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Introduction to Accounting Principles

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 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

Cost Principle From an accountant's point of view. It is because of this basic accounting principle that numerous pages of "footnotes" are often attached to financial statements. 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. the amounts shown on financial statements are referred to as historical cost amounts. Full Disclosure Principle If certain information is important to an investor or lender using the financial statements. (An exception is certain investments in stocks and bonds that are actively traded on a stock exchange. 2010. the term "cost" refers to the amount spent (cash or the cash equivalent) when an item was originally obtained. On the income statement for the year ended December 31. 2010 thethree months ending December 31. 4. or the 5 weeks ended May 1. 2010 or the year ended December 31. It is imperative that the time interval (or period of time) be shown in the heading of each income statement. As an example. perhaps to a third-party appraiser. 3. A company usually lists its significant accounting policies as the first note to its financial statements. the amount was not known and an estimate had to be used. 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. The shorter the time interval. asset amounts are not adjusted to reflect any type of increase in value. 2010. For example. 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. whether that purchase happened last year or thirty years ago. statement of stockholders' equity. 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. For this reason. let's say a company is named in a lawsuit that demands a significant amount of money. 2010 the month ending December 31. Because of this accounting principle asset amounts are not adjusted upward for inflation.) If you want to know the current value of a company's long-term assets. 5. 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.transaction are combined (or shown with) dollars from a 2010 transaction. distinct time intervals such as the five months ended May 31. Time Period Assumption This accounting principle assumes that it is possible to report the complex and ongoing activities of a business in relatively short. 2010. If the company's financial situation is such that the accountant . that information should be disclosed within the statement or in the notes to the statement. and statement of cash flows. you will not get this information from a company's financial statements—you need to look elsewhere. the more likely the need for the accountant to estimate amounts relevant to that period. 6. the property tax bill is received on December 15 of each year. as a general rule. Hence. the amount is known. 2010. but for the income statement for the three months ended March 31. 2010. In fact.

Revenue Recognition Principle Under the accrual basis of accounting (as opposed to the cash basis of accounting). 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). a company could earn and report $20. revenues are recognized as soon as a product has been sold or a service has been performed. Materiality Because of this basic accounting principle or guideline. If a company agrees to give its employees 1% of its 2010 revenues as a bonus on January 15. 2011. an accountant might be allowed to violate another accounting principle if an amount is insignificant.000 of revenue in its first month of operation but receive $0 in actual cash in that month. 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. regardless of when the money is actually received.000 of revenue as soon as its work is done—it does not matter whether the client pays the $1.000. 9. (To learn more about adjusting entries go to Explanation of Adjusting Entries and Drills for Adjusting Entries. For example. Under this basic accounting principle. For example. the company should report the bonus as an expense in 2010 and the amount unpaid at December 31. 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. 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. Matching Principle This accounting principle requires companies to use the accrual basis of accounting. The going concern principle allows the company to defer some of its prepaid expenses until future accounting periods. 2010 as a liability. the matching principle directs the accountant to expense the cost over the five-year period. The matching principle requires that expenses be matched with revenues. 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.000 immediately or in 30 days. Because the printer will be used for five years.) 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 expense is occurring as the sales are occurring. Do not confuse revenue with a cash receipt. Because of materiality.) 8. the accountant is required to disclose this assessment.believes the company will not be able to continue on. 7. ABC should recognize $1. the accountant charges the ad amount to expense in the period that the ad is run. financial statements usually show amounts rounded to the . if ABC Consulting completes its service at an agreed price of $1.

