Introduction to Accounting Principles

There are general rules and concepts that govern the field of accounting. These general rulesreferred to as basic accounting principles and guidelinesform the groundwork on which more detailed, complicated, and legalistic accounting rules are based. For example, the Financial Accounting Standards Board (FASB) uses the basic accounting principles and guidelines as a basis for their own detailed and comprehensive set of accounting rules and standards. The phrase "generally accepted accounting principles" (or "GAAP") consists of three important sets of rules: (1) the basic accounting principles and guidelines, (2) the detailed rules and standards issued by FASB and its predecessor the Accounting Principles Board (APB), and (3) the generally accepted industry practices. If a company distributes its financial statements to the public, it is required to follow generally accepted accounting principles in the preparation of those statements. Further, if a company's stock is publicly traded, federal law requires the company's financial statements be audited by independent public accountants. Both the company's management and the independent accountants must certify that the financial statements and the related notes to the financial statements have been prepared in accordance with GAAP. GAAP is exceedingly useful because it attempts to standardize and regulate accounting definitions, assumptions, and methods. Because of generally accepted accounting principles we are able to assume that there is consistency from year to year in the methods used to prepare a company's financial statements. And although variations may exist, we can make reasonably confident conclusions when comparing one company to another, or comparing one company's financial statistics to the statistics for its industry. Over the years the generally accepted accounting principles have become more complex because financial transactions have become more complex.

Basic Accounting Principles and Guidelines

Since GAAP is founded on the basic accounting principles and guidelines, we can better understand GAAP if we understand those accounting principles. The table below lists the ten main accounting principles and guidelines together with a highly condensed explanation of each. Basic Accounting Principle

What It Means in Relationship to a Financial Statement

1. Economic Entity Assumption

The accountant keeps all of the business transactions of a sole proprietorship separate from the business owner's personal transactions. For legal purposes, a sole proprietorship and its owner are considered to be one entity, but for accounting purposes they are considered to be two separate entities.

2. Monetary Unit Assumption

Economic activity is measured in U.S. dollars, and only transactions that can be expressed in U.S. dollars are recorded. Because of this basic accounting principle, it is assumed that the dollar's purchasing power has not changed over time. As a result accountants ignore the effect of inflation on recorded amounts. For example, dollars from a 1960

transaction are combined (or shown with) dollars from a 2010 transaction. 3. Time Period Assumption

This accounting principle assumes that it is possible to report the complex and ongoing activities of a business in relatively short, distinct time intervals such as the five months ended May 31, 2010, or the 5 weeks ended May 1, 2010. The shorter the time interval, the more likely the need for the accountant to estimate amounts relevant to that period. For example, the property tax bill is received on December 15 of each year. On the income statement for the year ended December 31, 2010, the amount is known; but for the income statement for the three months ended March 31, 2010, the amount was not known and an estimate had to be used. It is imperative that the time interval (or period of time) be shown in the heading of each income statement, statement of stockholders' equity, and statement of cash flows. Labeling one of these financial statements with "December 31" is not good enoughthe reader needs to know if the statement covers the one week ending December 31, 2010 the month ending December 31, 2010 thethree months ending December 31, 2010 or the year ended December 31, 2010.

4. Cost Principle

From an accountant's point of view, the term "cost" refers to the amount spent (cash or the cash equivalent) when an item was originally obtained, whether that purchase happened last year or thirty years ago. For this reason, the amounts shown on financial statements are referred to as historical cost amounts. Because of this accounting principle asset amounts are not adjusted upward for inflation. In fact, as a general rule, asset amounts are not adjusted to reflect any type of increase in value. Hence, an asset amount does not reflect the amount of money a company would receive if it were to sell the asset at today's market value. (An exception is certain investments in stocks and bonds that are actively traded on a stock exchange.) If you want to know the current value of a company's long-term assets, you will not get this information from a company's financial statementsyou need to look elsewhere, perhaps to a third-party appraiser.

5. Full Disclosure Principle

If certain information is important to an investor or lender using the financial statements, that information should be disclosed within the statement or in the notes to the statement. It is because of this basic accounting principle that numerous pages of "footnotes" are often attached to financial statements. As an example, let's say a company is named in a lawsuit that demands a significant amount of money. When the financial statements are prepared it is not clear whether the company will be able to defend itself or whether it might lose the lawsuit. As a result of these conditions and because of the full disclosure principle the lawsuit will be described in the notes to the financial statements. A company usually lists its significant accounting policies as the first note to its financial statements.

