accounting

Module Three Lecture Notes Accounting is based on a set of principles referred to as “generally accepted accounting principles” (GAAP). It is important to understand the conceptual framework to help you understand that accounting has a logical structure. The Conceptual Framework “structure” is illustrated on page 61, Exhibit 2.1. The accounting principles have a hierarchy to the structure: All accounting information should be useful to the users of financial statements. Therefore, the qualitative characteristics are to ensure that the information is useful:

• Relevance – For information to be relevant, it must make a difference in helping users make decisions. In other words, if the information is not material (too small to matter), then the information is not relevant. The information can either be “predictive” in that it helps predict future events or it can be “confirmatory” in that it helps confirm prior expectations.

• Faithful Representation – for information to useful it must faithfully represent real- world economic events.

In addition to these fundamental characteristics, there are four additional characteristics that accounting information must possess to enhance its usefulness:

• Comparability – For information to be comparable a user must be able to compare the information from one period to the next. Also, this information must be applied consistently from one period to the next.

• Verifiability – Information is verifiable when the information can be confirmed independently. For example, when you purchase a new car, the purchase price can be verified independently by the bill of sale or contract that is signed with the dealer.

• Timeliness – In other words, the information must be made available before it loses its information to influence users. The net income of a company from six years ago is not useful in making investment decisions today.

• Understandability – This implies that the readers of the financial statements (given reasonable knowledge of accounting) can comprehend the meaning of the information being presented.

A good exercise to review the practical application of the Conceptual Framework is found on page 63 and 64 of the textbook (Cornerstone 2.1). It is important to understand how the accounting framework is the foundation of all GAAP. There are some assumptions that must be made and underlie all accounting information:

• Economic Entity assumption: Each company is accounted for as a separate economic entity from its owner or owners. Tim Cook’s personal transactions would never be recorded as part of Apple’s transactions. A sole proprietor’s accounting records would be maintained separate from his/her personal accounting records.

• Going-concern assumption: This assumption assumes that the entity will continue in the future at least long enough to meet all of its future commitments. In other words, if a corporation has raised capital by issuing 10-year bonds, the assumption is that the

corporation will be around at least long enough to meet this financial obligation. If we didn’t assume going-concern, then our current accounting procedure could not be followed. It wouldn’t make sense to record a liability on the books if we knew the company was going to file bankruptcy before those obligations were paid.

• Time period assumption: This allows the company’s transactions and operations to be divided into time periods (monthly, quarterly, annually, etc…) so net income (loss) can be measured.

• Monetary Unit assumption: This means that we assume that the company is keeping its accounting records based on monetary units. In other words, we wouldn’t want to be keeping track of accounting records based on chickens, or cows, or buckskins, etc…

There are also four basic principles of accounting used in the measurement and recording of business transactions:

• Historical Cost Principle: This principle requires that transactions are to be recorded at cost – the price paid at the time of the activity. This principle holds that the price paid is reliable because it can be documented.

• Revenue Recognition Principle: This principle holds that revenue should not be recorded until it is earned and is realized (or realizable). In other words, the earning process should be complete and the company should have either received cash payment or a receivable from a customer that commits them to pay for the services rendered or product purchased.

• Matching Principle: This principle requires that the revenue and expenses should be “matched” in a period. In other words, expenses should be recorded in the period that they were incurred to help generate the revenue. For example, advertising expenses should be recorded in the period in which they “aired” or were used to generate revenue.

• Conservatism Principle: This principle is designed to protect the users of the financial statements from inflated revenue and net income. When recording transactions, accountants should take care to use those methods which will least likely overstate a company’s assets or income.