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Explanation of the Topic...


Accounting Principles
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Part 1 Introduction to Accounting Principles, Basic Accounting Principles & Guidelines

Other Characteristics of Accounting Information, How Principles and Guidelines Affect Financial
Part 2
Statements

Introduction to Accounting Principles


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There are general rules and concepts that govern the field of accounting. These general rules—
referred to as basic accounting principles and guidelines—form 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 What It Means in Relationship to a Financial Statement
Principle

1. Economic The accountant keeps all of the business transactions of a sole proprietorship
Entity separate from the business owner's personal transactions. For legal purposes, a
Assumption 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 Economic activity is measured in U.S. dollars, and only transactions that can be
Unit expressed in U.S. dollars are recorded.
Assumption
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 2008 transaction.

3. Time Period This accounting principle assumes that it is possible to report the complex and
Assumption ongoing activities of a business in relatively short, distinct time intervals such as
the five months ended May 31, 2008, or the 5 weeks ended May 1, 2008. 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, 2008, the amount is known; but for the income statement for the
three months ended March 31, 2008, 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 enough—the reader needs to know if the statement covers the one
week ending December 31, 2008 the month ending December 31, 2008 the three
months ending December 31, 2008 or the year ended December 31, 2008.

4. Cost From an accountant's point of view, the term "cost" refers to the amount spent
Principle (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 statements—you need to look elsewhere, perhaps to a third-party
appraiser.

5. Full If certain information is important to an investor or lender using the financial


Disclosure statements, that information should be disclosed within the statement or in the
Principle 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 This accounting principle assumes that a company will continue to exist long
Concern enough to carry out its objectives and commitments and will not liquidate in the
Principle 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 This accounting principle requires companies to use the accrual basis of
Principle 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 2008 revenues as a
bonus on January 15, 2009, the company should report the bonus as an expense
in 2008 and the amount unpaid at December 31, 2008 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 andDrills for Adjusting Entries.)

8. Revenue Under the accrual basis of accounting (as opposed to the cash basis of
Recognition accounting),revenues are recognized as soon as a product has been sold or a
Principle 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 done—it
does not matter whether the client pays the $1,000 immediately or in 30 days. Do
not confuserevenue 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 judgement 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. If a situation arises where there are two acceptable alternatives for reporting an
Conservatism 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, potentiallosses from lawsuits will be reported on the financial
statements or in the notes, butpotential 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.

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Explanation of the Topic...


Accounting Principles
Print Email
Part 1 Introduction to Accounting Principles, Basic Accounting Principles & Guidelines

Other Characteristics of Accounting Information, How Principles and Guidelines Affect Financial
Part 2
Statements

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 $10,000—they 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, theFASB 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 to Explanation of Balance Sheet andDrills 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, 2008
have been recorded.) Because of theeconomic entity assumption, only the assets, liabilities,
and owner's equity specifically identified with Mary's Design Service are shown—the personal
assets of the owner, Mary Smith, are not included on the company's balance sheet.

Mary's Design Service


Balance Sheet
September 30, 2008

Assets Liabilities
Cash $ 300 Notes Payable $ 1,000
Accounts Receivable 1,000 Accounts Payable 325
Supplies 160 Wages Payable 75
Prepaid Insurance 90 Unearned Revenues 100
Land 10,000 Total Liabilities 1,500

Owner's Equity
M.Smith, Capital 10,050

Total Assets $11,550 Total Liabilities & Owner's Equity $11,550

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, the going 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 and Drills 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, 2008". (This means for the period
of January 1 through September 30, 2008.) If prepared under theaccrual 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, 2008

Revenues and Gains


Revenues $10,000
Gain on Sale of Land 5,000
Total Revenues and Gains 15,000

Expenses and Losses


Expenses 8,000
Loss on Sale of Computer 350
Total Expenses and Losses 8,350

Net Income $ 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 a Loss 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.

