CHAPTER 5

Accounting Concepts and Principles

- Accounting is the language of business and it is used to communicate financial

information. In order for that information to make sense, accounting is based on different
fundamental concepts and principles. These fundamental concepts and principles then form the
basis for all of the Generally Accepted Accounting Principles (GAAP).  By using these as the
foundation, readers of financial statements and other accounting information do not need to
make assumptions about what the numbers mean. GAAPs make information in accounting
statements relevant, reliable and comparable.
- GAAP have been largely developed:
•Through accounting practices or
•By authoritative bodies (organizations). Five major authoritative organizations that have
contributed to the development of GAAP are: AICPA, FASB, GASB, SEC, AAA
- The International Accounting Standards Board (IASB) issues standards that identifies
preferred accounting practices in the global economy and hopes to create harmony among
accounting practices in different countries.

Required Characteristics of Financial Statements

- Financial statements report the effects of completed business transactions of an entity to
users. So they should have the following characteristics
1. Relevance
Usefulness for decision making. The information must make a difference to someone who
does not already have the information.
2. Reliability
The accounting information must be free from bias, errors and it faithfully represent what it
purports to represent so that the user will depend on it to make decisions.
3. Comparability
Comparability is the ability to help users see similarities and differences among events and
conditions.
4. Understandability
Understandability means that users must understand the information within the context of
the decision being made. A company may present highly relevant and reliable information,
however it was useless to those who do not understand it.

- The current set of principles that accountants use rests upon some underlying assumptions.
The basic assumptions, concepts, and principles that we are going to discuss are considered
GAAP and apply to most financial statements. In addition to these concepts, there are other,
more technical standards accountants must follow when preparing financial statements which
are left for more advanced study.

Business Entity
- The business entity concept requires that the activity of a business enterprise be kept
separate and distinct from its owners and any other business enterprise. Even in proprietorships
and partnerships, where there is no separate legal existence, the accounts for the business must

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 be kept separate from those of the owner(s). In the event an individual owns more than one
unrelated business, each business must also be treated as a separate entity.

Going Concern(Continuity)
- In spite of numerous business failures, accountants assume, unless there is evidence to the
contrary, that a company will continue to operate indefinitely rather than be terminated in the
near future.
- The classification of assets and liabilities as current and long-term, the reporting of
prepayments as assets, the recording and reporting of assets at cost in stead of market, periodic
allocation of cost of assets over their estimated life in the form of depreciation and
amortization, are all justified by this concept.
- If liquidation appears likely the going concern concept can no longer be used. The financial
statements should clearly disclose the limited life the enterprise and they should be prepared
from the “quitting concern “or “liquidation” point of view.

Monetary Unit
- This assumption specifies that accounting should measure and report the results of a
business’s economic activities in terms of a monetary unit such as the U.S. dollar or Birr.
- This assumption has two major limitations:
•Many qualitative factors that affect the company, such as skill and experience of employees
and management, health and morale of employees are not reported because they cannot
be in monetary terms.
• It assumes stable money. Money unadjusted for inflation or deflation is used to measure our
financial statement items.
- As a solution for the stable money assumption price level adjusted (constant dollar)
information can be provided (but not required) as supplementary information if change in the
value of money is significant. The practice of reporting assets at historical cost in stead of their
current fair value is justified by this principle.

Accounting Period

- External users need periodic information to make decisions. This need for periodic
information requires that the economic life of an enterprise (presumed to be indefinite) be
divided into artificial time periods for financials reporting, for example, monthly, quarterly,
yearly.
- Many companies have a fiscal year that coincides with the calendar year.

- Without this concept a business would have only one time period running from the inception
of the business to its termination. The need for adjusting entries is justified by this concept.

Objectivity

- The objectivity concept states that accounting will be recorded on the basis of objective
evidence (invoices, receipts, bank statement, etc…). This makes the information free of bias and
subject to verification which maintain the confidence of the many user of the financial
statement. In the event something cannot be supported objectively, a number of subjective

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 methods are used to develop an estimate. The determination of items such as depreciation
expense and allowance for doubtful accounts are based on subjective factors. Still even
subjective factors are influenced by objective evidence such as past experience.

