ACCOUNTING THEORY UNDERLYING FINANCIAL ACCOUNTING

5-1 CHAPTER ACCOUNTING THEORY UNDERLYING FINANCIAL ACCOUNTING 5-2 Accounting Theory Defined “ 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.” 173 Structure of Accounting Theory Formal Approach Accounting theory provides a logical framework for accounting practice 5-3 Structure of Accounting Theory Formal Approach Accounting theory provides a logical framework for accounting practice ASSUMPTIONS 5-4 Structure of Accounting Theory Formal Approach Accounting theory provides a logical framework for accounting practice PRINCIPLES ASSUMPTIONS 5-5 Structure of Accounting Theory Formal Approach Accounting theory provides a logical framework for accounting practice RULES PRINCIPLES ASSUMPTIONS 5-6 Structure of Accounting Theory Informal Approach Accounting Theory Accounting theory is somewhat like a cloud, i.e not well-defined 5-7 Structure of Accounting Theory Informal Approach The terms "assumptions", "principles", "rules", "concepts", "postulates", "standards", etc are used many different ways in the profession Therefore, the authors' classification of these terms is not important to us in this course i.e., you not have to understand the authors’ theory structure - just know the meaning and relevance of the items/“ideas” on the following slides 5-8 5-9 Business Entity “Idea” Each Each business business has has an an identity identity separate separate from from its its owners owners The The business business is is the the accounting accounting entity entity Financial Financial statements statements report report only only the the activities, activities, resources, resources, and and obligations obligations of of that that business business 5-10 Going-Concern In In the the absence absence of of evidence evidence to to the the contrary, contrary, we we assume assume that that aa business business will will continue continue to to exist exist indefinitely indefinitely For For example, example, aa company company is is more more likely likely to to acquire acquire long-term long-term assets assets ifif itit can can assume assume that that the the company company will will continue continue to to exist exist indefinitely indefinitely ItIt is is fundamental fundamental to to the the matching matching principle principle 5-21 Major Principles/Ideas Exchange-Price Exchange-Price or or Historical Historical Cost Cost Matching Matching Revenue Revenue Recognition Recognition Expense Expense Recognition Recognition Gain Gain and and Loss Loss Recognition Recognition Full Full Disclosure Disclosure All All transactions transactions are are recorded recorded at at their their historical historical cost cost at at the the time time of of the the transaction transaction 5-22 Major Principles/Ideas Exchange-Price Exchange-Price or or Cost Cost Matching Matching Revenue Revenue Recognition Recognition Expense Expense Recognition Recognition Gain Gain and and Loss Loss Recognition Recognition Full Full Disclosure Disclosure The The most most important important principle principle ItIt provides provides the the basis basis for for accrual accrual accounting accounting 5-23 Major Principles/Ideas Exchange-Price Exchange-Price or or Historical Historical Cost Cost Matching Matching Revenue Revenue Recognition Recognition Expense Expense Recognition Recognition Gain Gain and and Loss Loss Recognition Recognition Full Full Disclosure Disclosure Revenues Revenues are are recorded recorded when when they they are are earned earned (i.e., (i.e., realized) realized) When When does does this this happen? happen? When Whentitle titlepasses passes Exceptions to Revenue Recognition Principle   Cash Cash basis basis of of revenue revenue recognition recognition   Installment Installment basis basis of of revenue revenue recognition recognition (Need (Need only only know know concept, concept, not not how how to to apply) apply)   Percentage-of-completion Percentage-of-completion basis basis of of revenue revenue recognition recognition   Revenue Revenue recognition recognition at at completion completion of of production production (Need (Need only only know know concept, concept, not not how how to to apply) apply) 180 181 5-24 5-25 Major Principles/Ideas Exchange-Price Exchange-Price or or Historical Historical Cost Cost Matching Matching Revenue Revenue Recognition Recognition Expense Expense Recognition Recognition Gain Gain and and Loss Loss Recognition Recognition Full Full Disclosure Disclosure Expenses Expenses should should be be recorded recorded as as they they are are incurred incurred in in the the process process of of earning earning revenues revenues 5-26 Major Principles/Ideas Exchange-Price Exchange-Price or or Historical Historical Cost Cost Matching Matching Revenue Revenue Recognition Recognition Expense Expense Recognition Recognition Gain Gain and and Loss Loss Recognition Recognition Full Full Disclosure Disclosure The The rules rules are are different different for for recognition recognition of of gains gains and and losses losses 5-27 Gain and Loss Recognition Gains Gains are are recognized/recorded recognized/recorded at at the the time time they they are are realized realized For Forexample, example,an anincrease increasein inthe thevalue valueof ofland land cannot cannotbe berecognized recognizedas as aagain gainuntil untilthe theland landis is actually sold actuallysold sold sold 5-28 Gain and Loss Recognition Gains Gains are are recognized/recorded recognized/recorded at at the the time time they they are are realized realized