Download Accounting Theory Defined

ACCOUNTING THEORY
UNDERLYING FINANCIAL
ACCOUNTING
Introduction to Accounting
Theory
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What is Accounting Theory
Accounting Theory & Policy Making
Measurement
Accounting Theory is defined as
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the basic
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assumptions
definitions
principles and
concepts that underlie the
rule making by a
legislative body
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the reporting of
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accounting and
financial information
applicable to financial
accounting, not to
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governmental or
managerial
Accounting Theory includes
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Conceptual Frameworks
Accounting Legislation
Concepts
Valuation Models
Hypotheses and Theories
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.
Development of
Accounting
Standards
Development of Accounting
Standards
History ..
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Prior to Securities act of 1933 and 1934 little
financial reporting was required.
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The securities acts assigned the power of
accounting role making for publicly held
companies to SEC
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They also required most publicly held
companies to be audited by independent
CPAs
The Standard Setting Process:
Parties Involved
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The (SEC) in turn delegated rule making to American
Institute of Certified Public Accountants (AICPA).
The Committee on Accounting Procedures (CAP) was
formed by (AICPA) in 1938-59 and issued 51
Accounting Research Bulletins (ARBs).
Accounting Principles Board (APB) issued 31 Opinions
from 1959-73
The financial Accounting Foundation (FAF) was created
by (AICPA) in 1973 and oversees 2 other bodies:
 Financial Accounting Standards Board (FASB) has
issued over 140 Statements (SFASs)from1973-present
 Governmental Accounting Standards Board (GASB)
International Accounting
Standards
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The International Accounting Standards
Committee (IASC) was formed in 1973.
The objective was to narrow divergence in
international financial reporting.
There are many similarities between U.S.
and International accounting standards.
The concern is that international standards
may not be as rigorous as U.S. standards.
History
1973 International Accounting Standards
Committee (IASC) founded by 10
national accountancy organisations.
1981 All members of IFAC became
members of IASC.
1999 100+ countries. Structure reviewed.
2001 International Accounting Standards
Board (IASB) began operations.
2005 Europe, Australia, 90+ countries
adopting IFRS
Structure
Trustees (19)
(appoint Board, IFRIC and
SAC)
(6 North America, 6 Europe, 4
Asia/Pacific, 3 Other)
IASB
Structure
Standards Advisory
Council (SAC)
(advises Board)
National standard
setters
(Australia/NZ,
Canada, France,
Germany, Japan,
UK, US.)
Board (14)
(approves IAS
[IFRS], ED, SIC
[IFRIC])
7 Liaison
Members
Intnl. Financial Reporting
Interpretations Committee
(12+1)
(publishes draft
Interpretations and prepares
draft of final Interpretations)
IASC Foundation
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19 trustees:
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6 from North America
6 from Europe
4 from Asia Pacific
3 from any area
Appoint IASB members, SAC and IFRIC
Monitor IASB’s effectiveness, raise funds,
approve budget, responsible for constitution
Standards Advisory
Council (SAC)
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About 50 members from throughout the
world.
Meets three times each year
Provides advice to IASB on priorities
Informs IASB of implications of proposed
standards
IASB
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Has the sole responsibility for setting
standards.
Approves principles-based standards, –
does not issue detailed application
guidelines.
Addresses business ventures – not public
sector, government or not-for-profit
activities.
International Financial Reporting
Interpretations Committee (IFRIC)
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12 voting members and a non-voting
chairman
Provide guidance on reporting issues not
specifically addressed in IASB’s standards, or
where unsatisfactory or conflicting
interpretations have developed.
IASB
… is committed to developing, in the
public interest, a single set of high
quality, global accounting standards
that require transparent and
comparable information in financial
statements …
IASB
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Has an agreement with FASB to achieve
convergence of standards.
Works in close co-operation with other
national standard setters.
Board members have liaison responsibilities
with a large number of countries and
international organisations.
Process
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Comment period for each document
Decisions made in open, public
meetings
Explain basis for conclusions in each
standard
Voting – approval by 8 of 14 members
Dissenting views published
Process
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Research
Discussion Paper
Exposure Draft
Standard
Implementation
Objectives of the Conceptual
Framework
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The Framework is to be the foundation for
building a set of coherent accounting
standards and rules.
The Framework is to be a reference of basic
accounting theory for solving emerging
practical problems of reporting.
FASB’S CONCEPTUAL
FRAMEWORK
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The conceptual framework developed by the
FASB serves as the basis for resolving accounting
and reporting problems.
The
Framework was to be the foundation for building a
set of coherent accounting standards and rules.
 The conceptual framework consists of:
1 objectives of financial reporting;
2 qualitative characteristics of
accounting information;
3 elements of financial statements; &
4 Operating guidelines (assumptions,
principles, and constraints).
Conceptual Framework for Financial Reporting
OBJECTIVES OF FINANCIAL
REPORTING
The FASB concluded that the objectives of financial
reporting are to provide information that:
1
2
3
Is useful to those making investment
and credit decisions.
Is helpful in assessing future cash flows.
Identifies the economic resources (assets),
the claims to those resources (liabilities),
and the changes in those resources and
claims.
Hierarchy of Accounting Qualities
External Financial Statements
First: Users and their needs:
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Side of economic interest
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Users with direct Interest.
Users with indirect Interest.
Side of the relation of business
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Internal users
External Users
USERS AND USES OF ACCOUNTING
Internal Users
Marketing managers
Production supervisors
Finance directors
Company officers
Investors
Creditors
Tax authorities
Regulatory agencies
Customers
Labor unions
External Users
QUESTIONS ASKED BY INTERNAL USERS
Is cash sufficient to pay bills?
Can we afford to give employee
pay raises this year?
What is the cost of manufacturing
each unit of product?
Which product line is the most
profitable?
QUALITATIVE CHARACTERISTICS
OF ACCOUNTING INFORMATION
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The FASB concluded that the overriding criterion
for accounting choices is decision usefulness.
To be useful, information should possess the
following qualitative characteristics:
1 Relevance
2 Reliability
3 Comparability
4 Consistency
Qualitative Characteristics of
Accounting Information
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Primary qualities of accounting information
are relevance and reliability.
Secondary qualities are comparability and
consistency of reported information.
RELEVANCE
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Accounting information has relevance 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).