Eight different accountants will wholly agree that the original cost of the land was $10. Consistency Accountants are expected to be consistent when applying accounting principles. For example. Reliable. conservatism directs the accountant to choose the alternative that will result in less net income and/or less asset amount. and objective. showing land at its original cost of $10. Because the current value amount is less reliable. and objective amounts involved. if a company has a history of using the FIFO cost flow assumption. if a company has an investment in stock that is actively traded on a stock exchange. verifiable. For example. and practices. Accountants are expected to be unbiased and objective. we have certain expectations of the information they present to us: 1. but potential gains will not be reported. but it does not allow a similar action for gains. accounting information should be reliable.000. We expect the accounting information to be reliable. the company may be required to show the current value of the stock instead of its original cost. you will likely receive eight different estimates. The accounting profession has been willing to move away from the cost principle if there are reliable. or to the nearest million dollars depending on the size of the company. 2. If the company changes this practice and begins using the LIFO cost flow assumption.nearest dollar. the original cost is used. 2. 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. less verifiable. and less objective than the original cost. We expect consistency in the accounting information. The basic accounting principle of conservatism leads accountants to anticipate or disclose losses. If you ask the same eight accountants to give you the land's current value.000—they can read the offer and acceptance for $10. Conservatism If a situation arises where there are two acceptable alternatives for reporting an item. Verifiable.000. For example. and review documents that confirm the cost was $10. that change must be clearly disclosed. procedures. Other Characteristics of Accounting Information When financial reports are generated by professional accountants. but will not write inventory up to an amount higher than the original cost. verifiable. 10. We expect comparability in the accounting information." It does not direct accountants to be conservative. an accountant may write inventory down to an amount that is lower than the original cost.000. .000. to the nearest thousand. verifiable. and objective. 3. verifiable. see a transfer tax based on $10. Also. For example. 1. and objective than showing it at its current market value of $250.000 (when it was purchased 50 years ago) is considered to be more reliable. potential losses from lawsuits will be reported on the financial statements or in the notes. Conservatism helps the accountant to "break a tie. and Objective In addition to the basic accounting principles and guidelines listed in Part 1.

(2) income statement. (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. Let's look below at how accounting principles and guidelines influence the (1) balance sheet. Mary Smith. Generally accepted accounting principles may provide for comparability between the financial statements of different companies. The cost principle requires that the land be shown in the asset account Land at its original cost of $10.000.000 Liabilities Notes Payable Accounts Payable Wages Payable Unearned Revenues Total Liabilities Owner's Equity M. some companies expensed R&D when incurred while other companies deferred R&D to the balance sheet and expensed them at a later date. are not included on the company's balance sheet. Mary's Design Service still owns the land. (In this case. 2010 have been recorded. Mary's Design Service Balance Sheet September 30.Smith.) Because of the economic entity assumption.500 10. and the land is now appraised at $250.000 rather than at the recently appraised amount of $250.000.3. a sole proprietorship owned by Mary Smith. the FASB requires that expenses related to research and development (R&D) be expensed when incurred. and owner's equity at one point in time. that point in time is after all of the transactions through September 30. lenders. 1. and owner's equity specifically identified with Mary's Design Service are shown—the personal assets of the owner.000 325 75 100 1. How Principles and Guidelines Affect Financial Statements The basic accounting principles and guidelines directly affect the way financial statements are prepared and interpreted.000 160 90 10. 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. For example. Balance Sheet Let's see how the basic accounting principles and guidelines affect the balance sheet of Mary's Design Service. Capital $ 1.000. For example. liabilities. . 2010 Assets Cash Accounts Receivable Supplies Prepaid Insurance Land $ 300 1. let's assume that a tract of land was purchased in 1956 for $10.050 $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. liabilities. Comparability Investors. and (3) the notes to the financial statements. only the assets.550 Total Assets $11. Prior to its rule.

) An income statement covers a period of time (or time interval). they are not reported as assets on the balance sheet. For example. 2. For example.If Mary's Design Service were to purchase a second piece of land. Similarly. quarter. their cost will be moved to the Supplies Expense account on the income statement. the amount paid for the trademark will be reported as an asset on the balance sheet of the company that bought the trademark. The cost of the unused supplies remains on the balance sheet in the asset account Supplies. Income Statement Let's see how the basic accounting principles and guidelines might affect the income statement of Mary's Design Service. an income statement will show how profitable a company was during the stated time interval. (This means for the period of January 1 through September 30. (To learn more about the income statement go to Explanation of Income Statement andDrills for Income Statement. Deferring insurance expense to the balance sheet is possible because of another basic accounting principle. If a company actually purchases the trademark of another company for a significant cost. 2010 Revenues and Gains Revenues Gain on Sale of Land Total Revenues and Gains $10. trademarks. 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. Coca-Cola's logo and Nike's logo are probably the most valuable assets of such companies. 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. 2010".000 15. 2010. thegoing concern assumption. The cost principle and monetary unit assumption prevent some very valuable assets from ever appearing on a company's balance sheet. The Prepaid Insurance account represents the cost of insurance that has not yet expired. This complies with the matching principle which requires expenses to be matched either with revenues or with the time period when they are used. 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. trade names.000 5. As the supplies are consumed. such as a year. Mary's Design Service Income Statement For the Nine Months Ending September 30. and logos are not reported on their balance sheets because they were not purchased. but because these were not purchased for a specific cost and we cannot objectively measure them in dollars.000 . yet they are not listed as assets on the company balance sheet. 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.) If prepared under the accrual basis of accounting. or four weeks. month. companies that sell consumer products with high profile brand names. the expired cost is moved to Insurance Expense on the income statement as required by the matching principle. and the sum of the two purchase prices would be reported as the total cost of land. As the insurance expires. a company might have an excellent reputation and a very skilled management team.

