1.01 Generally Accepted Accounting Principles – Accounting Constraints, Concepts, Assumptions, and Principles GAAP PowerPoint #3

Hierarchy of Qualitative Information Understandability Decision Usefulness Relevance Predictive Value Feedback Value Timeliness Reliability Verifiability Neutrality Representational Faithfulness Comparability and Consistency Cost/Benefit Discussed in PPT #2 http://www.fasb.org/jsp/FASB/Page/SectionPage&cid=1176156317989 Click on agreement, select yes Page 18 will contain the diagram above Materiality www.fasb.org

Constraints Cost Effectiveness Materiality Conservatism A constraint is a limit, regulation, or confinement within prescribed bounds. This term refers to the accounting guidelines that border the Hierarchy of Qualitative Information They consist of: Cost Effectiveness Materiality Conservatism

Cost Effectiveness Constraint Also called Cost Benefit Constraint The cost of providing accounting information should not exceed the benefit of the information it is reporting. Example: Your checkbook register and bank statement differs by $0.10. Rather than waste time to find the $0.10, the accountant should record the amount as miscellaneous expense or income.

Materiality Constraint Material means big enough to make a difference in the user’s decision-making process. States that the requirements of any accounting principle may be ignored when there is no effect on the decisions of the user of financial information. Example: A company purchases a Trashcan for $10. Per GAAP, this amount should be capitalized as an asset and depreciated. Because the amount is immaterial, the $10 can be recorded as an expense.

Conservatism Constraint Accountants use their judgment to record transactions that require estimation. Conservatism helps the accountant choose between 2 equally likely alternatives. Requires the accountant to record the transaction using the less optimistic choice. Example: There is the potential for a customer to sue the company. Although, the customer may choose not to sue, the accountant will disclose this potential lawsuit to investors.

Concepts Recognition Concept Measurement Concept Concepts are the ground rules of accounting that should be followed when preparing financial statements. These are: Recognition Concept Measurement Concept

Recognition Concept States that an item should be recognized (recorded) in the financial statements when: It can be defined by GAAP assumptions and principles It can be measured It is relevant to decision-making by users It is reliable

Measurement Concept States that every transaction is measured by the stated unit of measurement, such as the dollar The stated procedure of valuing assets, liabilities, equity, revenue, and expenses as defined by GAAP

Assumptions Assumptions are agreed upon rules of accounting, and are basic, understood beliefs. There are Four Basic Assumptions of Accounting: Economic Business Entity Going Concern Monetary Unit Time Period

Economic Business Entity Assumption All of the business transactions should be separate from the business owner’s personal transactions There should be no co-mingling of personal funds with business funds.

Going Concern Assumption Financial statements are prepared under the assumption that the company will remain in business indefinitely unless there is sufficient evidence otherwise. If there is evidence that a company may possibly have a going concern issue, this must be disclosed in the financial statements.

Monetary Unit Assumption Assumes a stable currency is going to be the unit of record. FASB accepts the nominal value of the US Dollar as the monetary unit of record unadjusted for inflation.

Time Period Assumption The entity’s activities are separated into periods of time such as months, quarters or years. Transactions must be accounted for within the time period they occur regardless of when cash is exchanged.

Principles of Accounting Principles are accounting rules used to prepare, present, and report financial statements. Principles dictate how events should be recorded and reported.

Cost Principle Assets are recorded at historical cost, not fair market value. For example, if a company purchases a building for $500,000 it should be recorded as such, and should remain on the books for that amount until disposed of. If the building appreciates to $700,000 in the next few years, no adjustment should be made.

Full Disclosure Principle All information pertaining to the operations and financial position of the entity must be reported within the period of time in question. Circumstances and events that make a difference to financial statement users should be disclosed.

Revenue Recognition Principle Revenue is earned and recognized upon product delivery or service completion, without regard to when cash is actually received. Also called accrual basis accounting Example: A customer purchases inventory from a company on credit. Even though no cash has yet been received, the sale is recorded.

Matching Principle The costs of doing business are recorded in the same period as the revenue they help generate, regardless of when the money is actually paid. Also called accrual basis accounting Example: A company orders merchandise on credit and has 30 days in which to pay. This purchase is recorded immediately, even though no cash has been paid.

Questions for Understanding/Discussion Explain what is meant by “The benefits of accounting information must exceed the costs.” What is meant by the term materiality in financial reporting? What is meant by the term conservatism in financial reporting? Explain the Going Concern assumption. Explain the Time Period assumption. Explain the accounting principles that guide accounting practice.