2. Accounting Principles Financial Accounting, Sixth Edition
Chapter 7
Accounting Principles
Financial Accounting, Sixth Edition

3. Study Objectives
Explain the meaning of GAAP and identify the key items of the conceptual framework.
Describe the basic objectives of financial reporting.
Discuss the qualitative characteristics of accounting information and elements of financial statements.
Identify the basic assumptions used by accountants.
Identify the basic principles of accounting.
Identify the two constraints in accounting.
Understand and analyze classified financial statements.
Explain the accounting principles used in international operations.
1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements?
Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases).
Forward-looking Information
Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image).
Timeliness (no real time financial information)

4. Accounting Principles
The
Conceptual
Framework of
Accounting
Assumptions
Principles
Constraints in Accounting
Statement Presentation and Analysis
Objectives of reporting
Qualitative characteristics
Elements of financial statements
Operating guidelines
Monetary unit
Economic entity
Time period
Going concern
Revenue recognition
Matching
Full disclosure
Cost
Materiality
Conservatism
Summary of conceptual framework
Classified balance sheet
Classified income statement
Analyzing financial statements
An international perspective
Service Cost - Actuaries compute service cost as the present value of the new benefits earned by employees during the year. Future salary levels considered in calculation.
Interest on Liability - Interest accrues each year on the PBO just as it does on any discounted debt.
Actual Return on Plan Assets - Increase in pension funds from interest, dividends, and realized and unrealized changes in the fair market value of the plan assets.
Amortization of Unrecognized Prior Service Cost - The cost of providing retroactive benefits is allocated to pension expense in the future, specifically to the remaining service-years of the affected employees.
Gain or Loss - Volatility in pension expense can be caused by sudden and large changes in the market value of plan assets and by changes in the projected benefit obligation. Two items comprise the gain or loss:
difference between the actual return and the expected return on plan assets and,
amortization of the unrecognized net gain or loss from previous periods

5. The Conceptual Framework of Accounting
Financial Statements
Balance Sheet
Income Statement
Statement of Retained Earnings
Statement of Cash Flows
Note Disclosure
Various users need financial information
The accounting profession has attempted to develop a set of standards that are generally accepted and universally practiced.
Generally Accepted Accounting Principles (GAAP)
SO 1 Explain the meaning of GAAP and identify the key items of the conceptual framework.

6. The Conceptual Framework of Accounting
Organizations Involved in Standard Setting:
Securities and Exchange Commission (SEC)
Financial Accounting Standards Board (FASB)
SO 1 Explain the meaning of GAAP and identify the key items of the conceptual framework.

7. The Conceptual Framework of Accounting
Conceptual Framework - “…a constitution, a coherent system of interrelated objectives and fundamentals.”
FASB’s conceptual framework consists of the following:
Objectives of financial reporting.
Qualitative characteristics of accounting information.
Elements of financial statements.
Operating guidelines (assumptions, principles, and constraints).
SO 1 Explain the meaning of GAAP and identify the key items of the conceptual framework.

8. Conceptual Framework Review: True True False
A conceptual framework underlying financial accounting is important because it can lead to consistent standards and it prescribes the nature, function, and limits of financial accounting and financial statements.
Technical Bulletins provide answers to specific questions related to the application and implementation of FASB Statement or Interpretations, APB Opinions, and ARBs. Technical Bulletins do not alter GAAP; they merely provide guidance on questions related to existing GAAP.
True
True
False
SO 1 Explain the meaning of GAAP and identify the key items of the conceptual framework.

9. Conceptual Framework Review: True False False
A conceptual framework underlying financial accounting is necessary because future accounting practice problems can be solved by reference to the conceptual framework and a formal standard-setting body will not be necessary.
Technical Bulletins provide answers to specific questions related to the application and implementation of FASB Statement or Interpretations, APB Opinions, and ARBs. Technical Bulletins do not alter GAAP; they merely provide guidance on questions related to existing GAAP.
True
False
False
SO 1 Explain the meaning of GAAP and identify the key items of the conceptual framework.