requires that a company's financial statements include disclosure notes. not in the land development business. Small business owners should discuss these two methods with their tax advisors. The $30. For example. The $300 selling price will not be included in the company's sales or revenues. 1. For example.000 (land that is shown in the company's accounting records at $25. the company receives an asset (cash of $300) but it must also remove $650 of asset amounts from its accounting records.000 selling price will not be reported as part of the company's revenues.000) Mary's Design Service will report a Gain on Sale of Land of $5.Expenses and Losses Expenses Loss on Sale of Computer Total Expenses and Losses Net Income 8. The notes to the financial statements are considered to be an integral part of the financial statements.650 Revenues are the fees that were earned during the period of time shown in the heading. If the company should sell some land for $30. even if the land could be sold today at a significantly higher amount? Cost Economic Entity Monetary Unit . Mary's Design Service is in the business of designing.) Gains are a net amount related to transactions that are not considered part of the company's main operations.350 $ 6. If the company sells that computer for $300. the full disclosure principle. The Notes To Financial Statements Another basic accounting principle. These notes include information that helps readers of the financial statements make investment and credit decisions. 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 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). The result is aLoss on Sale of Computer of $350. Losses are a net amount related to transactions that are not considered part of the company's main operating activities.000. the company paid to acquire the land. (The matching principle is what steers accountants toward using the accrual basis of accounting rather than the cash basis. let's say a retail clothing company owns an old computer that is carried on its accounting records at $650. 3.000 350 8. 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. Expenses are costs used up by the company in performing its main operations.

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 is associated with this action? Conservatism Materiality Monetary Unit 9. company might write-down the cost of inventory. nearest $1. This is acceptable under which accounting principle/guideline? Conservatism Cost Industry Practices . should select the alternative that will report less profit.3. less asset amount. 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. the accountant 10. This is based upon which principle/guideline? Conservatism Cost Materiality 11. the 8. For example. 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.000. 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. but will not write-up the cost of inventory. or a greater liability amount. 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. Public utilities' balance sheets list the plant assets before the current assets.

Which accounting principle/guideline prevented the company from reporting the $200. This would violate which accounting principle/guideline? Cost Full Disclosure Monetary Unit A company borrowed $100. 2010 and will make its only payment for interest when the note is paid off on June 1.000 to a customer on December 29. The company's 14.000 as a deposit for work that is to begin in early 2011. a company required a customer to pay $200. This action was the result of which accounting principle/guideline? . This complies with which principle/guideline? Cost Full Disclosure Matching Near the end of the year 2010.000. This practice may be acceptable because of which principle/guideline? Cost Matching Materiality A corporation pays its annual property tax bill of approximately $12. $200. During the year. recording it as an asset and depreciating it over its useful life. The 16. At the end of 2010 the company reported the 18.600.000 in one payment each 13. Accrual accounting is based on this principle/guideline. The company's sales terms require the customer to pay the company by January 28. 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. December 28. expensing the entire amount when it is purchased. 2011.000 as a liability on its balance sheet.000 on its 2010 income statement? Going Concern Materiality Revenue Recognition 19. This is an example of which accounting principle/guideline? Conservatism Matching Monetary Unit A company sold merchandise of $8. 2011.A large company purchases a $250 digital camera and expenses it immediately instead of 12. the corporation's monthly income statements report Property Tax Expense of $1. 2010.000 on December 1. 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. On the December 2010 income statement the accountant reported Interest Expense of $600. The total interest for the six months will be 20. A retailer wishes to report its merchandise inventory on its balance sheet at its retail value. This is proper under which accounting principle/guideline? Full Disclosure Monetary Unit Revenue Recognition 15. income statement reported the sale in December 2010. $3.000 is depreciated over its useful life of 10 years rather than 17.

Cost Matching Revenue Recognition .