Information must be available to decision
makers before it loses its capacity to
influence their decisions (timeliness).
RELIABILITY
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Reliability of information means that the
information is free of error and bias. In
short, it can be depended on.
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Information is verifiable, when, given the
same information, independent users can
arrive at similar conclusions.
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Information is faithful, when it represents
what really existed or happened.
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Information is neutral, when it is free from
bias.
COMPARABILITY AND
CONSISTENCY
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Comparability means that the information
should be comparable with accounting
information about other enterprises.
Consistency means that the same accounting
principles and methods should be used from
year to year within a company.
2003
2004
2005
Secondary Characteristics
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Secondary characteristics are: comparability and
consistency of reported information.
For information to be comparable, it must be:
measured and reported in a similar manner for different
enterprises.
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useful in the allocation of resources to the areas of
greatest benefit.
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useful to users in identifying real differences between
enterprises.
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Secondary Characteristics
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Accounting information is consistent, if the same
accounting principles are applied in a similar
manner from one period to the next.
Accounting principles may be changed, if the
change results in better reporting.
If principles are changed, the justification for, and the
nature and effect of the change, must be disclosed.
QUALITATIVE CHARACTERISTICS
OF ACCOUNTING INFORMATION
Useful
Financial
Information has:
Relevance
Reliability
1 Predictive value
1 Verifiable
2 Feedback value
2 Faithful representation
3 Timely
3 Neutral
Comparability
Consistency
External Financial Statements
Second: Basic Financial Statements
Balance Sheet
 Income Statement
 Statement of Cash Flows
 Statement of Stockholders’ Equity
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FINANCIAL STATEMENTS
After transactions are identified, recorded, and
summarized, 4 financial statements are prepared from
the summarized accounting data:
1 A balance sheet reports the assets, liabilities, and
owner’s equity at a specific date.
2 An income statement presents the revenues and
expenses and resulting net income or net loss for a
specific period of time.
3 A statement of cash flows summarizes information
about the cash inflows (receipts) and outflows
(payments) for a specific period of time.
4 An owner’s equity statement summarizes the changes
in owner’s equity for a specific period of time.
The Balance Sheet
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Summarizes a firms assets, liabilities,
and owner’s equity at a moment in
time
Amounts measured at historical
values and historical exchange rates
Prepared according to IFRS,
International Financial Reporting
Standards
Balance Sheet: Usefulness
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The balance sheet provides information for
evaluating:
Capital structure
Rates of return
Analyzing an enterprise’s:
 Liquidity
 Solvency
 Financial flexibility
Basic Elements of Financial Statements
Balance Sheet
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Assets: Probable future
economic benefits resulting
from past transactions
Liabilities: Probable future
sacrifices of economic
benefits resulting from past
transactions
Equity: Residual or
ownership interest
Investment by Owners:
Increases in net assets
Distributions to Owners:
Decreases in net assets
Income Statement
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Comprehensive Income:
All changes in equity from
non-owner sources
Revenues: Inflows from
entity’s ongoing operations
Expenses: Outflows from
entity’s ongoing operations
Gains: Increases in equity
from incidental transactions
Losses: Decreases in equity
from incidental transactions
The Annual Report
Usually Contains ...
–
–
–
–
–
–
financial statements.
notes to the financial statements.
a summary of accounting methods
used.
management discussion and analysis
of the financial statements.
an auditor’s report.
comparative financial data for 5 to 10
years.
Balance Sheet
Assets: probable future economic
benefits
 Liabilities: probable future
economic sacrifices
 Stockholders’ Equity: residual
interest, representing ownership
interest (also called net assets)
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THE BASIC ACCOUNTING
EQUATION
Assets
resources
owned by
a business
=
Liabilities
Stockholders’
+
Equity
claims
against
those
assets
owners’
residual
claim on
total assets
Assets
Current Assets :cash & cash
equivalents, short-term marketable
securities, accounts receivable,
inventory, other)
 Non Current Assets: Property, plant &
equipment, Long-term
investments,
and Other assets
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Liabilities
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Current Liabilities (accounts
payable, accrued & other
current liabilities)
Long-term debt
Bonds
Stockholders’ Equity
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Preferred stock
Common stock
Other paid-in capital
Retained earnings
Treasury stock
Other comprehensive income
Other equity items
THE OPERATING GUIDELINES
OF ACCOUNTING
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Operating guidelines are classified as assumptions,
principles, and constraints.
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Assumptions provide a foundation for the accounting
process.
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Principles indicate how transactions and other
economic events should be recorded.
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Constraints on the accounting process allow for a
relaxation of the principles under certain
circumstances.
Recognition and Measurement
Criteria
Basic
Assumptions
1. Economic
entity
2. Going
concern
3. Monetary
unit
4. Periodicity
Principles
1. Historical
cost
2. Revenue
recognition
3. Matching
4. Full
disclosure
Constraints
1. Cost benefit
2. Materiality
3. Industry
practices
4. Conservatism
Balance Sheet: Limitations
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Most assets and liabilities are stated at
historical cost.
Judgments and estimates are used in
determining many of the items.
The balance sheet does not report items that
can not be objectively determined.
It does not report information regarding offbalance sheet financing.
Income Statement
Revenues: inflows from major operations
 Expenses: outflows from major operations
 Gains & Losses: changes in equity from
peripheral activities
 Net income: bottom line all operating
activities recorded on the income statement
 Comprehensive income: Changes in equity
from all non-owner sources
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Usefulness of Income Statement
Evaluate the past performance of the
enterprise.
 Provide a basis for predicting future
performance.
 Help assess the risk or uncertainty of
achieving future cash flows.
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Limitations of the Income Statement
Items that cannot be measured reliably are
not reported in the income statement.
 Income numbers are affected by the
accounting methods employed.
 Income measurement involves judgment.
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Comprehensive Income
All changes in equity during a period,
except those resulting from investments
by or distributions to owners.
Other Comprehensive Income
Must be displayed as:
 A separate statement of comprehensive
income OR
 Combined income statement and
comprehensive income statement OR
 Part of statement of stockholders’ equity

