Financial Accounting, 4e

Weygandt, Kieso, & Kimmel

Prepared by
Gregory K. Lowry
Mercer University
Marianne Bradford
The University of Tennessee

John Wiley & Sons, Inc.

 CHAPTER 7
ACCOUNTING PRINCIPLES
After studying this chapter, you should be able to:
1 Explain the meaning of generally accepted
accounting principles and identify the key items
of the conceptual framework.
2 Describe the basic objectives of financial
reporting.
3 Discuss the qualitative characteristics of
accounting information and elements of
financial statements.
 CHAPTER 7
ACCOUNTING PRINCIPLES
After studying this chapter, you should be able to:
4 Identify the basics assumptions used by
accountants.
5 Identify the basic principles of accounting.
6 Identify the two constraints in accounting.
7 Understand and analyze classified financial
statements.
8 Explain the accounting principles used in
international operations.
 PREVIEW OF CHAPTER 7
ACCOUNTING
PRINCIPLES

The Conceptual Financial Statement

Constraints in
Framework of Assumptions Principles Presentation and
Accounting
Accounting Analysis

 Objectives of  Monetary unit  Revenue  Materiality  Classified balance

reporting recognition sheet
 Economic entity  Conservatism
 Qualitative  Matching  Classified income
 Time period  Summary of
characteristics statement
 Full disclosure conceptual
 Going concern
 Elements of framework  Analyzing financial
 Cost
financial statements
statements
 An international
 Operating perspective
guidelines
 THE 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.
 This support usually comes from the Financial
Accounting Standards Board (FASB) and Securities
and Exchange Commission (SEC).
 The FASB has the responsibility for developing
accounting principles in the United States.
 THE CONCEPTUAL FRAMEWORK
OF ACCOUNTING

 The conceptual framework developed by the

FASB serves as the basis for resolving accounting
and reporting problems.
 The conceptual framework consists of:
1 objectives of financial reporting;
2 qualitative characteristics of
accounting information;
3 elements of financial statements; and
4 Operating guidelines (assumptions,
principles, and constraints).
 OBJECTIVES OF
FINANCIAL REPORTING
The FASB concluded that the objectives of financial
reporting are to provide information that:
1 Is useful to those making investment and credit
decisions.
2 Is helpful in assessing future cash flows.
3 Identifies the economic resources (assets), the claims
to those resources (liabilities), and the changes in
those resources and claims.
QUALITATIVE CHARACTERISTICS
OF ACCOUNTING INFORMATION

 The FASB concluded that the overriding criterion by

which accounting choices should be judged is
decision usefulness.
 To be useful, information should possess the
following qualitative characteristics:
1 relevance,
2 reliability, and
3 comparability and consistency.
 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.
 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.

1999 2000 2001

 ILLUSTRATION 7-1
QUALITATIVE CHARACTERISTICS
OF ACCOUNTING INFORMATION

Useful
Financial
Information has:

Relevance Reliability
1 Predictive value 1 Verifiable
2 Feedback value 2 Faithful representation
3 Timely 3 Neutral

Comparability
and
Consistency
 ILLUSTRATION 7-2
THE OPERATING GUIDELINES OF
ACCOUNTING
 Operating guidelines are classified as assumptions,
principles, and constraints.
 Assumptions provide a foundation for the accounting
process.
 Principles indicate how transactions and other economic
events should be recorded.
 Constraints permit a company to modify generally accepted
accounting principles without reducing the usefulness of the
reported information.

Assumptions Principals Constraints

Monetary unit Revenue recognition Materiality
Economic entity Matching Conservatism
Time period Full disclosure
Going concern Cost
 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 1998 1999

QTR 1 JAN FEB MAR
QTR 2 APR MAY JUN
QTR 3 JUL AUG SEPT
QTR 4 OCT NOV DEC
 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
EXPENSE RECOGNITION PATTERN

Operating expenses contribute to the revenues

of the period but their association with revenues
is less direct than for cost of goods sold.
Provides No Apparent
Provides Future Benefits
(Unexpired Cost) Cost Future Benefit
(Expired 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 item’s impact on a
firm’s 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 Elements of
Characteristics of Financial Statements
Accounting Information

Operating Guidelines

Assumptions Principles

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:
 ILLUSTRATION 7-9
PROPRIETORSHIP BALANCE SHEET
 If the form of organization is a proprietorship, the term owner’s
equity is used instead of stockholders’ equity to describe that
section of the balance sheet.
 The Capital account 1 represents the owner’s investment in the
business and 2 is reported in the owner’s equity section of the
balance sheet for a proprietorship.
 Assume that Sally Field invests $90,000 on July 10 to start up
Med/Waste Company.
 The company’s balance sheet immediately after the investment is
shown below.

