEMENTS AND THEIR INTERRELATIONSHIPSFINANCIAL STATEMENTS AND THEIR INTERRELATIONSHIPS

SOFTBYTE

Income Statement

For the Month Ended September 30, 2002

Revenues Service revenue $ 4,700 Expenses Salaries expense $ 900

Rent expense 600 Advertising expense 250

Utilities expense 200

Total expenses 1,950

Net income

2,750

Net income of $2,750 shown on the income statement is added to the beginning balance of owner’s capital in the owner’s equity statement.Net income of $2,750 shown on the income statement is added to the beginning balance of owner’s capital in the owner’s equity statement.

FINANCIAL STATEMENTS AND THEIR INTERRELATIONSHIPSFINANCIAL STATEMENTS AND THEIR INTERRELATIONSHIPS

SOFTBYTE

Owner’s Equity Statement

For the Month Ended September 30, 2002

Capital, September 1 $ –0– Add: Investments $ 15,000 Net income 17,750 17,750 Less: Drawings 1,300 Capital, September 30 $ 16,450

2,750

Net income of $2,750 is determined from the information in the owner’s equity column of the Summary of Transactions.Net income of $2,750 is determined from the information in the owner’s equity column of the Summary of Transactions.

FINANCIAL STATEMENTS AND THEIR INTERRELATIONSHIPSFINANCIAL STATEMENTS AND THEIR INTERRELATIONSHIPS

SOFTBYTE

Owner’s Equity Statement

For the Month Ended September 30, 2002

Capital, September 1 $ –0– Add: Investments $ 15,000 Net income 2,750 17,750 17,750 Less: Drawings 1,300 Capital, September 30

$16,450

Net income of $2,750 carried forward from the income statement to the owner’s equity statement. The owner’s capital of $16,450 at the end of the reporting period is shown as the final total of the owner’s equity column of the Summary of Transactions.

Net income of $2,750 carried forward from the income statement to the owner’s equity statement. The owner’s capital of $16,450 at the end of the reporting period is shown as the final total of the owner’s equity column of the Summary of Transactions.

FINANCIAL STATEMENTS AND THEIR INTERRELATIONSHIPSFINANCIAL STATEMENTS AND THEIR INTERRELATIONSHIPS

Owner’s capital of $16,450 at the end of the reporting period shown in the owner’s equity statement is shown on the balance sheet.Owner’s capital of $16,450 at the end of the reporting period shown in the owner’s equity statement is shown on the balance sheet.

SOFTBYTE

Balance Sheet

September 30, 2002

Assets Cash $ 8,050 Accounts receivable 1,400 Supplies 1,600 Equipment 7,000 Total assets $ 18,050

Liabilities and Owner’s Equity Liabilities Accounts payable $ 1,600 Owner’s equity R. Neal, capital Total liabilities and owner’s equity $ 18,050

16,450

SOFTBYTE

Balance Sheet

September 30, 2002

Assets Cash $ 8,050 Accounts receivable 1,400 Supplies 1,600 Equipment 7,000 Total assets $ 18,050

Liabilities and Owner’s Equity Liabilities Accounts payable $ 1,600 Owner’s equity R. Neal, capital Total liabilities and owner’s equity $ 18,050

FINANCIAL STATEMENTS AND THEIR INTERRELATIONSHIPSFINANCIAL STATEMENTS AND THEIR INTERRELATIONSHIPS

16,450

Cash of $8,050 on the balance sheet is reported on the statement of cash flows.Cash of $8,050 on the balance sheet is reported on the statement of cash flows.

FINANCIAL STATEMENTS AND THEIR INTERRELATIONSHIPSFINANCIAL STATEMENTS AND THEIR INTERRELATIONSHIPS

SOFTBYTE

Statement of Cash Flows

For the Month Ended September 30, 2002

Cash flows from operating activities Cash receipts from revenues $ 3,300 Cash payments for expenses (1,950) Net cash provided by operating activities 1,350 Cash flows from investing activities Purchase of equipment (7,000) Cash flows from financing activities Investment by owners $ 15,000 Withdraws by owners (1,300) Net cash provided by financing activities 13,700 Net increase in cash 8,050 Cash at the beginning of the period –0– Cash at the end of the period

$ 8,050

Cash of $8,050 on the balance sheet and statement of cash flows is shown as the final total of the cash column of the Summary of Transactions.Cash of $8,050 on the balance sheet and statement of cash flows is shown as the final total of the cash column of the Summary of Transactions.

STUDY OBJECTIVE 9

................................

9. Differentiate between trading company and manufacturing company.

A trading company is an enterprise that buys and sells goods to earn a profit.1) Wholesalers sell to retailers

2) Retailers sell to consumers

A trader’s primary source of revenue is sales.

TRADING COMPANYTRADING COMPANY

Expenses for a trading company are divided into two categories:

1) cost of goods sold and

2) operating expensesCost of goods sold is the total cost of goods sold during the period.Operating expenses are expenses incurred in the process of earning

sales revenue. Examples are sales salaries and insurance expense.Gross profit is equal to Sales Revenue less Cost of Goods Sold.

MEASURING NET INCOMEMEASURING NET INCOME

Sales Revenue

Cost ofGoods Sold

Gross Profit

Operating Expenses

Net Income(Loss)

Less

Equals

Less

Equals

INCOME MEASUREMENT PROCESS FOR A TRADING COMPANY

INCOME MEASUREMENT PROCESS FOR A TRADING COMPANY

TRADING VS MANUFACTURING Trading activities involve buying and selling finished products

from another enterprise and resell them at a profit. Example: shoes, books.

Manufacturing activities involve buying raw materials and converting them into finished products. Subsequently, the finished products are sold to customers.

Examples: Purchase raw tomatoes, chilli and other related raw materials

and process them into tomato sauce Purchase wood planks and other related materials to produce

furniture

Syazliana Hj. Kasim

Faculty of Accountancy UiTM Shah Alam

58

Trading inventory has two common characteristics:

1 it is owned by the company and

2 it is in a form ready for sale in the ordinary course of business

TRADING INVENTORY CHARACTERISTICS

TRADING INVENTORY CHARACTERISTICS

Unlike trading inventory, manufacturing inventory may not yet be ready for sale. As a result, inventory is usually classified into three categories:

1 Finished goods - inventory which is completed and ready for sale.

2 Work in process - inventory in various stages of production but not yet completed.

3 Raw materials - components on hand waiting to be used in production.

A manufacturing company need to prepare Manufacturing Account

CLASSIFYING INVENTORY IN A MANUFACTURING ENVIRONMENT

CLASSIFYING INVENTORY IN A MANUFACTURING ENVIRONMENT

INTEGRATED ACCOUNTING STUDY (FAR 360) FINANCIAL ACCOUNTING MODULE 61