Cost Principle

- It is one of the oldest and most basic principles of accounting. It requires that assets and
liabilities should be recorded and reported based on their original transaction value, that is, their
historical costs. Cost is used because it is both relevant and reliable. Cost is relevant because it
represents the price paid, the assets sacrificed, or the commitment made at date of acquisition. It
is the amount for which someone or some entity should be accountable. Cost is reliable because
it is objectively measurable, factual, and verifiable. It is the result of an arm’s length exchange
transaction. As a result, cost is the basis used in preparing financial statements. Offers, assessed
values, appraisals for tax purpose and opinions have no effect on the accounting records because
they do not show exchange.
- However this principle has come under much criticism in that it is irrelevant because
subsequent to acquisition, cost is not equivalent to market value or current value. Using
historical cost implies money is a stable unit of measurement.

Revenue Recognition

- Revenues are inflows or enhancements of assets (or settlement of liabilities) from delivering
goods or providing services in the entity’s ongoing major or central operations. One of the most
difficult issues facing accountants concerns the recognition of revenue by a business
organization.
- Practically revenues may be recognized using different methods

1. At point of sale (delivery) method-- revenue is recognized when the product is delivered
or the service is rendered. In most circumstances, revenue is recognized at the point of sale
because most of the uncertainties related to the earning process are removed and the
exchange price is known. Theoretically, revenue from the production and sale of
merchandise and services emerges continuously as effort is expended. But usually it is not
possible to make an objective determination until both the contract price has been agreed
upon and the seller’s portion of the contract has been completed.
Thus revenue is normally recognized when earned regardless of when cash is actually
received.
You remember a liability (unearned revenue) account is used when cash is collected from
the customer before goods or services are delivered. And an asset account (accrued asset)
is used when cash is NOT collected from the customers by the time goods or services are
delivered.
2. Receipt of Payment—under this method revenue is considered to be realized at the time
the cash is collected, regardless of when the sale was made. This is the cash basis
accounting which is widely used by physicians, attorneys and other enterprises in which
professional services are the source of revenue. It has little theoretical justification but has
the practical advantage of simplicity of operation and avoidance of the problem of
estimating losses from uncollectible accounts. It is not an appropriate method of
measuring revenue from the sale of merchandise.

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3. Installment Method
The term installment sale describes any type of sale for which payment is required in
periodic installments over an extended period of time. The seller may technically retain title
to the goods until cash is fully collected and may have the right to repossess the goods in
case the buyer defaults. Generally, revenue from installment sale is recognized using the
point of sale method like ordinary sales.

Under some exceptional cases, where the collection of cash is not reasonably assured, the
installment method of recognizing revenue is used. Under the installment sales method of
accounting, each receipt of cash is considered to be revenue and to be composed of partial
amount of the cost of merchandise sold and gross profit on the sale. That is, the gross profit
(sales less cost of goods sold) on installment sales is deferred to those periods in which cash
is collected. Thus the recognition of revenue is based on periodic collection.

a) A gross profit percentage is determined on the entire contract by subtracting the cost
of goods sold from the sale price, and dividing by the sale price.
b) Each year the gross profit recognized is calculated by multiplying the amount
collected by the gross profit percentage.

