Module 5 Exhibits and Key Terms. Table of Contents. 1 Principles of Accounting Adjustments for Financial Reporting

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1 Table of Contents Prerequisites... 2 Useful Links... 2 References... 2 Exhibit 27: The underlying assumptions or concepts... 3 Exhibit 28: Methods of accounting for long-term contracts... 4 Exhibit 29: The major principles... 4 Exhibit 30: Modifying conventions... 5 Exhibit 31: A hierarchy of accounting qualities... 6 Key terms Principles of Accounting Adjustments for Financial Reporting

2 Prerequisites This course is part of a suite of courses designed to help students understand the language of accountancy, its use in decision making. Key to this are the processes and procedures used on a daily, monthly and annual basis to record, report on and analyze all the financial transactions of a business. Previous courses include 1. Accounting and Its Use in Business Decisions 2. Recording Business Transactions in Accounting 3. Adjustments for Financial Reporting 4. Completing the Accounting Cycle You may need to study some of the above to understand and complete this course Useful Links American Accounting Association Financial Accounting Standards Board's (FASB) American Institutes of Chartered Public Accountants (AICPA) Securities and Exchange Commission (SEC) International Financial Reporting Standards (IFRS) References Material referenced from the Financial Accounting Standards Board in the course content can be found at standards concepts statements FASB, Statement of Financial Accounting Concepts No. 1, "Objectives of Financial Reporting by Business Enterprises" (1978) FASB, Statement of Financial Accounting Concepts No. 2, "Qualitative Characteristics of Accounting Information" (1980) FASB, Statement of Financial Accounting Concepts No. 3, "Elements of Financial Statements of Business Enterprises" (1980) FASB Statement of Financial Accounting Concepts No. 6, "Elements of Financial Statements" (1985) Copyright by the Financial Accounting Standards Board, High Ridge Park, Stamford, Connecticut 06905, U.S.A. 2 Principles of Accounting Adjustments for Financial Reporting

3 Exhibit 27: The underlying assumptions or concepts Assumption / Concept Description Importance Business entity Going concern (continuity) Money measurement Stable dollar Periodicity (time periods) General-purpose financial statements. Substance over form Consistency Double entry Articulation Each business has an existence separate from its owners, creditors, employees, customers, other interested parties, and other businesses. An entity will continue to operate indefinitely unless strong evidence exists that the entity will terminate. Each business uses a monetary unit of measurement, such as the dollar, instead of physical or other units of measurement. The dollar is accepted as a reasonably stable unit of measure. An entity's life can be subdivided into months or years to report its economic activities. One set of financial statements serves the needs of all users. Accountants should record the economic substance of a transaction rather than its form. Generally requires that a company use the same accounting principles and reporting practices every accounting period. Every transaction has a twosided effect on each company or party engaging in the transaction. Financial statements are fundamentally related and articulate (interact) with each other. Defines the scope of the business such as a horse stable or physical fitness centre. Identifies which transactions should be recorded on the company's books Allows a company to continue carrying plant assets at their historical costs in spite of a change in their market values. Provides accountants with a common unit of measure to report economic activity. This concept permits us to add and subtract items on the financial statements. Permits us to make no adjustments in the financial statements, for the changing value of the dollar. This assumption works fairly well in the United States because of our relatively low inflation. Permits us to prepare financial statements that cover periods shorter than the entire life of a business. Thus, we know how well a business is performing before it terminates its operations. The need for adjusting entries arises because of this concept and the use of accrual accounting. Allows companies to prepare only one set of Financial statements instead of a separate set for each potential type of user of those statements. The financial statements should be free of bias so they do not favor the interests of any one type of user Encourages the accountant to record the true nature of a transaction rather than its apparent legal nature. This approach is the accounting equivalent of "tell it like it is". An apparent lease transaction that has all the characteristics of a purchase should be recorded as a purchase. Prevents a company from changing accounting methods whenever it likes to present a better picture or to manipulate income. The inventory and depreciation chapters (chapters 7 and 10) both mention the importance of this concept. Uses a system of checks and balances to help identify whether or not errors have been made in recording transacti0ns. When the debits do not equal the credits, this inequality immediately signals us to stop and find the error. Changes in account balances during an accounting period are reflected in financial statements that are related to one another. For instance, earning revenue increases net income on the income statement, retained earnings on the statement of retained earnings, and assets and retained earnings on the balance sheet. The statement of retained earnings ties the income statement and balance sheet together. 3 Principles of Accounting Adjustments for Financial Reporting