10. Conceptual Framework Review:
What are the Statements of Financial Accounting Concepts intended to establish?
Generally accepted accounting principles in financial reporting by business enterprises.
The meaning of “Present fairly in accordance with generally accepted accounting principles.”
The objectives and concepts for use in developing standards of financial accounting and reporting.
The hierarchy of sources of generally accepted accounting principles.
(CPA adapted)
SO 1 Explain the meaning of GAAP and identify the key items of the conceptual framework.

11. Objectives of Financial Reporting
Conceptual Framework
Objectives of Financial Reporting
To provide information that is useful to those making investment and credit decisions.
Helpful in assessing future cash flows.
Identify the economic resources (assets), the claims to those resources (liabilities), and the changes in those resources and claims.
SO 2 Describe the basic objectives of financial reporting.

12. Conceptual Framework Review:
According to the FASB conceptual framework, the objectives of financial reporting for business enterprises are based on?
Generally accepted accounting principles
Reporting on management’s stewardship.
The need for conservatism.
The needs of the users of the information.
(CPA adapted)
SO 2 Describe the basic objectives of financial reporting.

13. Conceptual Framework Question: Answer:
How does a company choose an acceptable accounting method, the amount and types of information to disclose, and the format in which to present it?
Answer:
By determining which alternative provides the most useful information for decision-making purposes (decision usefulness).
SO 3 Discuss the qualitative characteristics of accounting information and elements of financial statements.

14. Qualitative Characteristics
Conceptual Framework
Qualitative Characteristics
Relevance – making a difference in a decision.
Predictive value
Feedback value
Timeliness
Reliability
Verifiable
Representational faithfulness
Neutral - free of error and bias
SO 3 Discuss the qualitative characteristics of accounting information and elements of financial statements.

15. Qualitative Characteristics
Conceptual Framework
Qualitative Characteristics
Comparability – Information that is measured and reported in a similar manner for different companies is considered comparable.
Consistency - When a company applies the same accounting treatment to similar events from period to period.
SO 3 Discuss the qualitative characteristics of accounting information and elements of financial statements.

16. True True False True False False
Conceptual Framework
Review:
Relevance and reliability are the two primary qualities that make accounting information useful for decision making.
True
True
False
To be reliable, accounting information must be capable of making a difference in a decision.
True
False
False
SO 3 Discuss the qualitative characteristics of accounting information and elements of financial statements.

17. Conceptual Framework Review: True False False
Adherence to the concept of consistency requires that the same accounting principles be applied to similar transactions for a minimum of five years before any change in principle is adopted.
True
False
False
SO 3 Discuss the qualitative characteristics of accounting information and elements of financial statements.

18. Elements of Financial Statements
Conceptual Framework
Elements of Financial Statements
“Moment in Time”
“Period of Time”
Assets
Liabilities
Equity
Revenue
Expenses
Gains
Losses
SO 3 Discuss the qualitative characteristics of accounting information and elements of financial statements.

19. Conceptual Framework Elements
Illustration: Identify the element or elements associated with items below.
Elements
(a) Obligation to transfer resources arising from a past transaction.
(b) Items characterized by future economic benefit.
(c) Arises from income statement activities that constitute the entity’s ongoing major or central operations.
(b)
Assets
Liabilities
Equity
Revenue
Expenses
(a)
(c)
(c)
SO 3 Discuss the qualitative characteristics of accounting information and elements of financial statements.

20. Conceptual Framework Elements
Illustration: Identify the element or elements associated with items below.
Elements
(d) Residual interest in the net assets of the enterprise.
(e) Increases assets through sale of product.
(b)
Assets
Liabilities
Equity
Revenue
Expenses
(a)
(d)
(e)
(c)
(c)
SO 3 Discuss the qualitative characteristics of accounting information and elements of financial statements.

21. Conceptual Framework Review:
According to the FASB conceptual framework, an entity’s revenue may result from
A decrease in an asset from primary operations.
An increase in an asset from incidental transactions.
An increase in a liability from incidental transactions.
A decrease in a liability from primary operations.
(CPA adapted)
SO 3 Discuss the qualitative characteristics of accounting information and elements of financial statements.