Additional Information and Resources


Because the material covered here is considered an introduction to this topic, many complexities
have been omitted. You should always consult with an accounting professional for assistance
with your own specific circumstances.

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explanation, reinforcing drills, Q&A, puzzles, dictionary of terms, etc.

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Explanation of the Topic...


Financial Accounting
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Part 1 Introduction to Financial Accounting
Double Entry and the Accrual Basis of Accounting
Accounting Principles
Financial Statements
Financial Reporting
Financial Accounting vs. "Other" Accounting

Introduction to Financial Accounting


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Financial accounting is a specialized branch of accounting that keeps track of a company's
financial transactions. Using standardized guidelines, the transactions are recorded, summarized,
and presented in a financial report or financial statement such as an income statement or a
balance sheet.

Companies issue financial statements on a routine schedule. The statements are


considered external because they are given to people outside of the company, with the primary
recipients being owners/stockholders, as well as certain lenders. If a corporation's stock is
publicly traded, however, its financial statements (and other financial reportings) tend to be widely
circulated, and information will likely reach secondary recipients such as competitors, customers,
employees, labor organizations, and investment analysts.

It's important to point out that the purpose of financial accounting is not to report the value of a
company. Rather, its purpose is to provide enough information for others to assess the value of a
company for themselves.

Because external financial statements are used by a variety of people in a variety of ways,
financial accounting has common rules known as accounting standards and as generally
accepted accounting principles (GAAP). In the U.S., the Financial Accounting Standards
Board (FASB) is the organization that develops the accounting standards and principles.
Corporations whose stock is publicly traded must also comply with the reporting requirements of
the Securities and Exchange Commission (SEC), an agency of the U.S. government.

Double Entry and the Accrual Basis of Accounting


At the heart of financial accounting is the system known as double entry bookkeeping (or "double
entry accounting"). Each financial transaction that a company makes is recorded by using this
system.

The term "double entry" means that every transaction affects at least two accounts. For example,
if a company borrows $50,000 from its bank, the company's Cash account increases, and the
company's Notes Payable account increases. Double entry also means that one of the accounts
must have an amount entered as a debit, and one of the accounts must have an amount entered
as a credit. For any given transaction, the debit amount must equal the credit amount. (To learn
more about debits and credits, see Explanation of Debits & Credits.)

The advantage of double entry accounting is this: at any given time, the balance of a company's
asset accounts will equal the balance of its liability and stockholders' (or owner's) equity
accounts. (To learn more on how this equality is maintained, see the Explanation of Accounting
Equation.)

Financial accounting is required to follow the accrual basis of accounting (as opposed to the
"cash basis" of accounting). Under the accrual basis, revenues are reported when they
are earned, not when the money is received. Similarly, expenses are reported when they
are incurred, not when they are paid. For example, although a magazine publisher receives a $24
check from a customer for an annual subscription, the publisher reports as revenue a monthly
amount of $2 (one-twelfth of the annual subscription amount). In the same way, it reports its
property tax expense each month as one-twelfth of the annual property tax bill.

By following the accrual basis of accounting, a company's profitability, assets, liabilities and other
financial information is more in line with economic reality. (To learn more on achieving the accrual
basis of accounting, see the Explanation of Adjusting Entries.)

Accounting Principles
If financial accounting is going to be useful, a company's reports need to be credible, easy to
understand, and comparable to those of other companies. To this end, financial accounting
follows a set of common rules known asaccounting standards or generally accepted
accounting principles (GAAP, pronounced "gap").

GAAP is based on the fundamental principles of accounting-concepts such as cost principle,


matching principle, full disclosure, going concern, economic entity, conservatism, relevance, and
reliability. (You can learn more about the basic principles in Explanation of Accounting
Principles.)

GAAP, however, is not static. It includes some very complex standards that were issued in
response to some very complicated business transactions. GAAP also addresses accounting
practices that may be unique to particular industries, such as utility, banking, and insurance.
Often these practices are a response to changes in government regulations of the industry.