4 Exhibit 28: Methods of accounting for long-term contracts Number of Companies Percentage of completion Units of delivery Completed contract Source: American Institute of Certified Public Accountants, Accounting Trends & Techniques (New York: AICPA, 2004), p. 432 Exhibit 29: The major principles Principle Description Importance Exchange-price (or cost) Requires transfers of resources to be recorded at prices agreed on by the parties to the exchange at the time of the exchange Tells the accountant to record a transfer of resources at an objectively determinable amount at the time of the exchange. Also, selfconstructed assets are recorded at their actual cost rather than at some estimate of what they would have cost if they had been purchased. Revenue recognition Matching Gain and loss recognition Full disclosure Revenues should be earned and realized before they are recognized (recorded). Expenses should be recognized (recorded) as they are incurred to produce revenues Gains may be recorded only when realized, but losses should be recorded when they first become evident. Information important enough to influence the decisions of an informed user of the financial statements should be disclosed. Informs accountant that revenues generally should be recognized when services are performed or goods are sold. Exceptions are made for items such as installment sales and long-term construction projects Indicates that expenses are to be recorded as soon as they are incurred rather than waiting until some future time Tells the accountant to be conservative when recognizing gains and losses. Gains can only be recognized when they have been realized through sale or exchange. Losses should be recognized as soon as they become evident. Thus, potential losses can be recorded, but only gains that have actually been realized can be recorded. Requires the accountant to disclose everything that is important. A good rule to follow is: if in doubt, disclose. Another good rule is: if you are not consistent, disclose all the facts and the effect on income. 4 Principles of Accounting Adjustments for Financial Reporting

5 Exhibit 30: Modifying conventions Modifying Convention Description Importance Cost-benefit Materiality Conservatism Optional information should be included financial statements only if the benefits providing it exceed its costs. Only items that would affect a knowledgeable user's decision are material (important) and must be reported in a theoretically correct way. Transactions should be recorded so that assets and net income are not overstated. Lets the accountant know that information that is not required should be made available only if its benefits exceed its costs. An example may be companies going to the expense of providing information on the effects of inflation when the inflation rate is low and/or users do not seem to benefit significantly from the information. Allow accountants to treat immaterial (relatively small dollar amount) information in a theoretically incorrect but expedient manner. For instance, a wastebasket can be expensed rather than capitalized and depreciated even though it may last for 30 years. Warns accountants that assets and net income are not to be overstated. "Anticipate (and record) all possible losses and do not anticipate (or record) any possible gains" is common advice under this constraint. Also, conservative application of the matching principle involves making sure those adjustments for expenses for such items as uncollectible accounts, warranties, and depreciation are adequate. 5 Principles of Accounting Adjustments for Financial Reporting