6. Going Concern Principle

This accounting principle assumes that a company will continue to exist long enough to carry out its objectives and commitments and will not liquidate in the foreseeable future. If the company's financial situation is such that the accountant

believes the company will not be able to continue on, the accountant is required to disclose this assessment. The going concern principle allows the company to defer some of its prepaid expenses until future accounting periods. 7. Matching Principle

This accounting principle requires companies to use the accrual basis of accounting. The matching principle requires that expenses be matched with revenues. For example, sales commissions expense should be reported in the period when the sales were made (and not reported in the period when the commissions were paid). Wages to employees are reported as an expense in the week when the employees worked and not in the week when the employees are paid. If a company agrees to give its employees 1% of its 2010 revenues as a bonus on January 15, 2011, the company should report the bonus as an expense in 2010 and the amount unpaid at December 31, 2010 as a liability. (The expense is occurring as the sales are occurring.) Because we cannot measure the future economic benefit of things such as advertisements (and thereby we cannot match the ad expense with related future revenues), the accountant charges the ad amount to expense in the period that the ad is run. (To learn more about adjusting entries go to Explanation of Adjusting Entries and Drills for Adjusting Entries.)

8. Revenue Recognition Principle

Under the accrual basis of accounting (as opposed to the cash basis of accounting), revenues are recognized as soon as a product has been sold or a service has been performed, regardless of when the money is actually received. Under this basic accounting principle, a company could earn and report $20,000 of revenue in its first month of operation but receive $0 in actual cash in that month. For example, if ABC Consulting completes its service at an agreed price of $1,000, ABC should recognize $1,000 of revenue as soon as its work is doneit does not matter whether the client pays the $1,000 immediately or in 30 days. Do not confuse revenue with a cash receipt.

9. Materiality

Because of this basic accounting principle or guideline, an accountant might be allowed to violate another accounting principle if an amount is insignificant. Professional judgment is needed to decide whether an amount is insignificant or immaterial. An example of an obviously immaterial item is the purchase of a $150 printer by a highly profitable multi-million dollar company. Because the printer will be used for five years, the matching principle directs the accountant to expense the cost over the five-year period. The materiality guideline allows this company to violate the matching principle and to expense the entire cost of $150 in the year it is purchased. The justification is that no one would consider it misleading if $150 is expensed in the first year instead of $30 being expensed in each of the five years that it is used. Because of materiality, financial statements usually show amounts rounded to the

nearest dollar, to the nearest thousand, or to the nearest million dollars depending on the size of the company. 10. Conservatism

If a situation arises where there are two acceptable alternatives for reporting an item, conservatism directs the accountant to choose the alternative that will result in less net income and/or less asset amount. Conservatism helps the accountant to "break a tie." It does not direct accountants to be conservative. Accountants are expected to be unbiased and objective. The basic accounting principle of conservatism leads accountants to anticipate or disclose losses, but it does not allow a similar action for gains. For example, potential losses from lawsuits will be reported on the financial statements or in the notes, but potential gains will not be reported. Also, an accountant may write inventory down to an amount that is lower than the original cost, but will not write inventory up to an amount higher than the original cost.

Other Characteristics of Accounting Information

When financial reports are generated by professional accountants, we have certain expectations of the information they present to us:

1. We expect the accounting information to be reliable, verifiable, and objective. 2. We expect consistency in the accounting information. 3. We expect comparability in the accounting information.

1. Reliable, Verifiable, and Objective

In addition to the basic accounting principles and guidelines listed in Part 1, accounting information should be reliable, verifiable, and objective. For example, showing land at its original cost of $10,000 (when it was purchased 50 years ago) is considered to be more reliable, verifiable, and objective than showing it at its current market value of $250,000. Eight different accountants will wholly agree that the original cost of the land was $10,000they can read the offer and acceptance for $10,000, see a transfer tax based on $10,000, and review documents that confirm the cost was $10,000. If you ask the same eight accountants to give you the land's current value, you will likely receive eight different estimates. Because the current value amount is less reliable, less verifiable, and less objective than the original cost, the original cost is used. The accounting profession has been willing to move away from the cost principle if there are reliable, verifiable, and objective amounts involved. For example, if a company has an investment in stock that is actively traded on a stock exchange, the company may be required to show the current value of the stock instead of its original cost.

2. Consistency
Accountants are expected to be consistent when applying accounting principles, procedures, and practices. For example, if a company has a history of using the FIFO cost flow assumption, readers of the company's most current financial statements have every reason to expect that the company is continuing to use the FIFO cost flow assumption. If the company changes this practice and begins using the LIFO cost flow assumption, that change must be clearly disclosed.

3. Comparability
Investors, lenders, and other users of financial statements expect that financial statements of one company can be compared to the financial statements of another company in the same industry. Generally accepted accounting principles may provide for comparability between the financial statements of different companies. For example, the FASB requires that expenses related to research and development (R&D) be expensed when incurred. Prior to its rule, some companies expensed R&D when incurred while other companies deferred R&D to the balance sheet and expensed them at a later date.

