ACCOUNTING PRINCIPLES Third Canadian Edition Prepared by: Keri Norrie, Camosun College

ACCOUNTING PRINCIPLES CHAPTER 11

CONCEPTUAL FRAMEWORK OF ACCOUNTING Generally accepted accounting principlesare a set of rules and practices that are recognized as a general guide for financial reporting purposesGenerally 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 supportGenerally accepted means that these principles must have substantial authoritative support TheCanadian Institute of Chartered Accountants (CICA)is responsible for developing accounting principles in CanadaThe Canadian Institute of Chartered Accountants (CICA) is responsible for developing accounting principles in Canada

CICA’S CONCEPTUAL FRAMEWORK The conceptual framework consists of:The conceptual framework consists of: –objective of financial reporting, –qualitative characteristics of accounting information, –elements of financial statements, and –recognition and measurement criteria (assumptions, principles, and constraints)

OBJECTIVE OF FINANCIAL REPORTING The objective of financial reporting is to provide information that is useful for decision-makingThe objective of financial reporting is to provide information that is useful for decision-making

QUALITATIVE CHARACTERISTICS OF ACCOUNTING INFORMATION The accounting alternative selected should be one that generates the most useful financial information for decision makingThe accounting alternative selected should be one that generates the most useful financial information for decision making To be useful, information should possess the following qualitative characteristics:To be useful, information should possess the following qualitative characteristics: 1. understandability 2. relevance 3. reliability 4.comparability and consistency

UNDERSTANDABILITYUNDERSTANDABILITY Information must be understandable to its usersInformation must be understandable to its users Users are assumed to have a reasonable comprehension of, and ability to study, the accounting, business, and economic concepts needed to understand the informationUsers are assumed to have a reasonable comprehension of, and ability to study, the accounting, business, and economic concepts needed to understand the information

RELEVANCERELEVANCE Accounting information is relevant if it makes a difference in a decisionAccounting information is relevant if it makes a difference in a decision Relevant information helps users forecast future events (predictive value), or it confirms or corrects prior expectations (feedback value)Relevant information helps users forecast future events (predictive value), or it confirms or corrects prior expectations (feedback value) Information must be available to decision makers before it loses its capacity to influence their decisions (timeliness)Information must be available to decision makers before it loses its capacity to influence their decisions (timeliness)

RELIABILITYRELIABILITY Reliability of information means that the information is free of error and bias–it can be depended onReliability of information means that the information is free of error and bias–it can be depended on To be reliable, accounting information must be verifiable–there must be proof that it is free of error and biasTo be reliable, accounting information must be verifiable–there must be proof that it is free of error and bias The information must be a faithful representation of what it purports to be–it must be factualThe information must be a faithful representation of what it purports to be–it must be factual

COMPARABILITY AND CONSISTENCY Comparability means that the information should be comparable with the accounting information of other enterprisesComparability means that the information should be comparable with the accounting information of other enterprises Consistency means that the same accounting principles and methods should be used from year to year within a companyConsistency means that the same accounting principles and methods should be used from year to year within a company

Assumptions Going concern Monetary unit Economic entity Time period Principles Revenue recognition Matching Full disclosure Cost Constraints Cost-benefit Materiality Recognition and measurement criteria used by accountants to solve practical problems include assumptions, principles, and constraintsRecognition and measurement criteria used by accountants to solve practical problems include assumptions, principles, and constraints Assumptions provide a foundation for the accounting processAssumptions provide a foundation for the accounting process Principles indicate how economic events should be reported in the accounting processPrinciples indicate how economic events should be reported in the accounting process Constraints permit a company to modify generally accepted accounting principles without reducing the usefulness of the reported informationConstraints permit a company to modify generally accepted accounting principles without reducing the usefulness of the reported information RECOGNITION AND MEASUREMENT CRITERIA

GOING CONCERN ASSUMPTION The going concern assumption assumes that the company will continue to operate in the foreseeable future Implications: property, plant, and equipment is recorded at cost instead of liquidation value, amortization is used, items are labeled as current or non-current