Example: Assume the following facts:

Year 3 Year 4 Year 5

Installment sales $226,000 $248,000 $261,000
Cost of installment sales 164,980 176,080 195,750
Gross profit -------- -------- --------
Rate of Gross Profit -------- -------- --------
Cash Receipts
Year 3 Sales $85,000 $96,000 $45,000
Year 4 Sales 123,000 87,000
Year 5 Sales 47,000

Required:
a) Compute the amounts reported as gross profit for each of the three years using the point
of sale
b) Compute the gross profit percentage for each year
c) Compute the amounts reported as gross profit for each of the three years using the
installment method.
Solution
a) Point of sales method

GP of Year 3: Installment sales − Cost of installment sales

$226,000 − 164,980 = $61,020
GP of Year 4: Installment sales − Cost of installment sales
$248,000 − 176,080 = $71,920
GP of Year 5: Installment sales − Cost of installment sales
$261,000 − 195,750 = $65,250

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 b) Gross Profit Percentage
GP %ge = Cost of Installment Sales
Installment sales
Year 3 = $61,020/$226,000 = 27%
Year 4 = $71,920 /$248,000 = 29%
Year 5 = $65,250 /$261,000 = 25%
c) Installment Method

GP of Year 3:
Cash collected from year 3 sale $85,000 × 27% ----------- $22,950

GP of Year 4:
Cash collected from year 4 sale $123,000 × 29% ----------- $35,670
Cash collected from year 3 sale $96,000 × 27% ----------- 25,920
$61,590
GP of Year 5:
Cash collected from year 5 sale $45,000 × 25% ----------- $11,250
Cash collected from year 4 sale $87,000 × 29% ----------- 25,230
Cash collected from year 3 sale $45,000 × 27% ----------- 12,150
$48,630

4. During the Production Process

- How do we recognize revenue for enterprises engaged in large construction projects that
may take several years for completion such as roads, bridge, building, dams etc?

- Two basic methods of accounting for long-term construction contracts are used by the
accounting profession: (a) the completed-contract method, and (b) the percentage-of
completion method.

Completed-Contract Method
- Neither revenue nor the related costs would be recognized until the project is completed.
Thus no profit is recognized until the project is completed. It is consistent with the point-of-
sale recognition rule. This method is used only when
• the percentage-of-completion method is inapplicable- when there is uncertainty or future
costs are unpredictable making it difficult to estimate the progress of work done based on
which periodic revenue is recognized.
• the project is completed within a short period (such as 3 or 6 months)

Percentage-of-Completion Method

- This method says revenue producing activities have been performed during each year of
construction and revenue should be recognized in each year of construction even if estimation is
needed not when the project is completed. Thus recognizing revenue in only the year that the
contractual obligation is completed (completed-contract method) distorts revenue throughout the
project’s life making it less popular.

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- The percentage-of-completion method recognizes revenue, costs and the related profit from
the project periodically throughout the life of the project. This is the preferred method and is
more widely used.

- This method recognizes revenue in each period based on the estimated stage (degree) of
completion. Thus the conditions to use this method are:

1. When it is possible to estimate the degree of completion (progress of work done). Two
methods are used to measure the degree of completion:
a. Accounting estimate-- Cost-to-cost method—level of work
done is estimated by comparing total costs incurred to date to total costs expected
for the entire job. This method has become one of the most popular measures
used. We assume a relatively constant relationship exists between the two.
b. Engineering estimate—estimates provided by engineers
To use the cost to cost method it must be possible to estimate future construction costs.
2. The construction period is long

Percentage-of-Completion- Steps: Cost-to-Cost method

1. Estimated percentage of completion = ___Costs incurred to date______

Most recent estimated total costs*

* = Construction costs + Estimated costs to complete

incurred to date construction
Note that the estimated costs to complete should reflect any expected price increase
(e.g wage, materials, and OH items separately)
2. Revenue to date = Estimated total revenue × Estimated percentage of completion
3. Current period revenue = Revenue to date - Revenue recognized in prior periods
4. Gross profit = Current Period Revenue - Current costs
Illustration
Assume that XYZ Construction Co. has a contract starting beginning of year 1, to construct
a Br 30,000,000 bridge that is expected to be completed by the end of year 3 at estimated
cost of Br 26,000,000. The following data pertains to the construction period.
Year1 Year2 Year3
Costs to date Br 5,200,000 Br 19,800,000 Br 26,400,000
Estimated costs to complete 20,800,000 6,600,000 -0-
Required:
Compute revenue and operating income for the three years using the percentage-of-
completion method and the completed-contract method.
Solution
Completed-contract Method
Revenue, Cost, and Gross profit are zero for Year 1 and Year 2.
For Year 3:
Revenue ------------- Br 30,000,000
Costs ------------------ 26,400,000