ASSUMPTIONS
1 The Monetary unit assumption states that only
transaction data that can be expressed in terms of
money be included in the accounting records.
Example:
employee satisfaction and percent of
international employees are not transactions that
should be included in the financial records.
Customer Satisfaction
Percentage of
International Employees
Should be included
in accounting records
Salaries paid
ASSUMPTIONS
2 The Economic Entity Assumption states that the
activities of the entity be kept separate and distinct
from the activities of the owner of all other
economic entities.
Example: BMW activities
can be distinguished from
those of other car manufacturers such
as
Mercedes.
ASSUMPTIONS
3 The Time period assumption states
that the economic life of a business can
be divided into artificial time periods.
Example: months, quarters, and years
2000
QTR 1
QTR 2
QTR 3
QTR 4
2001
JAN
APR
JUL
OCT
FEB
MAY
AUG
NOV
2002
MAR
JUN
SEPT
DEC
ASSUMPTIONS
4 The Going concern assumption assumes that the
enterprise will continue in operation long enough
to carry out its existing objectives.
Implications: depreciation and amortization are
used, plant assets recorded at cost instead of
liquidation value, items are labeled as fixed or
long-term.
PRINCIPLES REVENUE
RECOGNITION

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The Revenue Recognition principle
dictates that revenue should be
recognized in the accounting period in
which it is earned.
When a sale is involved,
revenue is recognized at
the point of sale.
PERCENTAGE-OF-COMPLETION
METHOD OF REVENUE RECOGNITION
In long-term construction contracts, revenue
recognition is usually required before the contract is
completed.
 The percentage-of-completion method recognizes
revenue on the basis of reasonable estimates of
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
project.

