Principles of accounting II

CHAPTER THREE
3 ACCOUNTING CONCEPTS AND PRINCIPLES

3.1 Introduction

Financial accounting is covered by standards termed Generally Accepted Accounting Principles.  Note that
the validity of the standards depends to a certain degree on their being "generally accepted".  Principal
standard setting organizations include the following organizations:

Financial Accounting Standards Board (FASB), a private organization, and the most important rule setting
agency, issues Statements of Financial Accounting Standards.

Securities and Exchange Commission (SEC), a government body which can establish and enforce
accounting practices for publicly traded companies

Public Company Accounting Oversight Board (PCAOB), a private sector non-profit organization created
by the Sarbanes-Oxley Act, which regulates accountants and publicly traded companies

The American Institute of Certified Public Accountants (AICPA) has some influence on other standard
setting agencies and on financial accounting in general.

Being the most important rule setting agency, the FASB has developed a conceptual framework, a
constitution, for accounting standards.  This framework consists of four elements as described below.

                3.2 Objectives of Financial Reporting

Financial reporting should provide information that:
1.  Is useful in making investment and credit decisions
2.  Is helpful in assessing future cash flows

3.  Identifies economic resources, claims on those resources, and changes in resources and claims on the

              3.3 Qualitative Characteristics of Accounting Information

to be useful in making investment and credit decisions, accounting information should be:

1.  Relevant: the information should have a direct bearing on a financial decision.  To be
relevant financial information must provide feedback and/or have predictive
value, and are timely. 

2.  Reliable: accounting information free of bias and error.

3. Comparable: accounting information should be comparable firm to firm and year to year
4. Consistent: once adopted accounting procedures should not be changed absent disclosure in the financial
statements.

3.4 Accounting Assumptions

Accounting assumptions provide a foundation for the accounting process and consist of the following:

1. Monetary Unit Assumption 

Only transactions that can be expressed in monetary units/dollars are included in the accounting records. 
Accountants view the dollar as stable and do not adjust for inflation.

2. Economic/Business Entity Assumption    

Compiled by Habtamu T. MU, CBE, DCS 1

Principles of accounting II
Activities of the business entity are kept separate and apart from the activities of the owner.

3. Going Concern Assumption       

Accountants assume that a business entity has an indefinite life.

4. Time Period Assumption           

The economic life of the business can be divided into regular time periods, based on a foundation of the
accounting assumptions.

3.5 Accounting principles

The following accounting principles have been developed directing how business transactions should be
recorded and reported.  

1. Revenue Principle                    

Revenue should be reported when earned which is usually when the product or service has been delivered
to the customer.

2. Matching Principle                   

Expenses should be recorded in the same period as the revenue they generate.

3. Disclosure Principle                  

A company's financial statements should report sufficient information for outsiders to make informed
decisions about the company.  Material facts need to be disclosed!

4. Cost Principle: assets should be recorded at their historical cost.

5. Materiality principle             

Only material items need to be recorded.  An item or event is material if

there is an expectation that knowing about it would influence the users of
financial statements.

6. Conservatism Principle            

When choosing between two equally acceptable procedures, accountants
should choose the one that is least likely to overstate assets and income.

Compiled by Habtamu T. MU, CBE, DCS 2