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 Gross profit Br 3,600,000
Note that period costs (operating expenses) such as general and administrative expenses would
be deducted from gross profit to determine net income in each year.
Percentage-of-Completion Method
Year 1 Year2 Year 3
a. % complete to date 5,200,000 = 20% 19,800,000 = 75% 100 %
26,000,000 26,400,000
Estimated revenue and GP

Revenue recognized 30,000,000 × 20% 30,000,000 × 75% 30,000,000

= 6,000,000 less 6,000,000 less 22,500,000
= 16,500,000 = 7,500,000
Gross Profit recognized
Revenue 6,000,000 16,500,000 7,500,000
Less: Cost 5,200,000 14,600,000 6,600,000
Gross Profit 800,000 1,900,000 900,000

Note that the method used to recognize revenue on a long-term contract should be noted in
the financial statements.

Comparison of the two methods:

- The principal advantage of the completed-contract method is that it is based on final results,
whereas the P-of-c method is dependent upon estimates for unperformed work. The principal
disadvantage of the completed-contract method is that when the period of a contract extends
into more than one period, there will be an irregular recognition of income.

Matching

- Expenses are resources used up to generate revenues.

- To avoid overstatement of income in any one period, the matching principle requires that   
revenues and related expenses be recorded in the same accounting period. Thus it requires that
expenses be recorded when incurred in earning revenues regardless of when cash is actually
paid.

- All costs directly associated with a given revenue must be matched with that revenue.

- Some expenses are not associated with specific revenue items but with a given time period.
Expenditures, for instance for plant asset, must be allocated over their useful life and remain as
unexpired cost or assets.

a. An asset account is established when cash is paid for property or services before they are
used up. The asset is an expense deferral since it will be used in the future (deferred).
b. A liability account is used when cash is not paid out when services are provided by
employees or goods are received from suppliers. The liability is an expense accrual

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 because the expense has been accrued or increased before cash is actually spent. The
cash payment will occur in the future.
c. Expenses are outflows of net assets. Expenses are decreases of assets or increases in
liabilities. Expenses are recorded by the historical cost expended or to be expended (cost
principle).

Full Disclosure

- This principle states that information important enough to influence the decisions of an
informed user of the financial statement should be disclosed. Depending on its nature, this
information should be disclosed:

a) The financial statements—formalized, structured means of communicating financial

information. To be recorded in the financial statements, an item should meet the
definition of a basic element, be measurable with sufficient certainty, and be relevant
and reliable.

b) Notes to the financial statement—generally amplify or explain the items presented in

the main body of the statements. Information in the notes does not have to be
quantifiable, nor does it need to qualify as an element. Some of the things which are
disclosed in note are:

 Accounting Methods (Policies) used—when there are several acceptable alternative

methods that could have a significant effect on amounts reported on the statements
such as inventory costing and depreciation methods and the revenue recognition
method used.

 Changes in accounting estimates—if the effect of the change in estimate on net

income is material for the year in which the change is made. Examples are change in
life and/or salvage value of long-lived assets, change in the uncollectible rate for
receivables.

 Contingent liabilities—these are potential obligations that will materialize only if

certain events occur in the future. If they are probable and reasonable estimable, they
must be recorded in the accounts. Examples include vacation payable and warranty
payable. If the amount cannot be reasonably estimated, the details of the contingency
should be disclosed in notes to the financial statements. The most common examples
are potential liabilities related to litigation, guarantees, and discounting receivables.

