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Prepared by Gregory K. Lowry Mercer University Marianne Bradford The University of Tennessee
PREVIEW OF CHAPTER 7
ACCOUNTING PRINCIPLES
Assumptions
Monetary Economic Time
Principles
Constraints in Accounting
Materiality Conservatism Summary
unit entity
Revenue
recognition
Matching Full Cost
sheet
Classified
period concern
Going
disclosure
of conceptual framework
statement
Analyzing
statements
An international perspective
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 we must be able to prove 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.
1999
2000
2001
Relevance
1 Predictive value 2 Feedback value 3 Timely
Reliability
1 Verifiable
2 Faithful representation 3 Neutral
ILLUSTRATION 7-2
Principals
Revenue recognition Matching Full disclosure Cost
Constraints
Materiality Conservatism
ASSUMPTIONS
1 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. 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 economic events can be identified with a particular unit of accountability. 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
1997
QTR 1 QTR 2 QTR 3 QTR 4 JAN APR JUL OCT
1998
FEB MAY AUG NOV MAR JUN SEPT DEC
1999
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.
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 expended 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 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 Unexpired costs become operating expenses through use or consumption or through the passage of time.
ILLUSTRATION 7-4
Cost Incurred
Benefits Decrease
Asset
Expense
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 are recorded at their cost. Cost is used because it is both relevant and reliable. 1 Cost is relevant because if 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.
CONSTRAINTS IN ACCOUNTING
Constraints permit a company to modify generally accepted accounting principles without reducing the usefulness of the reported information. The constraints are materiality and conservatism. 1 Materiality relates to an items impact on a firms overall financial condition and operations. 2 Conservatism in accounting means that, when in doubt, the accountant chooses the method that will be the least likely to overstate assets and income.
ILLUSTRATION 7-7
CONCEPTUAL FRAMEWORK
CONSTRAINTS
Objectives of Financial Reporting
Qualitative Characteristics of Accounting Information
CONSTRAINTS
ILLUSTRATION 7-8
STANDARD CLASSIFICATION OF BALANCE SHEET The balance sheet is composed of 3 major elements: 1 assets, 2 liabilities, and 3 stockholders equity. Additional segregation within these groups is considered useful to financial statement readers. The following classification breakdown is usually found:
Assets Current assets Long-term investments Property, plant, and equipment Intangible assets Liabilities and Stockholders Equity Current liabilities Long-term liabilities Stockholders equity
INCOME TAX
ILLUSTRATION 7-11
INCOME STATEMENT WITH INCOME TAXES
Note that income before income taxes is reported before income tax expense.
LEADS INC. Income Statement For the Year Ended December 31, 2002
Sales Cost of goods sold Gross profit Operating expenses Income from operations Other revenues and gains Other expenses and losses Income before income taxes Income tax expense Net income $ 800,000 600,000 200,000 50,000 150,000 10,000 4,000 156,000 46,800 $ 109,200
Credit
ILLUSTRATION 7-12
EARNINGS PER SHARE FORMULA NO CHANGE IN OUTSTANDING SHARES Earnings per share (EPS) indicates the net income earned by each share of common stock. Thus, earnings per share is only reported for common stock. The formula for computing earnings per share when there has been no change in outstanding shares during the year is as follows:
Net Income
Number of Shares Outstanding Earnings per Share
ILLUSTRATION 7-13
BASIC EARNINGS PER SHARE DISCLOSURE
Due to its importance, EPS is required to be reported on the face of the income statement. This amount is usually simply reported below net income on the statement. Leads, Inc. has net income of $109,200. Assuming that it has 54,600 shares of common stock outstanding for the year, EPS is $2.00 ($109,200 54,600), and is presented as follows:
Net income Earnings per Share $ 109,200 $ 2.00
ILLUSTRATION 7-14
Total assets
$ 244,000
ILLUSTRATION 7-14
ILLUSTRATION 7-15
CURRENT RATIO FORMULA AND COMPUTATION
The current ratio is current assets divided by current liabilities. With its 2.23:1 ratio, Genlytes short-term debt-paying ability appears to be very favorable compared to reasonable performance standards.
Current Assets
Current Liabilities
Current Ratio
$156,000
$70,000
2.23:1
ILLUSTRATION 7-16
WORKING CAPITAL FORMULA AND COMPUTATION
The excess of current assets over current liabilities is called working capital. For Genlyte Inc., working capital is $86,000, as shown below.
Current Assets
Current Liabilities
Working Capital
$156,000
$70,000
$86,000
ILLUSTRATION 7-17
PROFIT MARGIN FORMULA AND COMPUTATION
The profit margin percentage measures the percentage of each dollar of sales that results in net income and is calculated by dividing net income by net sales for the period. Genlyte Incs profit margin percentage is 3.3% which seems too low compared to reasonable performance standards.
Net Income
Net Sales
$14,000
$430,000
3.3%
ILLUSTRATION 7-18
RETURN ON ASSETS FORMULA AND COMPUTATION
Rate of return on assets is an overall measure of profitability that is calculated by dividing net income by total assets. Genlyte Incs rate of return on assets is relatively low at 5.7% compared to reasonable performance standards which suggests that Genlyte may not be using its assets effectively.
Net Income
Total Assets
Return on Assets
$14,000
$244,000
5.7%
RETURN ON COMMON STOCKHOLDERS EQUITY FORMULA AND COMPUTATION Return on common stockholders equity is a measure of profitability that is calculated by dividing net income by common stockholders equity. Genlyte Incs return on common stockholders equity is quite good at 23.3% compared to reasonable performance standards.
Net Income
ILLUSTRATION 7-19
Common Equity
$14,000
$60,000
23.3%
Total Assets
$184,000
$244,000
75.4%
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