Accounting

Principles

Prepared by:
Md Masud Chowdhury
[email protected]
 Generally Accepted Accounting
Principles (GAAP)
CHAPTER
• Financial accounting information is historical in
nature, reporting on what has happened in the past.
To facilitate comparisons between companies, this
information must conform to certain accounting
standards or principles called generally accepted
accounting principles (GAAP). These generally
accepted accounting principles for businesses or
GAAP
governmental organizations have developed through
accounting practice or been established by an
authoritative organization.
The Financial Accounting Standards Board (FASB) develops the
Generally Accepted Accounting Principles (GAAP). The process
of developing GAAP include:

• FASB members issue a discussion memorandum,

• FASB collects all responses and suggestions from Securities and Exchange
Commission (SEC), the American Institute of Certified Public Accountants
(AICPA), the American Accounting Association (AAA), public accounting
firms, and other involved parties.
• FASB presents the exposure draft,
• FASB obtains responses to the exposure draft from Securities and Exchange
Commission (SEC), the American Institute of Certified Public Accountants
(AICPA), the American Accounting Association (AAA), public accounting
firms, and other involved parties.
• FASB issues the final statement of principle, all principles are modified and
refined as accountants respond to constantly changing business environment.
 Generally Accepted Accounting
Principles

Assumptions:
1.Accounting Entity Constraints
2.Going Concern 1.Estimates and Judgments
3.Measurement and Units of Measure of 2.Materiality
a company – 3.Consistency
4.Periodicity 4.Conservatism

Principles:
1)Historical Cost –
2)Revenue Recognition
3)Matching Principle
4)Disclosure –
 Assumption#1.
Assumption#1. Accounting
Accounting Entity
Entity

A company is considered a separate “living” enterprise, apart from its

owners. In other words, a corporation is a “fictional” being:
 It has a name.
 It has a birthdate and birthplace (referred to as incorporation
date and place, respectively).
 It is engaged in clearly defined activities.
 It regularly reports its financial health (through financial
reports) to the general public.
 It pays taxes.
 It can file lawsuits.
 Why Assume “Accounting Entity”?

• It Provides Context. The accounting entity assumption

enables users of financial reports to tell whose financials they
are reviewing and therefore places those financials into
context.

• It Promotes Ownership. The assumption of a company as a

separate economic entity promotes ownership in the business,
since its current and future owners know that their financial
liability is limited to the value of their investment while they
are legally shielded from any potential lawsuits brought
against the company.
 Assumption 2: Going Concern

• A company is considered viable and a “going

concern” for the foreseeable future. In other words, a
corporation is assumed to remain in existence for an
indefinitely long time.
• Exxon Mobil, for example, has existed since 1882,
and General Electric has been around since 1892;
both of these companies are expected to continue to
operate in the future. To assume that an entity will
continue to remain in business is fundamental to
accounting for publicly held companies.
 Why Assume “Going Concern”?

• The going concern assumption essentially says that a company

expects to continue operating indefinitely; that is, it expects to
realize its assets at the recorded amounts and to extinguish its
liabilities in the normal course of business.

• If this assumption is incorrect or untenable for a particular

company (think of a liquidation or a fire sale), then the methods
prescribed by Generally Accepted Accounting Principles
(GAAP) for accounting for various transactions would need to
be adjusted, with consequences to revenues, expenses, and
equity.
 Assumption 3: Measurement and
Units of Measure

Financial statements have limitations; they show only measurable activities of

a corporation such as its quantifiable resources, its liabilities (money owed by
it), amount of taxes facing it, and so forth. For example, financial statements
exclude:
•Internally developed trademarks and patents (think of Coke, Microsoft,
General Electric)—the value of these brands cannot be quantified or
recorded.

•Employee and customer loyalty—their value is undeterminable. Since

financial statements show only measurable activities of a company, they must
be reported in the national monetary unit: U.S. financial statements are
reported in U.S. dollars (Exhibit 2.2); European financial statements now use
the euro as a standard monetary unit.
 Assumption 4: Periodicity

• A continuous life of an entity can be divided into

measured periods of time, for which financial
statements are prepared. U.S. companies are
required to file quarterly (10-Q) and annual (10-K)
financial reports. Typically one calendar year
represents one accounting year (usually referred to as
a fiscal year) for a company. Be aware that while
many corporations align their fiscal years with
calendar years, others do not.
 Summing Up the Accounting
Assumption

We have just covered four assumptions in accounting:

•Accounting Entity – A corporation is considered a “living, fictional” being

•Going Concern – A corporation is assumed to remain in existence

indefinitely.