How Principles and Guidelines Affect Financial Statements

The basic accounting principles and guidelines directly affect the way financial statements are prepared and interpreted. Let's look below at how accounting principles and guidelines influence the (1) balance sheet, (2) income statement, and (3) the notes to the financial statements.

1. Balance Sheet
Let's see how the basic accounting principles and guidelines affect the balance sheet of Mary's Design Service, a sole proprietorship owned by Mary Smith. (To learn more about the balance sheet go toExplanation of Balance Sheet and Drills for Balance Sheet.) A balance sheet is a snapshot of a company's assets, liabilities, and owner's equity at one point in time. (In this case, that point in time is after all of the transactions through September 30, 2010 have been recorded.) Because of the economic entity assumption, only the assets, liabilities, and owner's equity specifically identified with Mary's Design Service are shownthe personal assets of the owner, Mary Smith, are not included on the company's balance sheet. Mary's Design Service Balance Sheet September 30, 2010

Assets Cash Accounts Receivable Supplies Prepaid Insurance Land

300 1,000 160 90 10,000

Liabilities Notes Payable Accounts Payable Wages Payable Unearned Revenues Total Liabilities Owner's Equity M.Smith, Capital

$ 1,000 325 75 100 1,500

10,050 $11,550

Total Assets

$11,550

Total Liabilities & Owner's Equity

The assets listed on the balance sheet have a cost that can be measured and each amount shown is the original cost of each asset. For example, let's assume that a tract of land was purchased in 1956 for $10,000. Mary's Design Service still owns the land, and the land is now appraised at $250,000. The cost principle requires that the land be shown in the asset account Land at its original cost of $10,000 rather than at the recently appraised amount of $250,000.

If Mary's Design Service were to purchase a second piece of land, the monetary unit assumption dictates that the purchase price of the land bought today would simply be added to the purchase price of the land bought in 1956, and the sum of the two purchase prices would be reported as the total cost of land. The Supplies account shows the cost of supplies (if material in amount) that were obtained by Mary's Design Service but have not yet been used. As the supplies are consumed, their cost will be moved to the Supplies Expense account on the income statement. This complies with the matching principle which requires expenses to be matched either with revenues or with the time period when they are used. The cost of the unused supplies remains on the balance sheet in the asset account Supplies. The Prepaid Insurance account represents the cost of insurance that has not yet expired. As the insurance expires, the expired cost is moved to Insurance Expense on the income statement as required by the matching principle. The cost of the insurance that has not yet expired remains on Mary's Design Service's balance sheet (is "deferred" to the balance sheet) in the asset account Prepaid Insurance. Deferring insurance expense to the balance sheet is possible because of another basic accounting principle, thegoing concern assumption. The cost principle and monetary unit assumption prevent some very valuable assets from ever appearing on a company's balance sheet. For example, companies that sell consumer products with high profile brand names, trade names, trademarks, and logos are not reported on their balance sheets because they were not purchased. For example, Coca-Cola's logo and Nike's logo are probably the most valuable assets of such companies, yet they are not listed as assets on the company balance sheet. Similarly, a company might have an excellent reputation and a very skilled management team, but because these were not purchased for a specific cost and we cannot objectively measure them in dollars, they are not reported as assets on the balance sheet. If a company actually purchases the trademark of another company for a significant cost, the amount paid for the trademark will be reported as an asset on the balance sheet of the company that bought the trademark.

2. Income Statement
Let's see how the basic accounting principles and guidelines might affect the income statement of Mary's Design Service. (To learn more about the income statement go to Explanation of Income Statement andDrills for Income Statement.) An income statement covers a period of time (or time interval), such as a year, quarter, month, or four weeks. It is imperative to indicate the period of time in the heading of the income statement such as "For the Nine Months Ended September 30, 2010". (This means for the period of January 1 through September 30, 2010.) If prepared under the accrual basis of accounting, an income statement will show how profitable a company was during the stated time interval.

Mary's Design Service Income Statement For the Nine Months Ending September 30, 2010 Revenues and Gains Revenues Gain on Sale of Land Total Revenues and Gains

$10,000 5,000 15,000

Expenses and Losses Expenses Loss on Sale of Computer Total Expenses and Losses Net Income

8,000 350 8,350 $ 6,650

Revenues are the fees that were earned during the period of time shown in the heading. Recognizing revenues when they are earned instead of when the cash is actually received follows the revenue recognition principle and the matching principle. (The matching principle is what steers accountants toward using the accrual basis of accounting rather than the cash basis. Small business owners should discuss these two methods with their tax advisors.) Gains are a net amount related to transactions that are not considered part of the company's main operations. For example, Mary's Design Service is in the business of designing, not in the land development business. If the company should sell some land for $30,000 (land that is shown in the company's accounting records at $25,000) Mary's Design Service will report a Gain on Sale of Land of $5,000. The $30,000 selling price will not be reported as part of the company's revenues. Expenses are costs used up by the company in performing its main operations. The matching principle requires that expenses be reported on the income statement when the related sales are made or when the costs are used up (rather than in the period when they are paid). Losses are a net amount related to transactions that are not considered part of the company's main operating activities. For example, let's say a retail clothing company owns an old computer that is carried on its accounting records at $650. If the company sells that computer for $300, the company receives an asset (cash of $300) but it must also remove $650 of asset amounts from its accounting records. The result is aLoss on Sale of Computer of $350. The $300 selling price will not be included in the company's sales or revenues.

