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

(GAAP)

1. General Accepted Accounting Principles

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.
Environment and Theoretical Structure of Financial Acounting 4

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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Authority Official Release Congress SEC Regulation S-X ASR and FRR Staff Accounting Bulletins 1938 Accounting Profession AICPA 1938-1959 CAP ARBs (51) 1959-1973 APB APB Opinions (31) 1973 FASB . 1. Statement of Financial Accounting Standards 2. Interpretations 3. Concepts of Financial Accounting 4. Technique Bulletins 5. Statements issued by EITF
Environment and Theoretical Structure of Financial Accounting 6

Year 1934

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-byproblem 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.

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 9

Financial Reporting: A Theoretical Structure

A Conceptual Framework for Financial Reporting
SFAC N0. 1 First Level Objectives
Qualitative SFAC No. 8 Characteristic Elements Second Level of Accounting (SFAC No. 6) Information

SFAC No.5

Recognition and Measurement Concepts

Principles Historical Cost Revenue Matching Full Disclosure

Third level

Assumptions Entity GoingConcern Monetary unit Periodicity

Constraints Cost/Benefit Materiality Industry Practice Conservatism

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Environment and Theoretical Structure of Financial Accounting

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 2) Faithful Representation 1) Relevance a) Complete a) Predictive value b) Confirmatory value b) Neutral c) Free from error c) Materiality
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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) Matching 4) Full Disclosure (footnote disclosure)

III. Constraints
1) Cost-Benefit 2) Materiality 3) Industry Practice 4) 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.
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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.
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5. Income Statement Formats

Multiple -Step Income Statement (see illustration 5-11 of textbook for an Example) :
$150,000 (80,000) 70,000 (40,000) 30,000 $2,000 (9,000) 3,000

Net sales revenue Cost of good sold Gross margin Operating expenses Selling, Administration and Depreciation Income form operations Other icome (expense): Interest revenue Interest expense Gain on sale of equipment Income before income tax Income tax expense Net income

(4,000) 26,000 (10,000) $16,000

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Accrual Accounting and the Financial Statements

Income Statement Formats (contd.)

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

$150,000 2,000 3,000 $155,000

Revenues: Net sales Interest revenue Gain on sale of equipment Total revenue Expenses: Cost of goods sold Selling, administrative and depr. Interest expense Income tax expense Total expenses Net Income

80.000 40,000 9,000 10,000 139,000 $ 16,000

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Accounting for Merchandising Operations

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

6. Analyzing Financial Statements

Liquidity

Measuring a companys ability to pay current liabilities.

Current ratio = Current Assets Current Liabilities Working Capital = Current assets Current Liabilities
Financial Statement Analysis 25

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

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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

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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
Financial Statement Analysis 28