•Unitsof Measure of a company – Measurement and Financial statements

show only measurable activities. Financial statements must be reported in the
national monetary unit (i.e., U.S. dollars for U.S. companies).

•Periodicity – A company’s continuous life can be divided into measured

periods of time for which financial statements are prepared. U.S. companies
are required to file quarterly and annual reports.
GAAP • Principle 1: Historical Cost

Principles • Principle 2: Revenue

Recognition.

• Principle 3: Matching
Principle.

• Principle 4. Full Disclosure

 Principle 1: Historical Cost

• Financial statements report companies’ resources at

an initial historical or acquisition cost.
• Let’s assume a company purchased a piece of land
for $1 million 10 years ago. Under GAAP, it will
continue to record this original purchase price
(typically called book value) even though the market
value (referred to as fair value) of this land has risen
to $10 million.
 Why is such undervaluation of a
company’s resources required?
There are two reasons:
• It represents the easiest measurement method without the
need for constant appraisal and revaluation. Just imagine the
considerable amount of effort and subjectivity required to
determine the fair value of all of General Electric’s resources
(plants, facilities, land) every year.

• Additionally, marking resources up to fair value allows for

management discretion and subjectivity, which GAAP
attempts to minimize by using historical cost.
 Principles 2 and 3
Accrual Basis

Accrual basis of accounting is one of the

most important concepts in accounting, and
governs the company’s timing in recording
its revenues (i.e., sales) and associated
expenses.
 Principle 2: Revenue Recognition.

Accrual basis of accounting dictates that

revenues must be recorded when earned and
measurable.
 Principle 3: Matching Principle.

• Under the matching principle, costs

associated with making a product must be
recorded (“matched” to) the revenue
generated from that product during the
same period.
 The following transactions occurred on the specified
dates:

 Amazon.com purchases a book from a publisher for $10 on May 5, 2008.

 Amazon.com receives a $20 credit card order for that book on December
29, 2009.
 The book is shipped to the customer on January 4, 2010.
 Amazon.com receives cash on February 1, 2010.

From the options above, when should Amazon.com record revenue and
Expenses?
In line with the accrual principles of accounting, Amazon.com will record
$20 in revenues and $10 in expenses on January 4, 2008.
Why can’t companies immediately record these revenues and expenses?
According to the revenue recognition principle, a company cannot record
revenue until that order is shipped to a customer (only then is the revenue
actually earned) and collection from that customer, who used a credit
card, is reasonably assured.
 Principle 4: Full Disclosure

Under the full disclosure principle, companies must

reveal all relevant economic information that they
determine to make a difference to their users. Such
disclosure should be accomplished in the following
sections of companies’ reports:
•Financial statements
•Notes to financial statements
•Supplementary information
Summing up The Accounting Principles

We just covered four underlying principles in accounting:

•Historical Cost – Financial statements report companies’
resources and obligations at an initial historical cost. This
conservative measure precludes constant appraisal and
revaluation.
•Revenue Recognition – Revenues must be recorded when
earned and measurable.
•Matching Principle – Costs of a product must be recorded
during the same period as revenue from selling it.
•Disclosure – Companies must reveal all relevant economic
information determined to make a difference to their users.
 Constraint 1: Estimates and
Judgments

Certain measurements cannot be performed completely

accurately, and must therefore utilize conservative
estimates and judgments.

•For example, a company cannot fully predict the

amount of money it will not collect from its customers,
who having purchased goods from it on credit,
ultimately decide not to pay. Instead, a company must
make a conservative estimate based on its past
experience with bad customers.
 Constraint 2: Materiality

• Inclusion and disclosure of financial transactions in

financial statements hinge on their size and effect on
the company performing them.

• Note that materiality varies across different entities;

a material transaction (taking out a $1,000 loan) for a
local lemonade stand is likely immaterial for General
Electric, whose financial information is reported in
billions of dollars.
 Constraint 3: Consistency

• For each company, the preparation of financial

statements must utilize measurement techniques and
assumptions that are consistent from one period to
another.
• Keep in mind that, companies can choose among
several different accounting methods to measure the
monetary value of their inventories. What matters is
that a company consistently applies the same
inventory method across different fiscal years.
 Constraint 4: Conservatism

Financial statements should be prepared with

a downward measurement bias. Assets and
revenues should not be overstated, while
liabilities and expenses should not be
understated.
STEPS IN THE ACCOUNTING CYCLE
1. Analyse
transactions 2. Journalize the
9. Coming transactions
next chapter
3. Post to ledger
accounts
8. Coming
4. Prepare a
next chapter
trial balance

7. Prepare 5. Journalize
financial and post
statements adjusting
6. Prepare
adjusted trial entries
balance
 Questions

THANKS