3. The Notes To Financial Statements

Another basic accounting principle, the full disclosure principle, requires that a company's financial statements include disclosure notes. These notes include information that helps readers of the financial statements make investment and credit decisions. The notes to the financial statements are considered to be an integral part of the financial statements.

1.

The personal assets of the owner of a company will not appear on the company's balance sheet because of which principle/guideline? Cost Economic Entity Monetary Unit

Which principle/guideline requires a company's balance sheet to report its land at the amount 2. the company paid to acquire the land, even if the land could be sold today at a significantly higher amount? Cost Economic Entity Monetary Unit

3.

Which principle/guideline allows a company to ignore the change in the purchasing power of the dollar over time? Cost Economic Entity Monetary Unit

4.

Which principle/guideline requires the company's financial statements to have footnotes containing information that is important to users of the financial statements? Conservatism Economic Entity Full Disclosure

5.

Which principle/guideline justifies a company violating an accounting principle because the amounts are immaterial? Conservatism Full Disclosure Materiality

6.

Which principle/guideline is associated with the assumption that the company will continue on long enough to carry out its objectives and commitments? Economic Entity Going Concern Time Period

A very large corporation's financial statements have the dollar amounts rounded to the 7. nearest $1,000. Which accounting principle/guideline justifies not reporting the amounts to the penny? Full Disclosure Materiality Monetary Unit

Accountants might recognize losses but not gains in certain situations. For example, the 8. company might write-down the cost of inventory, but will not write-up the cost of inventory. Which principle/guideline is associated with this action? Conservatism Materiality Monetary Unit

9.

Which principle/guideline directs a company to show all the expenses related to its revenues of a specified period even if the expenses were not paid in that period? Cost Matching Monetary Unit

When the accountant has to choose between two acceptable alternatives, the accountant 10. should select the alternative that will report less profit, less asset amount, or a greater liability amount. This is based upon which principle/guideline? Conservatism Cost Materiality

11.

Public utilities' balance sheets list the plant assets before the current assets. This is acceptable under which accounting principle/guideline? Conservatism Cost Industry Practices

A large company purchases a $250 digital camera and expenses it immediately instead of 12. recording it as an asset and depreciating it over its useful life. This practice may be acceptable because of which principle/guideline? Cost Matching Materiality

A corporation pays its annual property tax bill of approximately $12,000 in one payment each 13. December 28. During the year, the corporation's monthly income statements report Property Tax Expense of $1,000. This is an example of which accounting principle/guideline? Conservatism Matching Monetary Unit

A company sold merchandise of $8,000 to a customer on December 29, 2010. The company's sales terms require the customer to pay the company by January 28, 2011. The company's 14. income statement reported the sale in December 2010. This is proper under which accounting principle/guideline? Full Disclosure Monetary Unit Revenue Recognition

15. Accrual accounting is based on this principle/guideline. Cost Full Disclosure Matching

The creative chief executive of a corporation who is personally responsible for numerous inventions and innovations is not reported as an asset on the corporation's balance sheet. The 16. accounting principle/guideline that prevents the corporation for reporting this person as an asset is Conservatism Cost Going Concern

An asset with a cost of $120,000 is depreciated over its useful life of 10 years rather than 17. expensing the entire amount when it is purchased. This complies with which principle/guideline? Cost Full Disclosure Matching

Near the end of the year 2010, a company required a customer to pay $200,000 as a deposit for work that is to begin in early 2011. At the end of 2010 the company reported the 18. $200,000 as a liability on its balance sheet. Which accounting principle/guideline prevented the company from reporting the $200,000 on its 2010 income statement? Going Concern Materiality Revenue Recognition

19.

A retailer wishes to report its merchandise inventory on its balance sheet at its retail value. This would violate which accounting principle/guideline? Cost Full Disclosure Monetary Unit

A company borrowed $100,000 on December 1, 2010 and will make its only payment for interest when the note is paid off on June 1, 2011. The total interest for the six months will be 20. $3,600. On the December 2010 income statement the accountant reported Interest Expense of $600. This action was the result of which accounting principle/guideline?

Cost

Matching

Revenue Recognition