The monetary unit assumption states that only transaction data capable of being expressed in terms of money should be included in the accounting records of the economic entityThe monetary unit assumption states that only transaction data capable of being expressed in terms of money should be included in the accounting records of the economic entity Also assumes unit of measure ($) remains sufficiently stable over time; ignores inflationary and deflationary effectsAlso assumes unit of measure ($) remains sufficiently stable over time; ignores inflationary and deflationary effects MONETARY UNIT ASSUMPTION Should not be included in accounting records Customer satisfaction Percentage of international employees Salaries paid Should be included in accounting records

ECONOMIC ENTITY ASSUMPTION The economic entity assumption states that economic events can be identified with a particular unit of accountabilityThe economic entity assumption states that economic events can be identified with a particular unit of accountability Example: Harvey’s activities can be distinguished from those of other food service providers such as Swiss ChaletExample: Harvey’s activities can be distinguished from those of other food service providers such as Swiss Chalet

TIME PERIOD ASSUMPTION The time period assumption states that the economic life of a business can be divided into artificial time periods Example: months, quarters, and years QTR 1 QTR 2 QTR 3 QTR JAN FEB MAR APR MAY JUN JUL AUG SEPT OCT NOV DEC

The revenue recognition principle states that revenue should be recognized in the accounting period in which it is earnedThe revenue recognition principle states that revenue should be recognized in the accounting period in which it is earned Revenue should be recognized when all of the following guidelines are met:Revenue should be recognized when all of the following guidelines are met: –Production/sales essentially complete –Revenues measurable –Collection reasonably assured –Expenses determinable REVENUE RECOGNITION PRINCIPLE

Revenue can be recognized:Revenue can be recognized: 1. At point of sale 2. During production 3.At completion of production 4.Upon collection of cash REVENUE RECOGNITION

PERCENTAGE-OF-COMPLETION METHOD OF REVENUE RECOGNITION The percentage-of-completion method recognizes revenue and income on the basis of reasonable estimates of the project’s progress toward completionThe percentage-of-completion method recognizes revenue and income on the basis of reasonable estimates of the project’s progress toward completion A project’s progress toward completion is measured by comparing the costs incurred in a year to total estimated costs of the entire projectA project’s progress toward completion is measured by comparing the costs incurred in a year to total estimated costs of the entire project

FORMULA TO RECOGNIZE REVENUE IN THE PERCENTAGE-OF-COMPLETION METHOD (ILLUSTRATION 11-3) FORMULA TO RECOGNIZE REVENUE IN THE PERCENTAGE-OF-COMPLETION METHOD (ILLUSTRATION 11-3) The costs incurred in the current period are then subtracted from the revenue recognized during the current period to arrive at the gross profit ÷ = Cost Incurred (Current Period) Total Estimated Cost Percent Complete (Current Period) Total Revenue Revenue Recognized (Current Period) = 

REVISING PERCENTAGE-OF-COMPLETION METHOD (ILLUSTRATION 11-4) It may not be possible to estimate costs with absolute accuracy each year. Realistically, revisions of cost estimates are often necessary. Such revisions require a slightly revised formula. By using costs to date and percentage complete to date, revised revenue to date can be calculated. By subtracting revenue already recognized, the amount of revenue for the current period is calculated. ÷= Cost Incurred (To Date) Total Estimated Cost Percent Complete (To Date) Percent Complete (To Date) Total Revenue Revised Revenue (To Date) =  Revised Revenue (To Date) Revenue Recognized Previously Revenue Recognized (Current Period ) = –

INSTALMENT METHOD OF REVENUE RECOGNITION The cash basis is generally used only when it is difficult to determine the revenue amount at the time of a credit sale because collection is so uncertainThe cash basis is generally used only when it is difficult to determine the revenue amount at the time of a credit sale because collection is so uncertain The instalment method, which uses the cash basis, is a popular approach to revenue recognitionThe instalment method, which uses the cash basis, is a popular approach to revenue recognition Under the instalment method, gross profit is recognized in the period in which the cash is collectedUnder the instalment method, gross profit is recognized in the period in which the cash is collected