MED/WASTE COMPANY
Balance Sheet
July 10, 2002

Cash $ 90,000 Sally Field, Capital $ 90,000

 ILLUSTRATION 7-10
PARTNERSHIP BALANCE SHEET

 If the form of organization is a partnership, each partner has a

separate capital account and the owner’s equity section shows the
capital accounts of all partners.
 Assume that A. Roy and B. Siegfried form a partnership on
December 11, 2002 by each investing $60,000.
 The company’s balance sheet immediately after their investments
is shown below.

ROY AND SEIGFRIED

Balance Sheet
December 11, 2002

Cash $ 120,000 A. Roy, Capital $ 60,000

B. Siegfried, Capital 60,000
$ 120,000 $ 120,000
 FINANCIAL STATEMENT
PRESENTATION AND ANALYSIS
The multiple-step income statement for Sellers Electronix,
Inc. in Chapter 5 included the following:
1 Sales revenue section – Presents the sales, discounts,
allowances, and other related information to arrive at
the net amount of sales revenue.
2 Cost of goods sold – Indicates the cost of goods sold to
produce sales.
3 Operating expenses – Provides information on both selling
and administrative expenses.
4 Other revenues and gains – Indicates revenues earned or
gains resulting from nonoperating transactions.
5 Other expenses and losses – Indicates expenses or losses
incurred from nonoperating transactions.
 INCOME TAX EXPENSE
 Income taxes must be paid and reported for
a corporation since a corporation is a legal
entity that is separate and distinct from its
owners.
 Corporate income taxes (or income tax
expense) are reported in a separate section
of the income statement before net income.
NET INCOME

INCOME TAX
 ILLUSTRATION 7-11
INCOME STATEMENT WITH INCOME TAXES

Note LEADS INC.

that Income Statement
income For the Year Ended December 31, 2002
before Sales $ 800,000
income Cost of goods sold 600,000
taxes is Gross profit 200,000
Operating expenses 50,000
reported
Income from operations 150,000
before Other revenues and gains 10,000
income Other expenses and losses 4,000
tax Income before income taxes 156,000
Income tax expense 46,800
expense.
Net income $ 109,200
RECORDING INCOME TAXES

Income tax expense and the related liability for

income taxes payable are recorded as part of the
adjusting process preceding financial statement
preparation. Using the previous data for Leads
Inc., the adjusting entry for income tax expense at
December 31, 2002, would be as follows:

46,800

46,800
 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:

Number of Earnings
Net
Income ÷ Shares = per
Outstanding 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:
 ILLUSTRATION 7-14
FINANCIAL STATEMENTS – GENLYTE INC.

In analyzing and interpreting financial statement

information, 3 major characteristics are generally evaluated:
1 liquidity,
2 profitability, and
3 solvency.
GENLYTE INC.
Balance Sheet
December 31,2002

Assets Liabilities and Stockholders’ Equity

Current assets $ 156,000 Current liabilities $ 70,000
Plant and equipment (net) 74,000 Long-term liabilities 114,000
Intangible assets 14,000 Stockholders’ equity 60,000
Total assets $ 244,000 Total liabilities and stockholders’ equity $ 244,000
 ILLUSTRATION 7-14
FINANCIAL STATEMENTS – GENLYTE INC.

GENLYTE INC.
Income Statement
For the Year Ended December 31, 2002

Net sales $ 430,000

Cost of goods sales 295,000
Gross profit 135,000
Selling and administrative expenses 109,000
Income from operations 26,000
Other expenses and losses 5,000
Income before income taxes 21,000
Income tax expense 7,000
Net income $ 14,000
Earnings per share $ 0.35
 ILLUSTRATION 7-15
CURRENT RATIO FORMULA AND COMPUTATION

 The current ratio is current assets

divided by current liabilities.
 With its 2.23:1 ratio, Genlyte’s
short-term debt-paying ability appears
to be very favorable compared to
reasonable performance standards.

Current Current Current

Assets ÷ Liabilities = 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 Current Workin

Assets - Liabilities = g
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 Inc’s profit margin percentage is 3.3%
which seems too low compared to reasonable
performance standards.
Profit
Net Net
Income ÷ Sales = Margin
Percentage

$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 Inc’s 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 Total Return on

Income ÷ Assets = Assets

$14,000 ÷ $244,000 = 5.7%

 ILLUSTRATION 7-19
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 Inc’s return on common stockholders’
equity is quite good at 23.3% compared to
reasonable performance standards.
Return on
Net Common Common
Income ÷ Equity = Stockholders’
Equity

$14,000 ÷ $60,000 = 23.3%

 ILLUSTRATION 7-20
DEBT TO TOTAL ASSETS
FORMULA AND COMPUTATION

 Debt to total assets ratio is a measure of

solvency that is calculated by dividing total
debt (liabilities) by total assets.
 Genlyte Inc’s debt to total assets ratio is 75.4%
which means that Genlyte’s creditors have
provided about 3/4 of its total assets.

Total Total Debt to Total

Debt ÷ Assets = Assets Ratio

$184,000 ÷ $244,000 = 75.4%

 COPYRIGHT

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 CHAPTER 7
ACCOUNTING PRINCIPLES