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Transcript
ACCOUNTING THEORY UNDERLYING FINANCIAL ACCOUNTING Introduction to Accounting Theory What is Accounting Theory Accounting Theory & Policy Making Measurement Accounting Theory is defined as the basic assumptions definitions principles and concepts that underlie the rule making by a legislative body the reporting of accounting and financial information applicable to financial accounting, not to governmental or managerial Accounting Theory includes 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 .. Prior to Securities act of 1933 and 1934 little financial reporting was required. The securities acts assigned the power of accounting role making for publicly held companies to SEC They also required most publicly held companies to be audited by independent CPAs The Standard Setting Process: Parties Involved 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 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 19 trustees: 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) 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 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) 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 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 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 Research Discussion Paper Exposure Draft Standard Implementation Objectives of the Conceptual Framework 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 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: Side of economic interest Users with direct Interest. Users with indirect Interest. Side of the relation of business 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 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 Primary qualities of accounting information are relevance and reliability. Secondary qualities are comparability and consistency of reported information. RELEVANCE 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 Reliability of information means that the information is free of error and bias. In short, it can be depended on. Information is verifiable, when, given the same information, independent users can arrive at similar conclusions. Information is faithful, when it represents what really existed or happened. Information is neutral, when it is free from bias. COMPARABILITY AND CONSISTENCY 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 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. useful in the allocation of resources to the areas of greatest benefit. useful to users in identifying real differences between enterprises. Secondary Characteristics 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 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 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 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 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 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) 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 Liabilities Current Liabilities (accounts payable, accrued & other current liabilities) Long-term debt Bonds Stockholders’ Equity Preferred stock Common stock Other paid-in capital Retained earnings Treasury stock Other comprehensive income Other equity items THE OPERATING GUIDELINES OF ACCOUNTING Operating guidelines are classified as assumptions, principles, and constraints. Assumptions provide a foundation for the accounting process. Principles indicate how transactions and other economic events should be recorded. 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 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 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. 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. 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 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) 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.