FORMULA TO RECOGNIZE REVENUE IN
THE PERCENTAGE-OF-COMPLETION
METHOD
Costs Incurred
(Current
Period)
Percent
Complete
(Current
Period)
÷
X
Total
Estimated
Cost
Total Revenue
=
=
Percent
Complete
(Current
Period)
Revenue
Recognized
(Current
Period)
FORMULA TO COMPUTE GROSS
PROFIT
IN CURRENT PERIOD
The costs incurred in the current period are then
subtracted from the revenue recognized during the
current period to arrive at the gross profit.
Revenue
Recognized
(Current
Period)
_
Cost Incurred
(Current
Period)
=
Gross Profit
Recognized
(Current
Period)
REVENUE RECOGNIZED
PERCENTAGE-OF-COMPLETION METHOD
Warrior Construction Co. has a contract to build a dam for $400
million. It will take 3 years (starting in 2000) at a construction
cost of $360 million. Assume that Warrior incurs $54 million in
2000, $180 million in 2001, and $126 million in 2002 on the dam
project. The portion of the $400 million of revenue recognized in
each of the 3 years is shown below:
Year
2000
2001
2002
Totals
Costs
Incurred
(Current
Period)
÷
$ 54,000,000
180,000,000
126,000,000
$ 360,000,000
Percent
Total
Complete
Estimated
(Current
Total
Cost
=
Period) X
Revenue
=
$ 360,000,000
15%
$ 400,000,000
360,000,000
50%
400,000,000
Balance required to complete the contract
Revenue
Recognized
(Current
Period)
$ 60,000,000
200,000,000
140,000,000
$ 400,000,000
GROSS PROFIT RECOGNIZED PERCENTAGE-OFCOMPLETION METHOD
The gross profit recognized each period for Warrior Construction
Co. is as shown below. Use of the percentage-of-completion method
involves some subjectivity. As a result, errors are possible in
determining the amount of revenue recognized. To wait until
completion would seriously distort the financial statements. If it is
not possible to obtain dependable estimates of costs and progress,
then the revenue should be recognized at the completion date and
not by the percentage-of-completion method.
Year
2000
2001
2002
Totals
Revenue
Recognized
(Current
Period)
$ 60,000,000
200,000,000
140,000,000
$ 400,000,000
–
Actual Cost
Incurred
(Current
Period)
$ 54,000,000
180,000,000
126,000,000
$ 360,000,000
═
Gross Profit
Recognized
(Current
Period)
$ 6,000,000
20,000,000
14,000,000
$ 40,000,000
INSTALLMENT METHOD OF
REVENUE RECOGNITION
Another basis for revenue recognition is the receipt
of cash.
 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
uncertain.
 The installment method, which uses the cash basis,
is a popular approach to revenue recognition.
 Under the installment method gross profit is
recognized in the period in which the cash is
collected.

GROSS PROFIT FORMULAINSTALLMENT METHOD
Under installment method, each cash collection
from a customer consists of
1 a partial recovery of the cost of goods sold and
2 partial gross profit from the sale.
 The formula to recognize gross profit is shown
below.