22. Conceptual Framework
Operating Guidelines

23. Assumptions
Assumptions provide a foundation for the accounting process.
Monetary Unit
Economic Entity
Periodicity
Going Concern
SO 4 Identify the basic assumptions used by accountants.

24. Monetary Unit Assumptions
Only transaction data capable of being expressed in terms of money should be included in the accounting records of the economic entity.
SO 4 Identify the basic assumptions used by accountants.

25. Economic Entity Assumptions Economic events can be identified with
a particular unit of accountability.
SO 4 Identify the basic assumptions used by accountants.

26. Time Period Assumptions
The economic life of a business can be divided into artificial time periods.
SO 4 Identify the basic assumptions used by accountants.

27. Going Concern Assumptions
The enterprise will continue in operation long enough to carry out its existing objectives.
SO 4 Identify the basic assumptions used by accountants.

28. Assumptions
Illustration: Identify which basic assumption of accounting is best described in each item below.
The economic activities of FedEx Corporation are divided into 12-month periods for the purpose of issuing annual reports.
(b) Solectron Corporation, Inc. does not adjust amounts in its financial statements for the effects of inflation.
(c) Walgreen Co. reports current and noncurrent classifications in its balance sheet.
(d) The economic activities of General Electric and its subsidiaries are merged for accounting and reporting purposes.
Periodicity
Monetary
Unit
Going Concern
Economic
Entity
SO 4 Identify the basic assumptions used by accountants.

29. Principles
Accounting principles dictate how economic events should be recorded and reported.
Revenue Recognition
Matching (Expense Recognition)
Full Disclosure
Cost
SO 5 Identify the basic principles of accounting.

30. Principles
Revenue Recognition - companies should recognize revenue in the accounting period in which it is earned.
SO 5 Identify the basic principles of accounting.

31. Principles
Matching - efforts (expenses) should be matched with accomplishment (revenues) whenever it is reasonable and practicable to do so. “Let the expense follow the revenues.”
Illustration Expense Recognition
SO 5 Identify the basic principles of accounting.

32. Matching Principle Principles
Illustration Basic Principles
SO 5 Identify the basic principles of accounting.

33. Principles
Full Disclosure – Provided through financial statements, notes to the financial statements, and supplementary information.
Illustration Basic Principles
SO 5 Identify the basic principles of accounting.

34. Principles
Cost Principle – the price, established by the exchange transaction, is the “cost”.
Illustration Basic Principles
SO 5 Identify the basic principles of accounting.

35. Principles
Illustration: Identify which basic principle of accounting is best described in each item below.
(a) Norfolk Southern Corporation reports revenue in its income statement when it is earned instead of when the cash is collected.
(b) Yahoo, Inc. recognizes depreciation expense for a machine over the 2-year period during which that machine helps the company earn revenue.
(c) Oracle Corporation reports information about pending lawsuits in the notes to its financial statements.
(d) Eastman Kodak Company reports land on its balance sheet at the amount paid to acquire it, even though the estimated fair market value is greater.
Revenue
Recognition
Matching
Full
Disclosure
Cost
SO 5 Identify the basic principles of accounting.

36. Constraints in Accounting
Constraints permit a company to modify generally accepted accounting principles without reducing the usefulness of the reported information.
Materiality
Conservatism
SO 6 Identify the two constraints in accounting.

37. Constraints in Accounting
Materiality - an item is material if its inclusion or omission would influence or change the judgment of a reasonable person.
Illustration Constraints
SO 6 Identify the two constraints in accounting.

38. Constraints in Accounting
Conservatism - When in doubt, choose the method that will be least likely to overstate assets and income.
Illustration Constraints
SO 6 Identify the two constraints in accounting.

39. Constraints in Accounting
Illustration What accounting constraints are illustrated by the items below?
(a) Crimson Tide Corporation does not accrue a contingent lawsuit gain of $650,000.
(b) Sun Devil Corporation expenses the cost of wastebaskets in the year they are acquired.
Conservatism
Materiality
SO 6 Identify the two constraints in accounting.

40. Summary of Conceptual Framework

41. Statement Presentation and Analysis
Classified Balance Sheet
Illustration Standard classification
SO 7 Understand and analyze classified financial statements.

