Accounting Principles

Second Canadian Edition

Weygandt Kieso Kimmel Trenholm

Carole Bowman, Sheridan College

Prepared by:

CHAPTER

12
ACCOUNTING PRINCIPLES

CONCEPTUAL FRAMEWORK OF ACCOUNTING

Generally accepted accounting principles are a set of rules and practices that are recognized as a general guide for financial reporting purposes. Generally accepted means that these principles must have substantial authoritative support. The Canadian Institute of Chartered Accountants (CICA) is responsible for developing accounting principles in Canada.

CICAS CONCEPTUAL FRAMEWORK

The conceptual framework consists of:

objective of financial reporting, qualitative characteristics of accounting information, elements of financial statements, and recognition and measurement criteria (assumptions, principles, and constraints).

OBJECTIVE OF FINANCIAL REPORTING

The objective of financial reporting is to provide information that is useful for decision-making

QUALITATIVE CHARACTERISTICS OF ACCOUNTING INFORMATION

The accounting alternative selected should be one that generates the most useful financial information for decision making. To be useful, information should possess the following qualitative characteristics: 1. understandability 2. relevance 3. reliability 4. comparability and consistency

UNDERSTANDABILITY

Information must be understandable by its users. Users are assumed to have a reasonable comprehension of, and ability to study, the accounting, business, and economic concepts needed to understand the information.

RELEVANCE

Accounting information is relevant 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 it can be depended on. To be reliable, accounting information must be verifiable there must be proof that it is free of error and bias. The information must be a faithful representation of what it purports to be it must be factual.

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.
2000 2001 2003

RECOGNITION AND MEASUREMENT CRITERIA

Recognition and measurement criteria used by accountants to solve practical problems include assumptions, principles, and constraints. Assumptions provide a foundation for the accounting process. Principles indicate how economic events should be reported in the accounting process. Constraints permit a company to modify generally accepted accounting principles without reducing the usefulness of the reported information.
Assumptions
Going concern Monetary unit Economic entity Time period

Principles
Revenue recognition Matching Full disclosure Cost

Cost - benefit Materiality

Constraint s

GOING CONCERN ASSUMPTION

The going concern assumption assumes that the enterprise will continue to operate in the foreseeable future. Implications: capital assets are recorded at cost instead of liquidation value, amortization is used, items are labeled as current or non-current.

MONETARY UNIT ASSUMPTION

The monetary unit assumption states that only transaction data capable of being expressed in terms of money should be included in the accounting records of the economic entity. Also assumes unit of measure ($) remains sufficiently stable over time. Ignores inflationary and deflationary effects.

Should not be included in accounting records Should be included in accounting records

Customer satisfaction Percentage of international employees Salaries paid

ECONOMIC ENTITY ASSUMPTION

The economic entity assumption states that economic events can be identified with a particular unit of accountability. Example: Harveys activities can be distinguished from those of other food services such as Swiss Chalet.

TIME PERIOD ASSUMPTION

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
JAN MAY SEPT DEC

2001

2003

FEB MAR APR JUN JUL AUG OCT NOV

REVENUE RECOGNITION PRINCIPLE

The revenue recognition principle says that revenue should be recognized in the accounting period in which it is earned.
Production/sales essentially complete Revenues measurable Collection reasonably assured Expenses determinable

REVENUE RECOGNITION

Revenue can be recognized:

1. 2. 3. 4. At point of sale During production At completion of production Upon collection of cash

PERCENTAGE-OF-COMPLETION METHOD OF REVENUE RECOGNITION

The percentage-of-completion method recognizes revenue and income on the basis of reasonable estimates of the projects progress toward completion. A projects progress toward completion is measured by comparing the costs incurred in a year to total estimated costs of the entire project.

ILLUSTRATION 12-4

FORMULA TO RECOGNIZE REVENUE IN THE PERCENTAGE-OF-COMPLETION METHOD

Cost Incurred (Current Period) Total Estimated Cost = Percent Complete (Current Period)

Percent Complete (Current Period)

Total Revenue

Revenue Recognized (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.

INSTALMENT METHOD OF REVENUE RECOGNITION

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 so uncertain. The instalment method, which uses the cash basis, is a popular approach to revenue recognition. Under the instalment method gross profit is recognized in the period in which the cash is collected.

ILLUSTRATION 12-8

GROSS PROFIT FORMULAINSTALMENT METHOD

Under the instalment method, each cash collection from a customer consists of 1. a partial recovery of the cost of goods sold, and 2. a partial gross profit from the sale. The formula to recognize gross profit is shown below.

Gross Profit

Sales Revenue

= =

Gross Profit Margin Gross Profit Recognized during the period

Gross Profit Margin

Cash Collections from Customer

MATCHING PRINCIPLE

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 expended to generate revenues.

MATCHING PRINCIPLE

Expired costs are costs that will generate revenues only in the current period and are therefore reported as operating expenses on the income statement. Unexpired costs are costs that will generate revenues in future accounting periods and are recognized as assets.

MATCHING PRINCIPLE
Unexpired costs become expenses through: 1. Cost of goods sold Costs carried as merchandise inventory are expensed as cost of goods sold in the period when the sale occurs so there is a direct matching of expenses with revenues. 2. Operating expenses Unexpired costs become operating expenses through use or consumption or through the passage of time.

FULL DISCLOSURE PRINCIPLE

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.

COST PRINCIPLE

The cost principle dictates that assets are recorded at their historic cost. Cost is used because it is both relevant and reliable. 1. Cost is relevant because it represents the price paid, the assets sacrificed, or the commitment made at the date of acquisition. 2. Cost is reliable because it is objectively measurable, factual, and verifiable.

CONSTRAINTS IN ACCOUNTING

Constraints permit a company to modify generally accepted accounting principles without reducing the usefulness of the reported information. The constraints are cost-benefit and materiality. 1. Cost-benefit means that the value of information should be greater than the cost of providing it. 2. Materiality relates to an items impact on a firms overall financial condition and operations.

CONCEPTUAL FRAMEWORK -SUMMARY

Objectives of Financial Reporting

Qualitative Characteristics of Accounting Information

Elements of Financial Statements

Recognition and Measurement Criteria

Assumptions Principles Constraints

INTERNATIONAL ACCOUNTING STANDARDS

World markets are intertwined. The International Accounting Standard Board (IASB) has more than 150 member accounting organizations representing more than 110 countries. The IASB has issued over 40 InternationalAccounting Standards to obtain uniformity in international accounting practices.

COPYRIGHT

Copyright 2002 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by CANCOPY (Canadian Reprography Collective) is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his / her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.