6 Exhibit 31: A hierarchy of accounting qualities 6 Principles of Accounting Adjustments for Financial Reporting

7 Key terms Accounting theory "A set of basic concepts and assumptions and related principles that explain and guide the accountant's actions in identifying, measuring, and communicating economic information. Bias Exists when accounting measurements are consistently too high or too low. Bias Exists when accounting measurements are consistently too high or too low. Business entity concept The specific unit for which accounting information is gathered. Business entities have a separate existence from owners, creditors, employees, customers, other interested parties, and other businesses. Comparability A qualitative characteristic of accounting information; when information is comparable, it reveals differences and similarities that are real and are not the result of differing accounting treatments. Completed-contract method A method of recognizing revenue on long-term projects under which no revenue is recognized until the period in which the project is completed; similar to recognizing revenue upon the completion of a sale. Completeness A qualitative characteristic of accounting information; requires disclosure of all significant information in a way that aids understanding and does not mislead; sometimes called the full disclosure principle. Conservatism Being cautious or prudent and making sure that net assets and net income are not overstated. Consistency Requires a company to use the same accounting principles and reporting practices through time. Cost-benefit consideration Determining whether benefits of including information in financial statements exceed costs. Cost principle See Exchange-price principle. Earning principle The requirement that revenue be substantially earned before it is recognized (recorded). Exchange-price (or cost) principle Transfers of resources are recorded at prices agreed on by the parties at the time of the exchange. Feedback value A qualitative characteristic that information has when it reveals the relative success of users in predicting outcomes. Financial reporting objectives The broad overriding goals sought by accountants engaging in financial reporting. Full disclosure principle Information important enough to influence the decisions of an informed user of the financial statements should be disclosed. Gain and loss recognition principle Gains may be recorded only when realized, but losses should be recorded when they first become evident. Gains Typically result from the sale of long-term assets for more than their book value. Going-concern (continuity) assumption The assumption that an entity will continue to operate indefinitely unless strong evidence exists that the entity will terminate. Historical cost The amount paid, or the fair market value of a liability incurred or other resources surrendered, to acquire an asset and place it in a condition and position for its intended use.bonds payable Written promises to pay a definite sum at a certain date as evidenced by formal printed certificates that are sometimes secured by liens on property, such as mortgages. Installment basis A revenue recognition procedure in which the percentage of total gross margin recognized in a period on an installment sale is equal to the percentage of total cash from the sale that is received in that period. Liquidation Terminating a business by ceasing business operations and selling off its assets. Losses Asset expirations that are usually involuntary and do not create revenues. Matching principle Expenses should be recognized as they are incurred to produce revenues. 7 Principles of Accounting Adjustments for Financial Reporting

8 Materiality A modifying convention that allows the accountant to deal with immaterial (unimportant) items in an expedient but theoretically incorrect manner; also a qualitative characteristic specifying that financial accounting report only information significant enough to influence decisions or evaluations. Modifying conventions Customs emerging from accounting practice that alter the results obtained from a strict application of accounting principles; conservatism is an example. Money measurement Use of a monetary unit of measurement, such as the dollar, instead of physical or other units of measurement feet, inches, grams, and so on. Neutrality A qualitative characteristic that requires accounting information to be free of measurement method bias. Percentage-of-completion method A method of recognizing revenue based on the estimated stage of completion of a long-term project. The stage of completion is measured by comparing actual costs incurred in a period with total estimated costs to be incurred in all periods. Period costs Costs that cannot be traced to specific products and are expensed in the period incurred. Periodicity (time periods) assumption An assumption of the accountant that an entity's life can be divided into time periods for reporting its economic activities. Predictive value A qualitative characteristic that information has when it improves users' abilities to predict outcomes of events. Product costs Costs incurred in the acquisition or manufacture of goods. Product costs are accounted for as if they were attached to the goods, with the result that they are charged to expense when the goods are sold. Qualitative characteristics Characteristics that accounting information should possess to be useful in decision making. Realization principle A principle that directs that revenue is recognized only after the seller acquires the right to receive payment from the buyer. Relevance A qualitative characteristic requiring that information be pertinent to or affect a decision. Reliability A qualitative characteristic requiring that information faithfully depict for users what it purports to represent. Representational faithfulness A qualitative characteristic requiring that accounting statements on economic activity correspond to the actual underlying activity. Revenue recognition principle The principle that revenues should be earned and realized before they are recognized (recorded). Stable dollar assumption An assumption that the dollar is a reasonably stable unit of measurement. Timeliness A qualitative characteristic requiring that accounting information be provided at a time when it may be considered before making a decision. Verifiability A qualitative characteristic of accounting information; information is verifiable when it can be substantially duplicated by independent measurers using the same measurement methods. 8 Principles of Accounting Adjustments for Financial Reporting