42. Statement Presentation and Analysis
Classified Balance Sheet
Illustration 7-9 Proprietorship balance sheet
A proprietorship, the balance sheet uses the term
“Owner’s equity” instead of “Stockholders’ equity”
SO 7 Understand and analyze classified financial statements.

43. Statement Presentation and Analysis
Classified Balance Sheet
Illustration Partnership balance sheet
In a partnership, each partner has a separate capital
account.
SO 7 Understand and analyze classified financial statements.

44. Statement Presentation and Analysis
Classified Income Statement
A multiple-step income statement generally includes the following.
Sales revenue
Cost of goods
Operating
Other revenues and gains
Other expenses and losses
Two additional items are income tax expense and earnings per share.
SO 7 Understand and analyze classified financial statements.

45. Statement Presentation and Analysis
Classified Income Statement
Illustration Income taxes
SO 7 Understand and analyze classified financial statements.

46. Number of Common Shares Outstanding
Statement Presentation and Analysis
Classified Income Statement
Net Income
Earnings Per Share =
Number of Common Shares Outstanding
Indicates the net income earned by each share of outstanding common stock.
SO 7 Understand and analyze classified financial statements.

47. Statement Presentation and Analysis
Analyzing Financial Statements
Three major characteristics are generally used:
Liquidity,
Profitability, and
Solvency.
SO 7 Understand and analyze classified financial statements.

48. Statement Presentation and Analysis
Liquidity
This ratio means that current assets are more than two times greater than current liabilities.
SO 7 Understand and analyze classified financial statements.

49. Statement Presentation and Analysis
Liquidity
Working capital provides some indication of the company’s
ability to meet its existing current obligations.
SO 7 Understand and analyze classified financial statements.

50. Statement Presentation and Analysis
Profitability
SO 7 Understand and analyze classified financial statements.

51. Statement Presentation and Analysis
Profitability
Profitability ratios measure the income or operating success of a company for a given period of time.
Profit Margin Percentage measures the percentage of each dollar of sales that results in net income.
SO 7 Understand and analyze classified financial statements.

52. Statement Presentation and Analysis
Profitability
Return on Assets is an overall measure of profitability.
Return on Common Equity shows the percentage of net income earned for each dollar of owners’ investment.
SO 7 Understand and analyze classified financial statements.

53. Statement Presentation and Analysis
Solvency
Solvency measures the ability of an enterprise to survive over a long period of time.
Debt to Total Assets measures the percentage of total assets that creditors, as opposed to stockholders, provide.
SO 7 Understand and analyze classified financial statements.

54. Statement Presentation and Analysis
An International Perspective
There are few recognized worldwide accounting standards. The International Accounting Standards Board (IASB), of which the United States is a member, is working to obtain conformity in international accounting practices.
SO 8 Explain the accounting principles used in international operations.

55. All About You Corporations Have Governance Structures—Do You?
Scandals and bankruptcies at Enron, WorldCom, and other companies brought many changes to the way America does business.
Many companies have developed a code of ethics to:
deter wrongdoing
promote honest and ethical conduct
indicate that management takes ethics seriously.

56. All About You Corporations Have Governance Structures—Do You?
Some Facts:
Under Sarbanes-Oxley, a company must disclose whether it has a code of ethics.
Enron had a code of ethics. Enron’s board of directors knowingly waived requirements of the code so that the CFO could set up and run special purpose entities.
In a recent survey of 1,436 workers, 34% said that they have seen unethical activities at their workplace, but only 47% said they are likely to report these activities.

57. All About You
Stockholders often lose money as a result of unethical behavior by management and they often file lawsuits against the company in an effort to recoup these losses.
Source: Elaine Buckberg, Todd Foster, and Ronald I. Miller, “Recent Trends in Shareholder Class Action Litigation: Are WorldCom and Enron the New Standard?” NERA Economic Consulting, (accessed June 26, 2006).

58. All About You What Do You Think?
Many universities have become concerned about student cheating. Many schools now have student ethics codes. Do you think that these ethics codes serve a useful purpose?
YES: Anything that will reduce unethical behavior is a good thing.
NO: The existence of an ethics code won’t affect student behavior.

59. Copyright
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