Chapter 1. accounting overview4

Objective 4

Accounting principles

How to Do Accounting: Principles

The rules that govern accounting are called GAAP

(generally accepted accounting principles).

The rules that govern accounting are called GAAP

(generally accepted accounting principles).

Accountants follow professional guidelines.Accountants follow professional guidelines.


Accounting entity principle Business transactions of the accounting entity should

be separated from personal transactions. Historical cost principle

Assets recorded at the cost paid to have them. Going concern principle

The assumption that an entity will continue in business.

Reporting period principle Artificial segment on the calendar used as the basis for

preparing the financial statements


Matching principle Revenue for a period shall match with expenses over the same

period of time to calculate profit. Monetary unit principle

The measurement unit used is the currency of the country in which the report is being prepared.

Conservatism principle Losses would be allowed for when expected to occur, while

gains would only be recognized if certain to happen. Consistency principle

Accounting methods used are applied consistently from one reporting period to another.


Accrual Principles Entity should prepare the financial statements on the basis that

transactions are recorded in them, not as cash is paid or received, but as revenue or expense are earned or incurred in the accounting period to which they relate.

The Entity Concept Example

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

The gas station made $250,000 in profits, while the coffee shop lost $50,000.

The Entity Concept Example

How much money did John make? At a first glance, we would assume that

John made $200,000. However, by applying the entity concept we

realize that the gas station made $250,000 while the coffee shop lost $50,000.

Going concern

A retailer commence business on 1 Jan and buy inventory of 20 washing machines, each costing $100. During the year, he sells 17 machines at $150/each. How should the remaining machines be valued at 31 Dec. in the following circumstances:

(a) He is forced to close down his business at the end of the year and the remaining machines be valued at 31 Dec. only $60 each in forced sale.

(b) He intends to continue his business into the next year.

The entity will continueto operate in the future.

The Going Concern Concept

Managers adopt anartificial period of time

to evaluate performance.

Accounting Period

Monthly

Quarterly

Semi-annually

Interim Period Statements

The Matching Principle

What is the matching principle? It is the basis for recording expenses. Expenses are the costs of assets and the

increase in liabilities incurred in the earning of revenues.

Expenses are recognized when the benefit from the expense is received.

Matching principle

Emma buys 20 T-shirts in her first month of trading (May) at a cost of $5 each.

(a) Emma sells all of them for $10 each.Profit= Revenue – Cost$100= 20*10-20*5(b) Emma only sells 18 T-shirtsProfit= 18*10-18*5=$90

Matching Expenses with Revenues Example Parker Floor sells a wood floor for $15,000

on the last day of May. The wood was purchased from the

manufacturer for $8,000 in March of the same year.

The floor is installed in June. When is income recognized?

Revenues $15,000Cost of goods sold 8,000Net income $ 7,000

May

Matching Expenses with Revenues Example

The dollar’s purchasingpower is relatively

stable.

The Monetary-Unit principle

Distinguish accrualaccounting from

cash-basis accounting.

Accrual principles

Accrual-basis:Transactions are

recordedwhen revenues areearned or expenses

are incurred.

Cash-basis:Transactions arerecorded whencash is paid or

cash is received.

The Two Bases of Accounting:

Accrual Versus Cash Example

In January 2002, Prensa Insurance sells a three-year health insurance policy to a business client.

The contract specifies that the client had to pay $150,000 in advance.

Yearly expenses amount to $20,000. What is the income or loss?


Accrual-Basis Accounting

2002 2003 2004(000 omitted)

Revenues $50 $50 $50Expenses 20 20 20Net income (loss) $30 $30 $30


Cash-Basis Accounting

2002 2003 2004(000 omitted)

Cash inflows $150 $ 0 $ 0Cash outflows 20 20 20Net income (loss) $130 ($20) ($20)

Objective 5

Requirements for Accounting information


Relevance –all accounting information is presented in general purpose financial report (personal transaction are omitted)

Reliability - information must be free of error and bias

Comparability - ability to compare information of different companies because they use the same accounting principles


Materiality- all significant items must be reported in accounting report.

Understandability – Reports being prepared in such s way that general users are able to comprehend their meaning.

Characteristics of Useful Information