GROSS PROFIT FORMULA– INSTALMENT METHOD ( ILLUSTRATION 11-5) INSTALMENT METHOD ( ILLUSTRATION 11-5) GROSS PROFIT FORMULA– INSTALMENT METHOD ( ILLUSTRATION 11-5) INSTALMENT METHOD ( ILLUSTRATION 11-5) Under the instalment method, each cash collection from a customer consists of Under the instalment method, each cash collection from a customer consists of –a partial recovery of the cost of goods sold, and –a partial gross profit from the sale The formula to recognize gross profit is shown below: The formula to recognize gross profit is shown below: Sales Revenue Gross Profit Margin Gross Profit Gross Profit Margin Cash Collections from Customer Gross Profit Recognized during the period   = =

Expense recognition is traditionally tied to revenue recognitionExpense recognition is traditionally tied to revenue recognition This practice–referred to as the matching principle–dictates that expenses be matched with revenues in the period in which efforts are expended to generate revenuesThis practice–referred to as the matching principle–dictates that expenses be matched with revenues in the period in which efforts are expended to generate revenues MATCHING PRINCIPLE

Expired costs are costs that will generate revenues only in the current period and are therefore reported as operating expenses on the income statementExpired costs are costs that will generate revenues only in the current period and are therefore reported as operating expenses on the income statement Unexpired costs are costs that will generate revenues in future accounting periods and are recognized as assetsUnexpired costs are costs that will generate revenues in future accounting periods and are recognized as assets MATCHING PRINCIPLE MATCHING PRINCIPLE

Unexpired costs become expenses through: 1.Cost of goods sold – Costs carried as merchandise inventory are expensed as cost of goods sold in the period when the sale occurs; there is a direct matching of expenses with revenues 2.Operating expenses – Unexpired costs become operating expenses through use or consumption or through the passage of time MATCHING PRINCIPLE

FULL DISCLOSURE PRINCIPLE The full disclosure principle requires that circumstances and events that make a difference to financial statement users be disclosedThe full disclosure principle requires that circumstances and events that make a difference to financial statement users be disclosed Compliance with the full disclosure principle is accomplished through:Compliance with the full disclosure principle is accomplished through: 1. the data in the financial statements and 2. the notes that accompany the statements A summary of significant accounting policies is usually the first note to the financial statementsA summary of significant accounting policies is usually the first note to the financial statements

COST PRINCIPLE The cost principle dictates that assets are recorded at their historic costThe cost principle dictates that assets are recorded at their historic cost Cost is used because it is both relevant and reliableCost is used because it is both relevant and reliable 1.Cost is relevant because it represents the price paid, the assets sacrificed, or the commitment made at the date of acquisition 2.Cost is reliable because it is objectively measurable, factual, and verifiable

CONSTRAINTS IN ACCOUNTING Constraints permit a company to modify generally accepted accounting principles without reducing the usefulness of the reported informationConstraints permit a company to modify generally accepted accounting principles without reducing the usefulness of the reported information The constraints are cost-benefit and materialityThe constraints are cost-benefit and materiality 1.Cost-benefit means that the value of information should be greater than the cost of providing it 2.Materiality relates to an item’s impact on a firm’s overall financial condition and operations

CONCEPTUAL FRAMEWORK– SUMMARY Objective of Financial Reporting Qualitative Characteristics of Accounting Information Elements of Financial Statements Recognition and Measurement Criteria AssumptionsPrinciplesConstraints

INTERNATIONAL ACCOUNTING STANDARDS World markets are intertwinedWorld markets are intertwined The International Accounting Standard Board (IASB) has more than 150 member accounting organizations representing more than 110 countriesThe International Accounting Standard Board (IASB) has more than 150 member accounting organizations representing more than 110 countries The IASB has issued over 40 international accounting standards to obtain uniformity in international accounting practicesThe IASB has issued over 40 international accounting standards to obtain uniformity in international accounting practices

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