BUS 120: Financial Accounting Chapter 7: Accounting Principles Dr. Al Taccone

Chapter 7: What you should learn The conceptual Framework of accounting * Qualitative characteristics * Elements of financial statements * Operating guidelines Assumptions Principles Constraints Financial statement presentation

THE CONCEPTUAL FRAMEWORK OF ACCOUNTING Generally accepted accounting principles are a set of rules and practices that are recognized as a general guide for financial reporting purposes. Generally accepted means that these principles must have substantial authoritative support. This support usually comes from the Financial Accounting Standards Board (FASB) and Securities and Exchange Commission (SEC). The FASB has the responsibility for developing accounting principles in the United States. 2

QUALITATIVE CHARACTERISTICS OF ACCOUNTING INFORMATION The FASB concluded that the overriding criterion by which accounting choices should be judged is decision usefulness. To be useful, information should possess the following qualitative characteristics: 1 relevance, 2 reliability, and 3 comparability and consistency. 5

THE OPERATING GUIDELINES OF ACCOUNTING Operating guidelines are classified as assumptions, principles, and constraints. Assumptions provide a foundation for the accounting process. Principles indicate how transactions and other economic events should be recorded. Constraints permit a company to modify generally accepted accounting principles without reducing the usefulness of the reported information. Assumptions Monetary unit Economic entity Time period Going concern Principals Revenue recognition Matching Full disclosure Cost Constraints Materiality Conservatism 17

ASSUMPTIONS Monetary unit Only transaction data that can be expressed in terms of money should be included in the accounting records of a company. Economic entity Economic events can be identified with a particular unit of accountability and are separate from actual owner’s financial data. Going concern Assumes a business will continue in operation long enough to carry out existing objectives. Time Period The economic life of a business can be divided into artificial time periods.

PRINCIPLES Revenue recognition Revenue should be recognized in the accounting period in which it is earned. Matching Expenses should be matched with revenues in the period in which the revenues are earned. (i.e. the need for prepaid expenses) Full disclosure Circumstances and events that make a difference to financial statement users be disclosed. Cost Asset must always be recorded at their cost and remain at their cost.

CONSTRAINTS Materiality Relates to an item’s impact on a firm’s overall financial condition and operations. Conservatism When in doubt, the accountant chooses the method that will be the least likely to overstate assets and income. In other words, use the method that will result in the conservative reporting of assets and income.

STANDARD CLASSIFICATION OF BALANCE SHEET The balance sheet is composed of 3 major elements: 1 assets, 2 liabilities, and 3 stockholders’ equity. Additional segregation within these groups is considered useful to financial statement readers. The following classification breakdown is usually found: 15

FINANCIAL STATEMENT RATIO ANALYSIS Expresses the relationship among selected items of financial statement data. Ratios measures: Liquidity—short term ability to pay maturing obligations. Profitability—the income or operating success of a business for a given period of time. Solvency—the ability of a business to survive over a long period of time.

Financial Ratios Earnings per share—income earned by each share of common stock (profitability ratio) Net income ÷ Number of shares outstanding Current ratio—short-term debt-paying ability (liquidity) Current assets ÷ Current liabilities

Financial Ratios (continued) Working capital—excess of current assets over current liabilities (liquidity). Current assets - Current liabilities Profit margin—percentage of each dollar of sales that results in net income (profitability). Net income ÷ Net sales

Financial Ratios (continued) Return on assets—overall measure of return on investment on assets (profitability). Net income ÷ Total assets Return on common stockholder’s equity—measure return on equity (profitability) Net income ÷ Common equity

Financial Ratios (continued) Debt to total assets—measures ability of business to survive over long periods of time (solvency). Total debt ÷ Total assets

FINANCIAL STATEMENT PRESENTATION The multiple-step income statement for Sellers Electronix, Inc. in Chapter 5 included the following: 1 Sales revenue section – Presents the sales, discounts, allowances, and other related information to arrive at the net amount of sales revenue. 2 Cost of goods sold – Indicates the cost of goods sold to produce sales. 3 Operating expenses – Provides information on both selling and administrative expenses. 4 Other revenues and gains – Indicates revenues earned or gains resulting from non-operating transactions. 5 Other expenses and losses – Indicates expenses or losses incurred from non-operating transactions.

INCOME STATEMENT WITH INCOME TAXES Note that income before income taxes is reported before income tax expense. LEADS INC. Income Statement For the Year Ended December 31, 2002 Sales $ 800,000 Cost of goods sold 600,000 Gross profit 200,000 Operating expenses 50,000 Income from operations 150,000 Other revenues and gains 10,000 Other expenses and losses 4,000 Income before income taxes 156,000 Income tax expense 46,800 Net income $ 109,200