For Forexample, example,an anincrease increasein inthe thevalue valueof ofland land cannot cannotbe berecognized recognizedas as aagain gainuntil untilthe theland landis is actually sold actuallysold sold sold Losses Losses are are recognized recognized when when they they become become apparent apparent For Forexample, example,aa decrease decreasein inthe thevalue valueof of inventory inventorywould would be be recognized recognizedas asaaloss losswhen when itit becomes becomesapparent apparent 5-29 Major Principles/Ideas Exchange-Price Exchange-Price or or Historical Historical Cost Cost Matching Matching Revenue Revenue Recognition Recognition Expense Expense Recognition Recognition Gain Gain and and Loss Loss Recognition Recognition Full Full Disclosure Disclosure Disclose Disclose in in the the financial financial statements statements or or related related notes, notes, all all information information important important enough enough to to influence influence aa stakeholder stakeholder 5-30 Cost-Benefit Consideration Optional Optional information information should should be be included included in in the the primary primary financial financial statements statements only only ifif the the benefits benefits of of providing providing itit exceed exceed the the costs costs For Forexample, example,providing providingaalisting listingof ofevery every sales salestransaction transactionmay may be be interesting, interesting, but but the thecost cost of ofproviding providingthat that information informationto toevery everyshareholder shareholder might mightbankrupt bankruptthe thecompany company 5-31 Materiality An An item item is is material material ifif knowledge knowledge of of the the item item would would affect affect the the decision decision of of an an informed informed user, user, therefore, therefore, this this is is aa somewhat somewhat nebulous nebulous concept concept Material Material items items must must be be reported reported An An item item can can be be material material either either in in amount amount or or in in nature nature Materiality Materiality in in amount amount is is relative relative to to the the size size of of the the amounts amounts on on aa company’s company’s fin fin stmts stmts (e.g (e.g.$50,000,000 $50,000,000 may may not not be be material material …) …) 5-32 Conservatism Transactions Transactions should should be be recorded recorded so so that that net net assets assets and and net net income income are are not not overstated overstated Anticipate Anticipate losses, losses, but but do not not anticipate anticipate gains gains Appears Appears in in the the notes notes to to the the financial financial statements statements Includes Includes aa discussion discussion of of the the major major accounting accounting policies policies pp 195 -197 Summary of Significant Accounting Policies 5-33 5-34 Almost Finished A good framework is the best foundation y a m m u Yo p fro i sk 18 B p S rk A (F ewo to am ect) r F oj 95 of P r p ar y nt m a m fi c g u i n i S n t ( ig n S cou es) i Ac olic P 5-35 Conclusion Virtual Keypad Questions [...]... but do do not not anticipate anticipate gains gains Appears Appears in in the the notes notes to to the the financial financial statements statements Includes Includes aa discussion discussion of of the the major major accounting accounting policies policies pp 195 -197 Summary of Significant Accounting Policies 5-33 5-34 Almost Finished A good framework is the best foundation y a m m u Yo p fro 6 i... have both both aa debit debit effect effect and and aa credit credit effect effect on on the the primary primary financial financial statements statements Total Total debits debits must must equal equal total total credits credits Articulation Articulation The The primary primary financial financial statements statements are are fundamentally fundamentally related related to to each each other other... Disclose Disclose in in the the financial financial statements statements or or related related notes, notes, all all information information important important enough enough to to influence influence aa stakeholder stakeholder 5-30 Cost-Benefit Consideration Optional Optional information information should should be be included included in in the the primary primary financial financial statements statements... companies companies use use the the same same principles principles A A change change from from one one acceptable acceptable accounting accounting principle principle to to another another must must be be disclosed disclosed in in the the notes notes to to the the financial financial statements statements 5-19 Other Basic Ideas Double-Entry Double-Entry Bookkeeping Bookkeeping Every Every transaction... subsidiary companies are legally separate entities, GAAP says that a set of consolidated financial statements must be prepared as if they were one company, i.e., one economic entity 5-18 Other Basic Ideas Consistency Consistency Requires Requires that that aa company company use use the the same same accounting accounting principles principles from from one one period period to to the the next next... and Loss Loss Recognition Recognition Full Full Disclosure Disclosure The The most most important important principle principle ItIt provides provides the the basis basis for for accrual accrual accounting accounting 5-23 Major Principles/Ideas Exchange-Price Exchange-Price or or Historical Historical Cost Cost Matching Matching Revenue Revenue Recognition Recognition Expense Expense Recognition Recognition