 Events subsequent to date of statements—events occurring or becoming known

after the financial statement date but before their issuance should be disclosed if they
have a significant effect on the financial statements. Examples are loss from fire or
other calamites, issuance of long-term debt or capital stock, the purchase of another
business enterprise.

c) Supplementary statements (information)—may include details or amounts that present

a different perspective from that adopted in the financial statements. It may be

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 quantifiable information that is high in relevance but low in reliability, or information
that is helpful but not essential. A summary of interim financial statements in the annual
reports of publicly owned corporations. Diversified companies are involved in more than
one type of business activity and may also operate in foreign markets. To enable users of
the financial statements to evaluate the activities, growth potential, profitability, and
business risks of diversified enterprises, they are required to disclose information such as
revenue, income from operations, and identifiable assets associated with its business
segments that are significant with respect to the enterprise as a whole.

- Deciding how much disclosure is enough is difficult. Both inadequate disclosure and
excessive disclosure have their own problem.

Consistency

- The amount and direction of change in net income and financial position from period to
period is very important to readers and may greatly influence their decision. This requires the
application of the consistency concept. Accounting information is consistent if the same
accounting principles and measurement technique are applied in a similar manner from one
period to another (fiscal year to fiscal year, current quarter to past quarters, etc). We need to be
consistent b/c our financial statements should show the effect of the operation undertaken in the
organization not the effect of changes in accounting system. However, changes are not totally
prohibited. Accounting principles may be changed, if the change results in better reporting.
But if accounting methods are changed, the justification for, and the nature and effect of the
change in income, must be disclosed in the financial statements of the period in which the
change is made.
- Examples are change in inventory method, depreciation method, and method of accounting
for long-term construction contracts.

- The effect of the change in accounting principles is generally reported as cumulative effect
of change in accounting principle, based on retroactive computation, on the income statement of
the period in which the change is adopted. In some cases, the effect of the change could be
applied retroactively to past periods by presenting revised income statement for the earlier years
affected.

- The consistency concept does not require that a specific accounting method be used
uniformly throughout an enterprise. Different inventory costing and deprecation methods could
be used, for example, for different types of inventories and classes of assets.

Materiality

- The materiality concept proposes that there is no need to adhere to GAAP if the amounts
involved are insignificant (immaterial). The reason is that the decision of a reasonable person
will not be affected by the treatment if such items making the extra effort required to process
insignificant items not cost effective. Information is material if it can have an effect on a
decision made by users.
- For example if bad debt is estimated not to be large enough to affect decision made by users,
the direct write off method can be used. Another example is the treatment of low-cost asset such

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 as pencil sharpener, and waste baskets. Saving in clerical costs and convenience lend their hand
for such a practice. The practice of reporting amounts in the financial statements to the nearest
dollar or even the nearest hundreds or thousand of dollars (in large corporations) is justified by
materiality.

- Materiality is a matter of the relative significance of the element. Both quantitative and
qualitative judgments factors (e.g nature of the item) are to be considered in determining relative
significance.

Conservatism

- Conservatism is a reaction to uncertainty. When uncertainty exists as to a specific

accounting treatment, the users of financial statements are better served by understatement than
by overstatement of NI and assets. Conservatism is considered as a safeguard against the danger
of overstatement of earnings or financial position.
- Prime examples of its application: The use of LCM approach in valuing inventories;
accounting for uncollectibility of receivables; and Non-recognition of gain on disposal of plant
assets under special circumstances.

Exercise 1
Year 1 Year 2 Year 3
Installment sales $150,000 $100,000 $200,000
Cost of goods sold 112,500 -- ---
GP to Cost ratio 1:4
GP based on sales 35%
Collection from:
This year 50,000 30,000 80,000
Previous year 40,000 20,000
The year before the prev. --- 42,000

Required: Compute gross profit for year 2 and year 3 using the installment method

Exercise 2
Given the following data
Year1 Year2 Year3
Cost incurred in the year $1,200,000 c f
Estimated costs to complete a $3,400,000 -0-
from the end of this year
Revenue recognized for the year 1,500,000 4,500,000 e
Gross profit for the year b d $1,000,000

Required: Compute the missing figures assuming contract price of $10 million.

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