GAAP includes many specific pronouncements as issued by the Financial Accounting Standards
Board (FASB, pronounced "fas-bee"). The FASB is a non-government group that researches
current needs and develops accounting rules to meet those needs. (You can learn more about
FASB and its accounting pronouncements at www.FASB.org.)

In addition to following the provisions of GAAP, any corporation whose stock is publicly traded is
also subject to the reporting requirements of the Securities and Exchange Commission (SEC), an
agency of the U.S. government. These requirements mandate an annual report to stockholders
as well as an annual report to the SEC. The annual report to the SEC requires that independent
certified public accountants audit a company's financial statements, thus giving assurance that
the company has followed GAAP.

Financial Statements
Financial accounting generates the following general-purpose, external, financial statements:

1. Income statement (sometimes referred to as "results of operations" or "earnings


statement" or "profit and loss [P&L] statement")
2. Balance sheet (sometimes referred to as "statement of financial position")
3. Statement of cash flows (sometimes referred to as "cash flow statement")
4. Statement of stockholders' equity

Income Statement
The income statement reports a company's profitability during a specified period of time. The
period of time could be one year, one month, three months, 13 weeks, or any other time interval
chosen by the company.

The main components of the income statement are revenues, expenses, gains, and losses.
Revenues include such things as sales, service revenues, and interest revenue. Expenses
include the cost of goods sold, operating expenses (such as salaries, rent, utilities, advertising),
and nonoperating expenses (such as interest expense). If a corporation's stock is publicly traded,
the earnings per share of its common stock are reported on the income statement. (You can learn
more about the income statement at Explanation of Income Statement.)

Balance Sheet
The balance sheet is organized into three parts: (1) assets, (2) liabilities, and (3) stockholders'
equity at a specified date (typically, this date is the last day of an accounting period).

The first section of the balance sheet reports the company's assets and includes such things as
cash, accounts receivable, inventory, prepaid insurance, buildings, and equipment. The next
section reports the company's liabilities; these are obligations that are due at the date of the
balance sheet and often include the word "payable" in their title (Notes Payable, Accounts
Payable, Wages Payable, and Interest Payable). The final section is stockholders' equity, defined
as the difference between the amount of assets and the amount of liabilities. (You can learn more
about the balance sheet at Explanation of Balance Sheet.)

Statement of Cash Flows


The statement of cash flows explains the change in a company's cash (and cash equivalents)
during the time interval indicated in the heading of the statement. The change is divided into three
parts: (1) operating activities, (2) investing activities, and (3) financing activities.

The operating activities section explains how a company's cash (and cash equivalents) have
changed due to operations.Investing activities refer to amounts spent or received in transactions
involving long-term assets. The financing activitiessection reports such things as cash received
through the issuance of long-term debt, the issuance of stock, or money spent to retire long-term
liabilities. (You can learn more about the statement of cash flows at Explanation of Cash Flow
Statement.)

Statement of Stockholders' Equity


The statement of stockholders' (or shareholders') equity lists the changes in stockholders' equity
for the same period as the income statement and the cash flow statement. The changes will
include items such as net income, other comprehensive income, dividends, the repurchase of
common stock, and the exercise of stock options.

Financial Reporting
Financial reporting is a broader concept than financial statements. In addition to the financial
statements, financial reporting includes the company's annual report to stockholders, its annual
report to the Securities and Exchange Commission (Form 10-K), its proxy statement, and other
financial information reported by the company.

Financial Accounting vs. "Other" Accounting


Financial accounting represents just one sector in the field of business accounting. Another
sector, managerial accounting, is so named because it provides financial information to a
company's management. This information is generally internal (not distributed outside of the
company) and is primarily used by management to make decisions. Other sectors of the
accounting field include cost accounting, tax accounting, and auditing.

Visit Accounting Careers to learn more about the scope and variety of accounting.

Additional Information and Resources


Because the material covered here is considered an introduction to this topic, many complexities
have been omitted. You should always consult with an accounting professional for assistance
with your own specific circumstances.

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