Cash Collections
from Customers
x
Gross Profit
Percentage
=
Gross Profit
Recognized
during the
Period
GROSS PROFIT RECOGNIZED
INSTALLMENT METHOD
An Iowa farm machinery dealer had installment sales in its first year of
operations of $600,000 and a cost of goods sold on installment of $420,000.
Therefore, total gross profit is $180,000 ($600,000 - $420,000), and the gross
profit percentage is 30% ($180,000 ÷ $600,000). The collections on the
installment sales were: First year, $280,000 (down payments plus monthly
payments), second year, $200,000, and third year, $120,000. The collections of
cash and recognition of the gross profit are summarized below (ignoring
interest charges).
Year
2000
Cash
Collected
X
$ 280,000
Gross Profit
Percentage
30%
2001
200,000
30%
2002
120,000
30%
Totals
$ 600,000
=
Gross Profit
Recognized
$ 84,000
60,000
36,000
$ 180,000
PRINCIPLES MATCHING
(EXPENSE RECOGNITION)
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Expense 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 made to generate revenues.
To understand the various approaches for matching expenses
and revenues on the income statement, it is necessary to examine
the nature of expenses.
1 Expired costs are costs that will generate revenues only in
the current period and are therefore reported as
operating expenses on the income statement.
2 Unexpired costs are costs that will generate revenues in
future accounting periods and are recognized as assets.
PRINCIPLES MATCHING
(EXPENSE RECOGNITION)
Unexpired costs become expenses in 2 ways:
1) Cost of goods sold – Costs carried as
merchandise inventory become expensed when the
inventory is sold. They are expensed as cost of
goods sold in the period in which the sale occurs –
so there is a direct matching of expenses with
revenues.
2) Operating expenses – Other unexpired costs
become operating expenses through use or
consumption or through the passage of time.
EXPENSE RECOGNITION
PATTERN
Operating expenses contribute to the revenues of
the period but their association with revenues is
less direct than for cost of goods sold.
Provides Future
Benefit
Asset
Cost
Incurred
Benefits Decrease
Provides No
Apparent Future
Benefits
Expense
MATCHING PRINCIPLE


The practice of expense recognition is
referred to as the matching principle.
The matching principle dictates that efforts
(expenses) be matched with accomplishments
(revenues).
Revenues
earned
this month
are offset
against....
expenses
incurred in
earning the
revenue
GAAP RELATIONSHIPS IN
REVENUE & EXPENSE RECOGNITION
Time-Period Assumption
Economic life of business
can be divided into
artificial time periods
Revenue-Recognition
Principle
Revenue recognized in
the accounting period in
which it is earned
Matching Principle
Expenses matched with revenues
in the same period when efforts are
expended to generate revenues
WHY ADJUSTING ENTRIES ARE
NECESSARY
Adjusting entries are needed to ensure that revenue
recognition and matching principles are followed
1 Revenues are recorded in the period earned, and......
2 Expenses are recognized in the period incurred.
PRINCIPLES
FULL DISCLOSURE



The 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
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 statements.
PRINCIPLES
COST


The cost principle dictates that assets be recorded
at their cost.
Cost is used because it is both relevant and reliable.
1 Cost is relevant because it represents a) the
price paid, b) the assets sacrificed, or c) the
commitment made at the date of
acquisition.
2 Cost is reliable because it is a) objectively
measurable, b) factual, and c) verifiable.
BASIC PRINCIPLES USED IN
ACCOUNTING
Matching
Revenue Recognition
At point of sale
Costs
Matching
At end
of production
Sales Revenue
Materials
At time
cash received
During
production
Labor
Operating Expenses
Revenue should be recognized in the
accounting period in which it is earned
(generally at point of sale).
Delivery
Expenses should be
matched with revenues
Advertising
Cost
Utilities
Full Disclosure
* Financial Statements
* Balance Sheet
* Income Statement
* Retained Earnings
Statement
* Cash Flow Statement
Assets should be recorded at cost.
Circumstances and events that make a
difference to financial statement users
should be disclosed.
CONSTRAINTS IN
ACCOUNTING

Constraints permit a company to modify
generally accepted accounting principles
without reducing the usefulness of the
reported information.
Constraints: The Cost Benefit Rule
Cost-Benefit Relationship
•
•
•
The cost of providing information should not
outweigh the benefit derived.
Costs and benefits are not always obvious or
measurable.
Sound judgment must be used in providing
information.
Constraints: Materiality
Materiality refers to an item’s importance to a
firm’s overall financial operations.
•
•
•
An item must make a difference to be material and
be disclosed.
It is a matter of the relative significance of the
element.
Both quantitative and qualitative factors are to be
considered in determining relative significance.
Constraints: Industry Practices
Industry Practices
•
•
The nature of some industries sometimes
require departures from basic accounting
theory.
If application of accounting theory results in
statements that are not comparable or
consistent, then industry practices must be
examined for possible explanations.
Constraints: Conservatism



Conservatism suggests that the preparer,
when in doubt, choose a conservative
solution.
This solution will be least likely to overstate
assets and income.
Conservatism does not suggest that net
assets or net income be deliberately
understated.
CONSTRAINTS IN
ACCOUNTING
Materiality
Conservatism
$
$
$
$
$ $
$
$
$
When in doubt, choose the solution
If dollar amounts of costs are small, that will be least likely to overstate
GAAP does not have to be followed. assets and income.